On Staking: A New Mechanism for a New Asset Class
Why the Social Characteristics of Staking Make it More than a "Productive Asset" Meme
Cryptoeconomics describes the combination of financial incentives and cryptography - an alliance between human and non-human actors - that forms the foundation of trust in blockchain-based networks. Cryptoeconomics is an essential part of DeFi, as DeFi builders and users envision a new financial system without banks - the traditional, centralized pillars of trust.
Accordingly, the action of “staking” has become a key element of cryptoeconomic systems. Broadly speaking, staking requires an actor to deposit cryptoassets into a smart contract in order to gain some reward or functionality. Staking represents another way to earn income on tokens either at the blockchain layer (layer 1) or the application layer (layer 2).
Because staking generates yield, it has become one of the ways to turn tokens into “productive assets.” However, staking serves a much greater purpose within cryptoeconomic systems, as it has become an important social signal between users and protocols. Staking can help build confidence in a protocol, accrue reputation to a user’s digital identity, and grow a community.
In this essay, I explain the different functions of staking, how staking can be an important mechanism in strengthening the social layer of blockchains and blockchain-based applications, and how to better leverage this novel transaction in order to create long term value for DeFi and the broader crypto industry.
LAYER 1 VS LAYER 2
The staking mechanism has different use cases and implications depending on the environment it is deployed in.
For layer 1, staking grants cryptoeconomic actors certain rights - rights that come with conditions, as well as potential rewards. For example, with proof-of-stake (PoS) consensus systems, transactions are included in newly created blocks by validators chosen according to their “stake,” or the amount of tokens they have deposited. Compared to proof-of-work, where miners compete with computational power for the right to create new blocks (and collect the resultant block rewards and fees), validators compete with the amount of the blockchain’s native token they have deposited in the network’s staking contract. The staking mechanism enables these participants to contribute labor, in the form of providing security to the network. While validators stand to gain a percentage of their stake from performing honestly (and including only valid transactions in blocks), a portion of their staked tokens can also be slashed if they exhibit malicious behavior that comprises network integrity. This behavior can range from operating with tremendous latency to attempting a double-spend attack. Thus, economic incentives, in addition to cryptographic assurances, help protect the network from adversarial actors.
On layer 2, DeFi protocols leverage staking mechanisms to help direct various outcomes. In the case of Sushiswap, tokenholders stake SUSHI to receive a portion of all trading fees accrued by the decentralized exchange (DEX). On the other hand, staked AAVE tokens serve as a backstop for the protocol, or “collateral of last resort.” If the money market protocol Aave suffers a liquidity event, a portion of the staked tokens is then sold to protect depositors and secure the protocol, a risk which is compensated with rewards allocated by the staking mechanism. Lastly, OlympusDAO uses staking as a way to bootstrap their new monetary base asset, OHM. Stakers are rewarded through increases in OHM supply called “rebases.” More importantly though, staking has strengthened the Olympus community, as stakers are welcomed as a part of the “Ohmies,” a group of like-minded participants incentivized by financial reward and galvanized by a collective identity.
Here we begin to see that, in addition to turning tokens into “productive assets,” staking functions more fundamentally as a social mechanism.
A SOCIAL MECHANISM
I have spoken before about how the value of cryptoassets exists on a social layer. In my opinion, staking strengthens the social layer of blockchains and decentralized applications by enhancing public perception, building trust, and growing communities. Addressing layer 2 specifically, I would like to highlight three DeFi applications that have shaped this vision of staking as a social mechanism: OlympusDAO, Curve, and Alpha. Each project has leveraged staking to yield a stronger community and more sustainable growth.
As mentioned above, the explicit use case of staking on Olympus is to evenly distribute rewards to stakers through newly minted OHM tokens. This has greatly rewarded those early adopters willing to shoulder the risk inherent in growing a new monetary base asset. In addition, anyone familiar with OHM (or DeFi for that matter) knows that staking in the OlympusDAO community has become synonymous with “(3,3)” - the optimal collaborative strategy within a payoff matrix. If everyone stakes, no one sells, and everyone profits. As a result, “(3,3)” shows up in people’s Twitter or Discord handles, indicating them as an OHM staker, an “Ohmie,” and a believer in the future of the Olympus protocol. This collective identity has resulted in one of the strongest communities in crypto.
At first glance, staking on the DEX Curve looks like a financial incentive mechanism only. Depositing the native token, CRV, in Curve’s time-locked contract earns boosted CRV rewards, as well as the right to vote in protocol governance. The longer you lock your tokens, the greater the rewards and voting power. Thus, in addition to the desire to earn more CRV, staking CRV also reflects an actor's confidence in the protocol, as the time-lock contract extends out to a maximum of four years (almost a lifetime in crypto!). In return for paying out the associated CRV rewards, and thereby inflating the protocol’s token, Curve ensures that those with the strongest conviction receive the highest share of CRV supply. This helps align participants towards the long term success of the protocol.
For multiple reasons, Alpha Finance has been perhaps the most creative when it comes to deploying a staking mechanism on their platform. First, depending on the total amount of ALPHA a user has staked, they are assigned a tier, which unlocks additional utility within the application. Second, Alpha has been one of the first projects to blend NFTs with DeFi, issuing a diamond hands NFT to long term stakers. This action came right after a dramatic decline in token prices, and thus, the NFT reflected the extreme conviction required to stake ALPHA (and not sell) during a particularly uncertain time in crypto markets. Both the Alpha tiers and diamonds hands are a way of assigning reputation to users and, combined with financial incentives, help grow the community. Lastly, in addition to a portion of protocol revenue, stakers are also rewarded with airdrops of tokens from projects launching on the Alpha Launchpad. The community of Alpha stakers is thus introduced to the project, helping to bootstrap the network of the nascent application.
MAXIMIZING CRYPTOECONOMIC POTENTIAL
So far, staking mechanisms have been primarily designed with characteristics that aim to increase the amount and duration of tokens staked, and thus, decrease the amount of tokens available to sell. For example, financial rewards and voting power that increase the longer the token is staked, as in the case of Curve, or longer “cool-down” periods after unstaking during which the token may not be exchanged, in the case of Aave or Alpha. These functions alone do not take advantage of staking’s full potential.
Staking can and should be leveraged to ensure long term interest alignment between a project and its community of stakers, not just maximize the amount of tokens staked. In addition, staking should help improve public perception of the token, protocol, and community. What follows are recommendations to help develop a staking program that maximizes the effectiveness and value of cryptoeconomic systems.
Staking should incentivize active participation in the protocol, and perhaps punish passive “rent-seeking” through inflation. Just holding (and not selling) a project’s token does not contribute significant value, and thus, should not be rewarded by a project that would be better off directing the funds toward growth. Rewarded contribution can be as simple as staking an LP token (as Aave allows), rather than the token itself, in order to prove that you actively provide liquidity. This model can be applied to other activities as well, from taking part in governance processes to frequently using the application. This way, staking becomes a new form of proof-of-work within individual ecosystems, with stakers receiving rewards based on the value (“work”) they contribute. The type of contributions incentivized should be defined on a protocol-by-protocol basis and can reflect any activity the community deems most value-added. This model reinforces the cooperative structure of crypto networks, whereby individual actors can generate capital and ownership by providing “labor.”
Staking can also be an important mechanism for managing reputation across Web 3.0. This applies to both the reputations of the protocols and the users. Because depositing tokens in a protocol, instead of outright holding them, takes some confidence in that protocol, the amount staked on a platform can boost its public image. This is why we already see major protocols prominently displaying the percentage of their native tokens staked on their platform. And this process of reputation accrual can also be applied to stakers. In proof-of-stake blockchains, validators accrue reputation based on uptime, latency, and honest performance. This reputation can be used both to boost rewards, as actors looking to delegate their stake target those with the best reputation, and reduce rewards, as adversarial behavior is punished by stake slashing. Similarly, staking on DeFi applications should be used to assign reputation to the stakers. This can be implemented similar to degenscore, but instead of valuing how many different projects a user has “aped into,” the assigned reputation should reflect the amount or duration of their stake in various projects. This reputation can help indicate the long (or short) term orientation of users and should be fungible across platforms, allowing it to be considered while allocating rewards in future airdrops or distributing governance power in new projects.
An area that requires additional research and experimentation is the integration of NFTs in DeFi. NFTs are another way to assign and communicate reputation in Web 3.0, thereby strengthening the effects of staking as a social mechanism. Zapper, a DeFi dashboard, illustrates an interesting path forward here, enabling users to claim NFTs after completing certain tasks on their platform. In this way, stakers could claim individual NFTs based on goals the protocol assigns, including duration staked or amount of value-added by stakers (with metrics defined by community governance). As stated earlier, Alpha has already issued an NFT to users who staked the ALPHA token through a period of increased volatility. However, this example is just the beginning. With NFTs increasing in cultural and social significance, we will continue to witness their increased presence throughout DeFi in the near future.
CONCLUSION
While staking has turned into a meme for transforming tokens into “productive assets,” it continues to play a role of growing importance in complimenting cryptographic security assurances and supporting trust assumptions. By directing financial rewards and assigning reputations, staking further strengthens and secures the social layer of blockchains and decentralized applications.
Fundamentally, staking increases the socially-perceived value of a protocol - a function we are currently witnessing in the case of Ethereum. Staking the ETH token on the beacon chain is the beginning of the blockchain’s transition to proof-of-stake. But perhaps more importantly, becoming a validator on the beacon chain requires staking a minimum of 32 ETH, which is locked until ETH 2.0 is up and running at some time in the indefinite future. As this is a significant financial investment full of risk and uncertainty, the action of staking on the beacon chain projects a huge amount of trust in the Ethereum development team and confidence in the protocol. The amount of stake currently locked in the deposit contract says everything you need to know about the Ethereum community’s confidence in the network.
Staking is mutually beneficial, as it helps to build the public image of the protocol, while enhancing the reputation (and earning potential) of its users. Acknowledging that staking is more than just a way to make cryptoassets productive, and taking advantage of the inherently social characteristics of staking, will allow this new mechanism to contribute tremendously to crypto’s growth as an industry.