Staking-as-a-service is not a commodity

PROOF-OF-STAKE

Staking-as-a-Service is not a commodity
by Max Fiege

MAY 21, 2019, 3:33PM EDT  ·  9 MIN READ

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Industry analysts predicting the commoditization of Staking-as-a-Service providers fail to account for the development of special interest groups in networks with formal on-chain governance
Potential contentious issues include: treasury allocation, technical development and staking thresholds
Max Fiege is a cybersecurity consultant based out of San Francisco whose previous work for the Block focused on Proof-of-Work energy consumption. Follow him on Twitter @fiege_max

A boom of “picks and shovels” companies catering to Proof-of-Stake cryptocurrencies has emerged as a leading market narrative for 2019. At the center of this burgeoning industry lies the Staking-as-a-Service model, a product of protocols like Tezos, Decred, and Cosmos mandating a minimum threshold amount for asset staking. Like pools aggregate hashrate across miners on Proof-of-Work networks, these companies allow smaller holders to delegate their stake in return for a commensurate share of the block reward.

Given this parallel, analysts anticipate that the Staking-as-a-Service industry will succumb to a race to the bottom as companies undercut each other’s fees in providing a commodity service. Their commentary, however, fails to account for the role staking plays in the governance of these networks. We should expect that the political dimension of staking will result in a different outcome, in which Staking-as-a-Service companies evolve into special interest groups which then charge a premium for their sway over a protocol’s direction.

The politics of Proof-of-Stake
All networks that rely on either Liquid Proof-of-Stake (LPoS) or Proof-of-Stake (PoS) implement a minimum threshold for the amount required to stake as a validator. Holders that do not meet this threshold have the ability to delegate or pool their native asset to an existing validator – in doing so, they endow the recipient with their voting share of the total network.

The table below illustrates the degree to which these thresholds preclude the majority of holders from staking themselves. Do note the following caveats:

The threshold for Cosmos is dependent on being within the top 100 of network validators. At the time of writing, 10,000 ATOMs put one in the bottom quartile of these validators.
The threshold for Decred is dependent upon “ticket price,” a number that measured at 120 DCR at the time of writing.
Polkadot has yet to go live with its mainnet, and we can only estimate the market price for DOTs on the basis of its IOU market.
Tezos recently voted to decrease its minimum threshold for baking from 10,000 XTZ to 8,000 XTZ, a change that will go into effect this summer.


While both the dollar value and native amount thresholds for staking on these networks fluctuate, they purposefully skew to some upper stratum of the holder distribution. These thresholds normalize block propagation times (i.e. the more validators, the longer the block time) and ensure that validators are profitable. Their second-order effects incentivize holders to delegate or pool so as to negate the inflationary impact of staking yield and/or to have a say in governance.

That latter effect distorts what would otherwise be a commodity market for Staking-as-a-Service. Having a say in governance means different things for different networks, but the value implied has already proven itself significant for a number of them:

Decred: With 10% of all block rewards earmarked for the Politeia treasury, ticket-holders can submit, and subsequently vote on, funding proposals. They currently have ~610,000 DCR, or $15 million, in dry powder for any purpose the community sees fit to fund (e.g. core developer salaries, conference travel). Holders who cannot afford a single ticket can pool their DCR with Voting Service Providers (VSPs) to earn proportionate voting representation and staking yield.
Tezos: Bakers (i.e. validators) vote on up to 20 possible amendments per proposal period, which lasts for ~24 days during every ~96 day cycle of the Tezos governance mechanism. Unlike Decred ticket-holders, they do not have a treasury from which to draw capital; rather, specific proposals can include invoices for inflation funding separate from the annual 5.51% block reward rate.
Cosmos: Validators can submit a proposal at any point, but 512 ATOM from any source must be supplied before it can undergo a two-week voting period. Validators receive a refund for successful proposals, but lose their contributions to vetoed proposals, which are instead submitted to a community pool reserved for improving the “security, utility and value of the Cosmos Network.” Currently, validators have no way of accessing or deploying capital from the community pool, but early governance conversations indicate a preference for a mechanism similar to Politeia.
Just as companies advocate for friendly business regulations with government relations efforts, the teams and projects building on these networks will seek influence over governance proposals. They will need proper management of their own treasuries, buy-in from their members and supporters, and recognition on community forums in order to minimize the structural risk posed by protocol changes and public fund windfalls. The act of delegating or pooling one’s stake becomes political in such an environment: to contribute to one validator actively undermines the ability of any other to force their respective will.

The evolution of Staking-as-a-Service
Whereas choosing one honest mining pool over another has market-level implications, delegating to a specific validator or staking pool has network-level implications. In the case of the former, your decision has allocated marginal block reward shares from one pool to the other; regarding the latter, your decision could be the deciding vote in the liquidation of the community fund. One can argue that the Ghash.io mining pool incident of 2014 is evidence to the contrary, but that misses the point that Proof-of-Work commoditizes, whereas Proof-of-Stake politicizes, over time. For this reason, we should not expect Staking-as-a-Service companies to develop as mining pools for Bitcoin have.

We should instead look to the emergence of political organizations in traditional societies. This framing suggests that holders will tolerate economic rent-seeking in support of a response to an initial existential threat, and then accept it as the status quo as time goes on. Some examples of this:

Tithing in the early Catholic church under the yoke of Roman persecution persisted throughout its medieval golden age.
Union dues have increased as a portion of salary despite worker protections being written into law.
De facto party dues are expected of ranking members over the course of their term.
American Medical Association was founded in part to lobby state and federal governments for standardized healthcare legislation and regulation, and has now grown into a professional organization.
This raises the question: what will lead to the formation of such political entities “on-chain?” It remains too early to tell for now, as nascent competition among Staking-as-a-Service providers combined with relatively high staking yields indicate fee prices are still above break-even. The trigger for this event – when the first validator or pool markets itself to a specific holder demographic – will occur when a contentious governance proposal strikes during a period of market saturation. Following that, it’ll only be a matter of time as validators and pools realize they can charge a 5-10% fee instead of 1% by aligning themselves with some specific ideology. As that model ultimately gains traction, new holders will find themselves obligated to pledge to some organization or another if they want to engage in more than just asset speculation.

We can consider some contemporary conflicts to imagine what such an event might look like:

Treasury Allocation: As treasuries on networks like Decred and Cosmos expand in perpetuity, the gravity of any singular funding proposal will decrease. Should a network survive past the decade mark, it will very well have billions in dry powder capital to allocate as its holders see fit. Whether their funds get used for public goods (e.g. scaling R&D, open-source hardware production) or an all-expenses paid cruise for the top 100 holders is entirely up to a public forum. A staking service that levies a minimal up-charge to uphold a mandate for pragmatic capital allocation voting could tap into holder anxiety as a result.
Core Developer Sentiment: A network like Tezos allows for holders to vote on proposed protocol-level changes. In the early days of the network, the majority of technically-significant proposals made come from what one might consider to be a core developer team (e.g. Nomadic Labs). However, as the network matures, the risk that inexperienced or malicious developers gain traction for compromising changes grows. To mitigate this risk, a core developer team could leverage its reputation by running a validator or pool with heightened fees to fund itself.
Staking Thresholds: Current Proof-of-Stake networks are taking a wide variety of approaches to the issue of validator pools. They range on a spectrum from Ethereum requiring 32 ETH to Tezos requiring 8,000 XTZ and Cosmos simply cutting off any address beneath the top 100. As iteration results in a clearer consensus around what the ideal threshold is in practice, other networks will want to adopt the rules of the optimal one. Their might be holder resistance to this, however, if expanding the validator pool threatens the incumbents’ staking fee revenues. In this case, an enterprising pool or validator could seek to coordinate on behalf of marginal holders who don’t mind paying a higher fee in anticipation of becoming a validator upon the proposal passing.
These three examples highlight not only how political activity will emerge for Proof-of-Stake cryptocurrencies, but why it is necessary for long-term network sustainability. They show how the decision to delegate one’s stake grows more serious over time, which lies in contrast to the concept of anti-fragility pushed in the Bitcoin community. That is to say, the attack surface of a dominant Proof-of-Work cryptocurrency shrinks over time, while that of a Proof-of-Stake one grows over time. This need for political coordination results in a deadweight loss to the network in the form of staking fees, akin to lobbying or patronage in traditional political systems.

So, Proof-of-Stake brings politics on the blockchain: now what? In the near term, large exchanges like Coinbase and Binance will probably dominate, given that they can stomach staking being a loss-leader while most holders are apathetic about early stage governance. But just as Bitcoin has reenacted the history of money in real time (digital gold, wildcat banking, oh my!), we should anticipate that the dominant Proof-of-Stake cryptocurrency will do the same for political organization. Even for a network like Ethereum 2.0, which has no on-chain governance mechanism, the threat posed by a hard-fork does not necessarily decrease over time like it would in a Proof-of-Work system. Whether developers can design systems that can outlast remains to be seen; after all, what’s the average lifespan of a currency or a country?