Sesterce’s take on: Why the mining industry has turned its back on PoW?

Insights

A 3 part series :

Part 1 : Myths about PoW energy consumption and lack of efficiency (JULY)

Part 2 : The business of “Staking” (August)

Part 3 : Witnessing the next flippening, PoW vs PoS (September)

This is the second part of 3-part series dedicated to PoW and PoS, if you haven’t read part One we strongly recommend that you do before reading this article.

We are going to show I) How PoS project have risen from the ashses of the 2017 bubble and have become the new norm in the industry, favored by traditional medias as the miracle solution to the PoW problem. We are going to study II) What make PoS so appealing to the public, but also to institutional investors looking to diversify their portfolios as the market outlook for bonds and traditional equities seems uncertain. Finally, III) We’ll dive into the race for the development of new financial services related to Staking in order to understand what’s at “stake” (pun intended) for exchanges and investment funds

Part II: The business of Staking

I) A) The exponential rise of PoS

As we’ve seen last week, a growing narrative within the ecosystem is pushing the idea that Proof-Of-Work is a bad system that will inevitably fail in time. The most common proposed alternative is Proof-Of-Stake or PoS. (In this article we will also cover Delegated PoS, but overall both fit the same narrative)

The most common way of defining PoS is :

“A system that requires the user to show ownership of a certain number of cryptocurrency units. The creator of a new block is chosen in a pseudo-random way, depending on the user’s wealth, also defined as ‘stake’. In the proof of stake system, blocks are said to be ‘forged’ or ‘minted’, not mined. Users who validate transactions and create new blocks in this system are referred to as forgers. In order to validate transactions and create blocks, a forger must first put their own coins at ‘stake’.Think of this as their holdings being held in an escrow account: if they validate a fraudulent transaction, they lose their holdings, as well as their rights to participate as a forger in the future. Once the forger puts their stake up, they can partake in the forging process, and because they have staked their own money, they are in theory now incentivized to validate the right transactions.”

This system does not provide a way to handle the initial distribution of coins at the founding phase of the cryptocurrency, so cryptocurrencies which use this system either begin with an ICO and sell their pre-mined coins, or begin with the proof of work system, and switch over to the proof of stake system later (i.e Ethereum 2.0)

DPoS, a variation of the Proof of Stake consensus, seeks to reach consensus more efficiently. In a sense, DPoS is the next step in the evolution of consensus mechanisms. It builds on the original Proof of Stake consensus mechanism and drastically increases speed and scalability.

The first thing you’ll notice is how simpler PoS (and DPoS) seems to the average user of cryptocurrencies. This is, to me, the primary reason that has made this form of consensus so popular. Whereas in the traditional PoW system you must engage large capital and reduce your Opex as much as possible, in this system, in theory, everybody has a chance to participate. To put it in other worlds, DPoS is like a representative democracy where users can delegate their coins to “witnesses”, the most successful witnesses will have to right to validate transactions. Even you own 20$ of a certain coin, say TeZos, you have the right to delegate this voting power, and get rewarded for it.

The first appearance of a PoS token can be traced back to 2013 with PeerCoin (PPC) implementing it while keeping PoW altought the concept dates back to 2012 in a paper by Sunny King and Scott Nadal (creators of PeerCoin) intended to solve “bitcoin high energy consumption”. But many challenges remained to be solved before pretending to compete against the unparalleled genius of Satoshi Nakamoto :

1. Distribution. Since block rewards go to stakers, how do you distribute coins initially?
2. Monopolization. Those with a significant amount of coins reap most of all future coins.
3. 51% attack. Just like how Proof of Work (PoW) has to be wary of a 51% attack from a miner, so too does PoS have to be wary of a staker who has a 51% stake weight. (* Actually it can be 33% in the case of DPoS, more here)
4. Nothing at Stake (NoS). PoS adds a block when a node meets a set of conditions which includes stake weight. However, the coin forks when two nodes meet these conditions at the same time. The fork is then resolved by other nodes signing one of the two transactions. The hypothetical problem of NoS arises when 99% of all nodes sign both chains because there is no cost (nothing at stake) to verify these transactions. Therefore a 1% staker could potentially “double spend” by paying with coins on one chain but then verifying the other.

Since then many have attempted to propose their solution through various proposals, but I’d like to talk about one in particular that is relevant to this article.

Proposed by Vitalik Buterin in ==== Casper FFG (Friendly Finality Gadget) is a way to resolve the “Nothing at stake” problem and was made to ease the transition from PoW to PoS on ETH scheduled to begin in Q4 2019. In a sense Casper embodies the change in narrative that we’ve described previously. Just like MergedMining is a good idea for Blockchains, merging two forms of consensus could prove to be effective. To its core, this proposal aims to make it extremely costly for potential attackers to behave maliciously on a network that must remain trustless and be more Byzantine Fault Tolereant.

This is how POS under Casper would work: The validators stake a portion of their Ethers as stake. After that, they will start validating the blocks. Meaning, when they discover a block which they think can be added to the chain, they will validate it by placing a bet on it. If the block gets appended, then the validators will get a reward proportionate to their bets. The validators are responsible for confirming the blockchain at key checkpoints — approximately every 100 blocks. At these checkpoints, once 2/3 of the validators confirm a particular block then it becomes finalized. Once finalized, it will no longer be possible to change any of the blocks before the checkpoint. These checkpoints guarantee that history can never be changed on the blocks proceeding the checkpoint.

However, if a validator acts in a malicious manner and tries to do a “nothing at stake”, they will immediately be reprimanded, and all of their stake is going to get slashed (barbaric term to actually indicate that they will be burned).

The main narrative that lead to the 2017 bubble was the get rich quick schemes involving ICO and projects without a designated use case. As the bubble bursted and ICO are no longer the way to go for raising funds (i.e IEO’s and STO’s) people have been looking for the new trend that will produce the next bull run (i.e massive inflow of people in the market). And although stablecoins, privacy coins and especially Defi are all very interesting topics, to me it seems that 2019 will be the year of PoS because it is way more attractive than Mining.

Especially when you understand that Libra, the stablecoin by Facebook is fueled by HotStuff : “a recent protocol that leverages several decades of scientific advances in Byzantine fault tolerance (BFT) and achieves the strong scalability and security properties required by internet settings.” (Libra Whitepaper)

II) Why PoS seems way more attractive

It is true that when compared to actual yields on financial markets, Staking is very profitable for investors looking for a stable source of income the likes of a dividend. Indeed, as shown below by the Messari team, average reward is about 7.1% per year while the value locked in staking network is up 790% YoY to $6.5 Billions locked.

For a lousy comparison, the average return for a US Treasury Bond (2Y) is about 2% and the average dividend paid to investors in the traditional stock market is 3.26% compared to a dividend yield of 4.7 percent for telecommunications stocks that traded in the S&P 500.

Until now being a long-term cryptoasset investor was a rather straightforward experience: you obtain the desired cryptoasset, store it (or leave it on an exchange) and wait. The popularized “hodl” meme is the epitome of this approach that contrasts short-term trading strategies employed by many speculative crypto investors.

With the advent of protocols that allow for utilization of crytoassets, e.g. staking in Proof-of-Stake networks or lending out tokens, the optimal strategy for long-term investors probably won’t be to simply hodl.

However, while PoS is presented as the perfect alternative by many staking providers, one should know that it presents some risks associated with it (as with pretty much all assets in existence).

In anticipation of PoS networks starting to come online, there has been a boom in the number of ‘staking as a service’ businesses being launched. Most individuals and even funds don’t want to manage the day-to-day complexity of staking, and are willing to take a haircut on their staking revenue in order to hand off the process. At first glance this looks like an attractive business model — the amounts being paid out annually are 10–20%, and there’s significant margin for the SaaS providers to take a nice chunk out of that. And yet, key numbers will be moving in the wrong direction for a few different reasons, as Chorus states :

- Competition amongst Staking Providers: Right now those margins are fat, but it’s likely they’ll continue to compress in what is fundamentally a commodity industry. As more SaaS providers enter the industry, we’ll likely see a race to the bottom as everyone tries to snap up AUM in a short amount of time.

- Margin Compression due to Increased Staking: As more stakers come online, yields will decrease. There’s a ways to go before this happens since so little is currently staked, but that’s the eventual direction we’re headed.

- Competition from Large Custodians: New entrants are also going to face strong headwinds from existing custodians, who will begin offering staking services in the next couple of months. The general consensus is that ‘trust’ and ‘brand’ will allow some of the new entrants offering staking services to move ahead of the pack. However, this seems strange as none of them currently have existing brands, which will take time to develop, and incumbents (i.e. the Coinbases and BitGos of the world) ought to have a leg up. Larger custodians could also partner or acquire smaller staking services — it’s anyone’s guess which teams will be able to forge those relationships most effectively.

There are many statements describing staking rewards as risk-free or passive income floating around. Additionally, many staking projects bait with high token-denominated yields. Before participating in staking, one should be aware that staking tokens are usually used as collateral to ensure validators follow the network rules. PoS networks pay out rewards to those staking to compensate them for giving up liquidity of their assets and taking on the risk of being slashed in case of serious faults or extended downtime. In PoW, all rewards go to miners. Because these mostly consist of inflated tokens, holders of PoW coins are diluted to pay for the security of the network (at the time of the snapshot of data used that dilution amounts to around 3.7% per year in Bitcoin).

In PoS, token owners can avoid dilution by staking their tokens. As staking rewards are only paid out to those staking, the impact on a staker’s share of the total token supply depends on the staking ratio in the network, validator commission rates, effectiveness and security (slashings), as well as taxes paid on staking income. The following charts show the relative change in share of total token supply ownership comparing a hodler, a pre-tax delegator (using the average commission rates prevalent in Tezos and Cosmos), as well as a post-tax delegator that has to pay 30% income tax on staking rewards.

III) The StaaS industry

Staking is a process where a holder of a Proof-of-Stake (PoS) cryptoasset locks their funds in order to validate transactions. They are then compensated via protocol level inflation proportional to the amount staked as a percentage of the overall amount being staked. Staking is designed as an alternative to Proof-of-Work that maintains the long-term security and reliability of a protocol. Staking-as-a-service exists because staking can be a complex process that the everyday token holder might not want to perform. To participate in the inflation rewards, users can delegate their funds to corporations that run validating nodes who then stake user funds. Inflationary rewards are returned to the holders with a fee taken by the service provider.

Concerns have been raised about Staking-as-a-Service in that it could become reminiscent of our existing legacy system where providers could issue notes that represent staked funds. Since the likelihood of everyone redeeming them at once is slim, they could issue notes backed by only 90% reserves. This would be the same as fractional reserve banking and could slowly increase the inherent risk in the system. (We’ll address this matter in Part 3 of our series).

25% of the total cryptocurrency market (~$30 billion today) will use proof-of-stake (PoS) as a security model by the end of 2019. Investors of PoS currencies can participate in governance and collect staking rewards of $2.5 BN+ annually. *PREVISION

Staking As A Service platforms are meeting a demand of the market. First of all, providing a non-technical option for token holders to participate in staking is a vital service for the health, security and reliability of these projects. The more staked tokens, the more secure the chain is. One of the ways StaaS platforms are building robust communities around staking as a service, is by offering educational resources for network participants.

Many of these blockchains which employ PoS or DPoS have included governance models into the project’s design. The issue is that many of these governance models use staking, or operating a staking node, as the qualifier to vote or participate in governance issues. If a token holder is not savvy enough to run a node or stake tokens themselves, they can’t vote. By offering StaaS to these nontechnical network participants, it allows them to actively vote in governance issues and have a say in the future direction of their investment and the project. Global masternode statistics as of April 15th, 2019 (source : beyond hype blog)

Staking Rewards keep adding new data and now visualize the total value that is staked across all staking projects (PoS (e.g. Tezos and Cosmos), DPoS (e.g. EOS and Tron), and Masternodes (e.g. Dash)). According to their data, there is almost $6.5bn staked at the time of writing. A visualization comparing the dollar-equivalent of tokens staked across live networks.

As Jake Stott from Beyond Hype stated in a podcast:

“We’re seeing a lot of new players enter the market, and also seeing existing custody enterprises add StaaS services to their custody offerings. We’re seeing a higher level of sophistication among the communities and businesses in the staking sector. If staking goes mainstream, the masses may see it as an alternative way to save or store value.”

What does this mean for the future of blockchain as a whole?

“StaaS is the only feasible way that staking or mining could hit the real mainstream. It completely reduces nearly all of the technical friction that we currently see. The mass market needs plug and play solutions, with the ultimate convenience of zero maintenance. If crypto assets are soon seen to have stable returns through staking, it might open the market to a gigantic pool of passive investors, such as large pension or endowment funds. The possibility to get a steady 2–10% return (approximate quoted yield for most staking projects) could be seen as very attractive in a world still reeling from the aftereffects of the financial crisis and low interest rates.

This is obviously theoretical right now and we may be a couple of years away from any major institution staking at scale. But it does bring us back to the overarching point of this series. If this really does become a multi-billion-dollar industry in the next decade, the leaders of these first established and respected StaaS companies will have huge sway on the direction that this money flows. If PoS and DPoS become dominant, then long after the ICO Youtubers have died out, StaaS influencers and their communities will be the real power in the blockchain space.”

To get a brief overview of this space see below:

As the blockchain space grows, one must understand that the staking space for institutional investors differs from that of retail investors, as these entities are mostly bound by regulations or other limitations guiding how they may store and utilize their cryptoassets. Institutional investors include VC firms that invested in an early stage PoS project, hedge funds that may own a staking cryptoasset, and potentially a wide range of other traditional investment companies such as family offices or even banks. These entities may simply hire their own team to run staking infrastructure. Another option would be to partner with a professional staking provider, or to participate in staking through their custodian. Finally, institutional investors can also make use of delegation protocols and outsource validation work by delegating to staking services. We are already starting to see early examples of institutional investors running their own validator infrastructure (e.g. Polychain), hybrid fund/staking provider structures (e.g. Mythos Capital), as well as partnerships between funds and staking providers (e.g. Bison Trails and Notation Capital).

Centralized exchanges are another interesting case, as they are essentially controlling their customers funds and may potentially participate in staking on behalf of their users. Another option could be to create some separate type of staking account in their system or integrating a delegation option in the exchange interface itself. An early examples of an exchange participating in staking is gate.io. We’ll further develop on the risk associated with this in part 3.

Inthis second part out of three we have seen that the way PoS token are designed allows for both retail and institutional investors to get familiar with them to start earning interest and while PoS network are still young and very fragile securitywise the are potentially one the of the reasons why cryptocurrencies investments might become mainstream. Next month we’ll try to summarize the current market outlook and understand the consequences of these narrative changes on the ecosystem overall security and how the old demons of traditional finance could come back to haunt us.

Arguments in this article were taken from multiple people I like to get insights from within the community. Thinkers and researchers including: Neil Woodfin, Nic Carter, Dan Held, Awe_AndWonder, Derek Hsue, Gregory Trubetskoy and of course, Satoshi Nakamoto and the Chorus Blog.

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