This interview was done as part of the 2021 Staking Ecosystem Report by Staking Rewards.
The report was sponsored by StaFi Protocol.
Greenfield One: We make long-term bets on early developer teams building towards an open, decentralized and more robust architecture of tomorrow’s web.
Q: How do we ensure and incentivize further decentralization within the staking ecosystem?
A: I would look at decentralization from infrastructure (validator set) and stake distribution point of view. Both the validator set as well as stake distribution across it have to be sufficiently decentralized as to avoid a situation where one staker or a large validator entity amasses enough voting power to single-handedly influence governance proposals, critical cut-off value in PoS networks being 33% of staked tokens.
One of the current bottlenecks contributing to centralization in context for institutional staking are the custodians which for the most part lack sophisticated staking support via limiting the selection of validators one can delegate to as well as limiting whitelabel opportunities. I see this changing over time as the market becomes more competitive, which would allow more flexibility for institutions to delegate to multiple staking service providers.
In terms of fostering decentralization on the validator set level, protocol foundations should support smaller validators and incentivize new validators to come in via grant programs or token lease agreements. Foundations have to be very careful though with regards to treasury staking as this can sway the network economics in one way or another and price out smaller validators or kick them out of the validator set. Incentivised testnets with broad participation are also helpful to bootstrap initial validator set in a decentralized manner.
One of the primary means to decentralize on the stake level is for the larger validators to delegate some tokens to the smaller validators. This can be to some extent achieved on the protocol level by incentivizing even stake distribution across nodes (Polkadot/Kusama). Here initiatives like #KeepStakeDecentralized by Chris from Chainflow are helpful and worth supporting.
Decentralization is a means to an end and is not valuable by itself. The primary outcome of a decentralization is censorship-resistance and high availability of a network. As long as these characteristics are achieved, the network becomes sufficiently decentralized and the additional unit of decentralization we bring into the network does not bring much utility anymore. That means that there is a decentralization sweetspot, with most networks viewing it differently. Solana has been perhaps leading in exploration of where this “decentralization sweet spot” can be.
Q: What are the biggest challenges for Proof of Stake and Staking, that we still have to overcome or may still face?
A: One of the primary concerns of staking, especially given the rise of DeFi, has been the fact that staking yields compete with DeFi yields. Staking yields can be seen as rather stable and risk-free (excluding slashing risks), while DeFi yields are rather volatile and subject to overall market conditions such as demand for leverage in the system, etc. Staking derivatives are here to address this issue as the users would be able to utilize staked/bonded assets in DeFi. Staking derivatives however bring another issue – potential for centralization if the space ends up in a winner-takes-all situation (more on that below).
Structured staking products and staking aggregators could also end up contributing to the centralization by being able to leverage larger pools of capital (if the aggregation thesis plays out).
Recent regulations have put significant pressure on staking providers and the staking industry overall. Some implications might be that staking providers would be recognized as VASPs and would thus require a license. Participating in on-chain governance has also fallen under scrutiny as it can be argued that a validator voting on behalf of its users is exercising certain rights tied to digital assets and thus falls under custodian classification. I feel like most of these regulations have been conducted without the understanding of underlying concepts and business models. Organisations like EBA and its staking working group are working on contributing to the education of the policy makers on staking topics.
Fears of centralized exchanges gaining the major share of the staking market and outcompeting everyone by charging 0% staking fees did not turn out to be very justified as on the contrary, the fees CEXs are on the higher end compared to the broader market.
As the validator whitelabelling industry grows, more transparency would be needed on which infrastructure providers are larger entities utilizing to operate their validators. This, combined with the economies of scale and the ability to charge lower fees of these larger providers could lead to a “stealth-centralization” of the chain where the validators of separate entities are operated by the same provider in the background.
Q: There is a winner-takes-all sentiment emerging around staking derivatives. What do you think about this thesis?
A: One of the main arguments for the winner-takes-all situation in staking derivatives is based on the fact that the token holder will always go for the largest player whose staked token derivatives have the highest liquidity and largest number of DeFi integrations, which in turn would minimize or completely mitigate discount these derivatives might have compared to the original liquid un-staked token. Such centralization might put a lot of power in the hands of such a DAO, from curating the validator set and thus also being able to monopolize MEV extraction. Monopolizing MEV extraction would allow DAO to boost the staker rewards higher than the competition.
Such a prospect of decentralization is obviously not good for the space as no matter how hard we decentralize one part of the stack, if another one is centralized the system ends up being centralized anyways. Our platforms are as much decentralized as their most centralized component. I believe we won’t end up in a winner takes all scenario as the staking space even on one major chain like Ethereum has a large spectrum of players and stakeholders with different interests, investment horizons and risk tolerance. One example could be institutions either not staking assets due to regulatory or a risk-management standpoint or choose to run their own validators in the first place. Capital pouring into staking derivatives space will also not flock to one single project but rather facilitate competition and growth of alternatives.
In his Onion model for blockchain security Hasu argues that the last security layer of a blockchain are social guarantees. In other words once a system approaches such a state that would negatively impact the participants with the vested interest in the system (miners, validators), they tend to decentralize on purpose not to shake the trust in the system. I would imagine a similar forced decentralization system to happen if any of the staking derivatives DAOs would approach gaining a majority network share with regards to staked ETH for example.
I believe the projects like Stakewise with its unique two-token model are a viable alternative to more established ETH2 staking derivatives/pools. Stakewise two-token design splits the principal token and the reward token minimizing IL in AMMs as well as opening for leveraged staking use-cases. Several competing projects are emerging as well so im pretty sure staking derivatives space will remain very hot for months and probably years to come.
Projects like Obol are also an interesting approach on decentralizing the underlying infrastructure below the validators using SSV (secret shared validators) by introducing a coordination layer for ETH staking and avoiding fallouts of single providers having a negative impact on the whole network. We will see how this approach plays out.
Q: Should VC funds run their own validators and/or actively participate in decentralized networks? If yes, how do these two different business models (VC and IT infra/devops) synergize?
A: One of the duties of a VC is to support its portfolio companies and their founders. Network Lifecycle Investment thesis, suggested by Coinfund, argues that Web3 networks go through a typical lifecycle, through which the token and investment character changes. It starts with a typical VC-style investment into an illiquid token or SAFT and later as the network goes live, there is a need to bootstrap its supply side (nodes, validators, keepers, transcoders, LPs, etc.) and assets become liquid and gain utility in the network and can be utilized within it.
Supply side bootstrapping is one of the main challenges new networks face. VCs can participate in that by either leveraging tech infrastructure (nodes, validators) or by bringing in liquidity in form of the acquired tokens bootstrapping TVL and/or initial network security. Some protocols are starting to experiment with merging the two by making validators also LP with their self-bond. These enables synergies as the funds tokens can be productively utilized in the network, earning additional returns, protecting from dilution as well as bootstrapping the network itself.
In the context of validation, a fund can either stake the assets, whitelabel the infrastructure (managed validator) or run one in-house. Staking should be a default option to avoid dilution. As funds get comfortable with staking, they might want to try out managed validators. Here there is a danger of shadow centralization where a lot of validators would look independent, but in reality be operated by the same large validation-aaS entities. The ultimate form of network support would be in-house validators, for which a dedicated devops person might be needed.
Q: What are the core value propositions of liquid staking solutions, besides liquidity?
A: The main goal of the staking derivatives besides liquidity is to avoid the opportunity cost of not being able participate in DeFi and leverage the staked assets.
Staking derivatives and the broader class of staking structured products open up for several use-cases such as being able to utilize leveraged staking or speculate on staking yield speculation, similar to what we can see emerging in DeFi. Being able to speculate on yields can also open up for a fixed-rate staking, where the tokenized future yield is exchanged into more of the principal token giving them a bond-like characteristic.
Q: An increasing portion of miner income on the current Proof-of-Work Ethereum comes from ordering transactions (often referred to as Miner Extractable Value). It is likely to assume that this will also continue into the Proof-of-Stake world. How do you think this will impact the staking market? Do you think the existence of MEV bears risks for the network? Do you think this can be mitigated?
A: As discussed above, the combination of potential centralization on the staking derivatives level and the increasing market share of these might prove to be a fertile ground for centralization of MEV extraction net detrimental to the space.
Generally speaking, here are two schools of thought here, some think of MEV as a core feature of any network and thus the approach to minimize its negative impact on users is to build solutions around it which would maximize fairness. Others regard MEV as a bug which should be mitigated. MEV analogs in traditional finance are illegal, while crypto space operates primarily under “code is law” regime.
We as crypto space need to collectively find our way forward via experimentation and trial and error as the question of fairness is very subjective and oftentimes lands in a rather philosophical domain. Vega is worth pointing out as one of the projects deeply exploring the concept of fairness in the context of derivatives and trading overall.
Q: Which protocol has the best approach towards governance? And why?
A: A colleague of mine Felix Machart recently published a comprehensive post on the long-term incentive alignment (link), where he dissects the case study of Curve and Sovryn and argues for the time-lock weighted token voting approach. The longer the tokens are locked for, the higher the weight (multiplier) of the voter should be. Using the weighted time of lock-ups in conjunction with governance decisions being rather long-term oriented makes sure the incentives are well-aligned.
Q: We have seen a lot of talk about PoW’s energy consumption in recent months. How important is energy efficiency for PoS’ case when it comes to long-term adoption?
A: Quite important but not hard to achieve for PoS chains, some are already carbon-neutral (e.g. Celo).
Q: What is your vision of the staking economy/industry in 5 years?
A: Staking and staking-based financial products will go mainstream. Most of the institutions would offer staking on top of the pure-play custody. As the space is being professionalized and the institutional share is increasing,s o will be the stake ratio.Some banks and more corporates will run validators and provide infrastructure to blockchain networks. Most of the PoS assets will be made liquid via staking derivatives and utilized in DeFi. MEV will become ever more relevant, boosting the staking rewards for stakers.
Q: Ethereum 2.0 – What are you most excited about? What are you concerned about?
A: It is very easy to get excited about Ethereum 2.0, the concerns are more interesting. The primary concern for me is the potential break in DeFi composability with the sharded approach. Another concern, as discussed above would be the danger of centralization in the winner-takes-all environment in case of staking derivatives and the subsequent centralization of MEV capture.
Q: With an increasing market-lead for proof-of-stake based networks. Is there a future for proof-of-work besides Bitcoin?
A: Merge-mining with BTC would probably be the way to go for newer chains which still want to rely on PoW. Adding new revenue streams for BTC miners might to some extent tackle the ever decreasing block subsidy of Bitcoin and emerging long-term network security concerns.