Understanding risk management in PoS networks
Not all networks are created equal
2019 is touted as the year of staking, with dozens of heavily funded Proof-of-Stake (PoS) networks going live or nearing launch. Although they bring with them exceptional growth potential, they also create new responsibilities for token holders that come with their own set of risks. It is essential for investors to be involved in the security and the governance of these networks, but not before understanding the underlying staking mechanics and economics, which differ greatly from one network to another.
Break Rules, Get Punished
A slashing is an event where the validator forfeits a defined proportion of staked tokens, which are then burned or redistributed to other stakeholders. To better understand slashing risks, let’s first detail what can be considered punishable behavior in a PoS environment. There are two main actions that may trigger punishment, based on the protocol rules: downtime and double-signing.
Downtime (aka an uptime violation) depends on the “liveness” of the validator: if the node is not signing transactions for X amount of time (where X varies depending on the network parameters), it will be considered inactive and may start losing out on block rewards. After a certain threshold Y is crossed, it might also be slashed, resulting in a permanent loss of stake and the potential suspension from the validator set. This can happen when a node’s cloud infrastructure goes down, or if the software becomes out of sync, for example.
More importantly, double-signing, or the action of signing two blocks at the same block height, is more severely punished by protocol parameters. This can either happen when an adversarial validator is trying to attack the network or because of a poorly set up redundant infrastructure, leading to one key signing the same block twice.
Different networks, different punishments
Most PoS networks have a combination of slashing parameters and with varying degrees of severity. Some networks will not punish any of those actions and will rely on opportunity costs and validator reputation to create an efficient delegation market, while others will punish one or both violations. Although less frequent, we also see scenarios where delegators are not at risk of any of their chosen validator’s actions, leading to a safer environment for delegation, potentially at the cost of establishing and maintaining a robust validator ecosystem. If delegators are not incentivized to select validators that operate securely or validators that contribute to the network and charge non-zero fees, professional operations will lack the resources and income necessary to bring more value to the network, hindering its growth.
In order to understand the extent of the parameter variations between the different chains, we look at nine networks that are either live or are expected to launch their mainnets in the next few weeks.
Networks that don’t slash
Starting with the most delegator-friendly networks, Aion, Algorand, and Tezos stand out as they do not punish delegators at any time, although Tezos does include slashing for validators. Tezos’ non-punitive approach to delegating, while still requiring an initial 21 day period before generating rewards, may be one of the reasons behind a high stake rate (over 70%), but more data would be required to conclude which factors influence staking participation the most.
Networks that do slash
At the opposite end of the spectrum, we find that Cosmos, Livepeer and ICON have opted for a higher degree of severity to make both delegators and validators accountable for protocol violations made by the validator. While Livepeer’s currently high inflation (145%+) may alleviate some of the token holders’ anxiety regarding staking risks, Cosmos is operating in a similar rewards environment as Tezos, despite having one of the highest double-signing slashing parameters. Although retail token holders often do not take the time to understand the implications of slashing, we have seen many institutional investors stay on the sidelines while they collect enough data to structure a proper risk management strategy. It will be interesting to see if, with more validator data points, institutional holders will be more comfortable to stake on these novel networks.
Many new networks, such as Polkadot, Solana, Skale, Oasis, Celo, and Near will be launching in the following months and will be looking to build on existing incentive designs to find the right balance between disincentives and incentives for delegators and validators alike. We have been impressed by the way many teams have been analyzing the current behavior of stakeholders on live networks and are leveraging validators’ knowledge to optimize their parameters before launch. While Proof-of-Stake is still in an experimental phase, new emerging standards driven by interactions with stakeholders should drive these networks forward.
The importance of risk management
As token holders and portfolio managers, we believe you should have an accessible way of understanding the intricacies of the various networks you are involved with and easily assess the tradeoffs between slashing risk and reward generation.
Figment is developing solutions to help its Prime clients establish proper risk management for staking and quantify the risk taken when choosing a validator. For more info, reach out at email@example.com.