Hashdex Staking

Staking is the process that allows holders of the native token of a Proof-of-Stake (PoS) blockchain – like Ethereum, Solana, or Polkadot – to participate in the network's consensus mechanism by locking up a certain amount of their tokens as collateral.

This flow is essential for the security of a PoS blockchain because it ensures that validators propose and attest to blocks without malicious actions. Validators’ “skin in the game” plays an important role in the network's integrity, incentivizing them to behave with accountability.

In the PoS model, validators are randomly selected by the consensus software to include transactions in new blocks, based on their stake in the network. For this service, they are rewarded with newly minted native tokens and transaction fees paid by network users (also denominated in native tokens). In most PoS systems, the more tokens a validator holds, the greater the likelihood they will be assigned new validation tasks and rewarded for them.

Depending on the PoS blockchain, a validator’s stake may be reduced as a penalty for malicious activities, such as double-signing (when a validator signs more than one block simultaneously) or double-attesting (voting for two different candidates proposed for the same block). This situation is known as slashing. If a validator behaves maliciously, they may lose part of their collateral and, depending on the network, be forced out of the validation process.

Thus, staking reinforces network security, reducing the risk of attacks where a group of validators seeks to control the majority of the consensus power, creating an opportunity to manipulate transactions. With a high enough stake, validators are incentivized to follow the network’s rules and are penalized for any malicious behavior.

Investors have three main incentives to engage in staking:

1. Avoid token dilution: The issuance of native tokens is the economic incentive that drives the development of decentralized blockchains. While this can foster network growth initially, the trade-off is the dilution of each investor’s share due to monetary expansion. Since stakers are responsible for validating transactions on a PoS blockchain, they receive the newly issued native tokens, thus protecting their holdings from dilution over time.
2. Earn real yield: As validation rewards include transaction fees (i.e., tokens that only circulate from the hands of end-users to validators), stakers effectively earn real yield on their holdings.
3. Contribute to network security: Stakers are responsible for providing security to the PoS blockchain they invest in. The more decentralized and capital allocated to a network, the more resilient and reliable the blockchain is, strengthening its long-term prospects and investment thesis.

From Hashdex’s perspective as an asset manager, these factors can meaningfully contribute to the pure buy-and-hold strategy, reducing the dilution of net asset value (NAV), potentially lowering the administrative costs of structured products, and promoting responsible investment management.

When validators add or attest to new blocks on the chain, they receive rewards. These rewards are determined by the consensus algorithm used by the blockchain network. In general, rewards are a percentage of the total value staked, distributed among the validators participating in the process. The specific parameters depend on each token and network but usually involve the following factors:

1. Staked value: The more tokens a user allocates to staking, the greater their potential absolute reward.
2. Network participation: The more validators involved in the consensus process, the lower the reward for each individual validator.
3. Block time: The time it takes to create a new block in the network can also affect staking rewards. A faster block time may result in more frequent rewards, while a slower block time may yield larger rewards per block.
4. Inflation rate: The token's inflation rate is an important factor in determining the reward. While some have a fixed inflation rate, others may adjust it based on the number of validators participating in the network.

To simplify understanding, the calculation below assumes there are no operating expenses and that the staking process only involves locking up assets:

Staking yield = (Block rewards / Total value staked in the network) * 100

Volatility Risk: The price of the crypto asset allocated to staking retains the same market risk as any non-staked crypto asset and is subject to price volatility, which can affect the validator's expected reward.

Liquidity Risk: The crypto asset allocated to staking is subject to a lock-up period while staked. Additionally, after requesting to unstake the crypto asset, it is unlocked according to the network's rules, with the unlocking period potentially being short or long depending on the characteristics of each network/crypto asset. In summary, the asset is not easily accessible or sellable during the staking period, which can impact the investor’s redemption payout.

Network Risk: The staking process involves supporting the operations of a blockchain network, which may be subject to security and stability risks. If the network experiences any security breach, this could affect the price of the crypto asset in question.

Technical Risk: The staking process requires the use of specific platforms or software, which are subject to technical issues. If technical problems occur with these platforms or software, staking rewards may be affected.

Slashing Risk: Some staking systems impose penalties, such as removal or burning of tokens, to discourage malicious behavior or operational errors by validators. If system rules are violated, the validator may lose part of their collateral and, depending on the network, be forced out of the blockchain validation process.

Various crypto assets can be used for staking, including native tokens for blockchains and utility/governance tokens for dApps. The specific list and their respective rewards depend on the protocol and network supporting these assets. Some examples include:

1. Ethereum (ETH) – Ethereum introduced staking as a way to secure the network and earn rewards.
2. Cardano (ADA) – Cardano uses a Proof-of-Stake consensus mechanism, allowing users to delegate their tokens to a staking pool to earn rewards.
3. Polkadot (DOT) – Polkadot uses a staking mechanism called “nomination,” where token holders can nominate validators to participate in the network’s consensus process.
4. Cosmos (ATOM) – Cosmos uses a Proof-of-Stake consensus mechanism that allows users to allocate their tokens for staking, earning rewards and participating in network governance.
5. Tezos (XTZ) – Tezos uses a Proof-of-Stake consensus mechanism, allowing users to delegate their tokens to a baker to participate in the network consensus and earn rewards.

The staking process involves locking a certain amount of crypto assets in a wallet on the network as collateral to participate in the consensus mechanism and validate transactions. This collateral may have minimum requirements, such as a minimum amount of crypto assets or a minimum time during which the stake must be held. The required amount of assets for staking depends on each network. For example, to operate as a validator on Ethereum's Beacon Chain, 32 ETH is required. It is worth noting that each network has the autonomy to change these requirements, such as time and minimum quantity, according to the internal definitions of its community and developers.

The minimum staking period depends on the blockchain or platform being used. When a user allocates their tokens for staking, there may be a lock-up period during which withdrawal is not permitted. The minimum time can vary from a few hours to several months or even years.

Staking rewards depend on various factors, such as the chosen asset, the reward offered by the network, and the amount allocated for staking.

Mining and staking are different ways for a blockchain network to achieve consensus. Both are methods for network nodes to include transactions in the next block, and in both cases, miners and validators have the opportunity to be rewarded for the service they provide to the network.

Mining involves using computing power to solve complex mathematical problems to determine who will validate transactions on the blockchain. Miners are rewarded for successfully including transactions. This process requires specialized hardware and consumes high amounts of energy.

On the other hand, staking is the process through which holders of a native token of a Proof-of-Stake (PoS) blockchain can participate in the network's consensus algorithm. This involves locking a certain amount of crypto assets for a period of time to validate transactions and contribute to network security. Users are rewarded for this service. PoS systems are considered more energy-efficient than PoW systems as they do not require such intense use of computational resources.

Delegated staking, also known as Delegated Proof-of-Stake (DPoS), is a variation of the Proof-of-Stake (PoS) consensus algorithm. In a delegated staking system, token holders can delegate staking to a validator, who is responsible for validating transactions and creating new blocks on their behalf.

Delegated staking is designed to address potential PoS issues, such as power concentration in a small group of participants. By allowing token holders to delegate the staking process to a trusted validator, even those with small amounts of assets can participate in the network and earn rewards.

Delegated staking also helps increase the speed and efficiency of transaction validation and block creation by reducing the number of participants directly involved in the process. By delegating staking to a validator, token holders can avoid active participation in the network while still earning rewards.

Choosing a validator for crypto asset staking is an important decision that can impact returns and investment security. By investing in crypto through funds managed by an asset manager like Hashdex, investors benefit from its expertise and due diligence regarding best practices in staking. Some factors to consider when choosing are:

1. Reputation and track record;
2. Technical expertise in operating and maintaining the security and reliability of nodes;
3. Fees;
4. Communication and transparency regarding strategy and performance;
5. Engagement with the community and stakeholders;
6. Protection against hacker attacks and other threats.

Depending on the PoS blockchain, a validator's participation may be reduced as a penalty for malicious activities—such as double-signing (when a validator signs more than one block simultaneously) or double-attesting (voting for two different candidates proposed for the same block)—or for operational errors. This situation is known as slashing. The validator may lose part of their collateral and, depending on the network, may be forced out of the blockchain validation process. This mechanism is designed to ensure network security.

Both staking and lending use crypto assets to earn returns, but staking is a concept native to the crypto markets, while lending is common in traditional finance. These two mechanisms also differ in their potential risks. The staking process involves locking crypto assets to support a blockchain network operation. Stakers receive rewards in the form of tokens for this service. On the other hand, lending is the process where users lend their crypto assets to provide liquidity to the network. In return, lenders receive interest payments to compensate for the use of their assets for a certain period, as well as for the risk of default.

Staked crypto assets can be lost in the event of slashing or if the network suffers hacker attacks or other security breaches. Additionally, stakers are subject to market risk, as the price of the asset is volatile. If the value of the crypto asset drops significantly, stakers may lose capital upon redemption.

In some cases, a blockchain network failure could result in the total loss of staked crypto assets. This could happen if the network experiences a hacker attack or another security breach that results in the loss of all funds, or if the network ceases to operate due to technical issues. In other cases, staked crypto assets may be returned to stakers even in the event of a failure. For example, if the blockchain network is designed with a mechanism that automatically returns the assets in failure events, users may be able to recover their funds.

Staking is an important mechanism in the development of crypto assets for several reasons:

1. Security: Staking contributes to the security and integrity of the blockchain network by incentivizing participants to validate transactions and penalizing them for malicious behavior or operational errors.
2. Governance: Staking can be used to facilitate decentralized governance models, where holders of an asset can vote on network proposals. This ensures that decisions are made transparently and democratically, without the need for a central authority.
3. Energy efficiency: Staking contributes to the blockchain network's energy efficiency by reducing or replacing mining activity, which is energy-intensive.
4. User rewards: Staking offers rewards for crypto asset holders who validate transactions on the network. This incentivizes users to participate in block inclusion on the network, thus increasing adoption.
5. Token economics: Staking is a central element of a blockchain's economy, as it helps regulate the supply and demand of the native token while ensuring that participation incentives are aligned with the network's objectives.