How to deal with crypto staking risks as a professional investor
If you’re a cryptocurrency investor you’ve probably heard a lot recently about Proof of Stake, a blockchain consensus mechanism that allows investors to stake their tokens for the right to validate new block transactions and receive a reward in return.
The headline numbers tell their own story. In the first quarter of 2022, annualized staking rewards hit their highest level at just under $15 billion, an increase of 57% from the previous year. In total, Proof of Stake assets had a 30% share of the total crypto market cap (49% if you exclude Bitcoin).
Why is Proof of Stake so popular?
Firstly, if you’re holding cryptocurrencies already, but not diversifying into Proof of Stake assets, you could be missing out. That’s because the reward paid to stakers is primarily made up of new tokens. Any portion of unstaked tokens is continuously shrinking relative to the total supply.
Then there’s the sustainability angle. The alternative consensus mechanism, Proof of Work, consumes vast quantities of electricity as miners compete to solve complex mathematical equations. According to the New York Times, Bitcoin’s annual energy consumption is 0.5% of all electricity consumption worldwide. Proof of Stake requires a minute fraction of this energy.
In addition, the Proof of Stake ecosystem has matured significantly in the past few years. Investors can stake with a growing number of professional organizations including custodians, exchanges, and institutional-grade validators. These organizations offer a variety of staking services that vary by token type, lock-up period, and local regulations. Making the right choice when selecting a partner will ensure that any Proof of Stake strategy aligns with your investment goals and those of your clients.
Managing liquidity risk when staking
What about risk? Before you launch into Proof of Stake, it’s important that you understand these factors and how they can be mitigated. Take liquidity risk. Most staking opportunities require the investor to lock their tokens for an agreed period, from hours to days, or even months. Whichever way the market turns during this time, your assets will be out of reach.
But there are more flexible alternatives. These include liquid staking, whereby your stake is added to a liquidity pool and in return, you receive a new token that represents your share. Tokens can be used both on the native platform and other decentralized finance apps. It’s a smart way of building trust and governance into the blockchain ecosystem while maintaining adequate liquidity for the trading wheels to turn.
What are staking ‘slashing’ risks?
The other important risk is ‘slashing’. The Proof of Stake consensus mechanism requires participants to behave responsibly for the overall good of the ecosystem. For this reason, blockchains penalize validators if they step out of line, by slashing the value of their stake. The two most common offenses are double-signing or going offline when the validator should be available to confirm a new block.
The best protection against these risks is to work with an institutional-grade validator that protects against double-signing and downtime. Many also offer insurance in the unlikely event that their services are compromised. Finoa, for example, works with well-established validators including Blockdaemon, Figment, and Chorus One.
Investors should also focus on established custodians that offer a broad choice of staking currencies from the 200 or so currently available. Make sure you choose a partner that curates a broad selection of trusted tokens that vary by price, market capitalization, and volume.
Diversifying by jurisdiction
If you’re thinking of getting into staking, it’s also worth researching the most crypto-friendly countries or territories for your investment. Until recently, the U.S. and Singapore led the way but the past year has seen European countries climb up the ranks, with Germany emerging as the most crypto-friendly country in the world.
Why Europe? In 2020, the European Parliament's economic and monetary affairs committee passed the proposed Markets in Crypto Assets (MiCA) framework. This legislation aims to support innovation and fair competition for the crypto economy while protecting investors and private consumers.
Germany was one of the first countries in the world to establish a legal framework for financial institutions enabling them to custody crypto assets under the German Banking Act. (Based in Berlin, Finoa is provisionally licensed as a financial services institution and so operates under the same legislation in Germany).
Germany’s crypto-friendly reputation was further enhanced by a Coincub survey at the start of 2022 that saw the country take the top spot above Singapore, the U.S., Australia, and Switzerland. Germany’s rise is based on new legislation that enables Germany’s long-term domestic savings industry to invest in crypto, including staked assets.
The country has also established a zero-tax policy on long-term capital gains from crypto and in relation to income tax, recently announcing that “for private individuals, the sale of purchased Bitcoin and Ether is tax-free after one year”. Meanwhile, the number of German Bitcoin and Ethereum nodes is second only to the U.S.
To sum up, Proof of Stake has enormous potential while offering a more sustainable alternative to Proof of Work. Like any investment there are risks, but there is a flourishing ecosystem of validators and custodians who can help mitigate against them. Add to this the number of governments introducing crypto-friendly legislation and there’s never been a better time to make Proof of Stake a part of your investment strategy. If you want to diversify your crypto investment or are looking to invest in cryptocurrencies for the first time, now is the moment to give Proof of Stake your full attention.
To find out more about crypto-staking and how to make the most out of it, contact the team at Finoa.