Blockchain Staking – What Big Risks are Involved for Funds?

WHAT IS BLOCKCHAIN STAKING?

Blockchain staking is becoming more and more relevant as the debate surrounding the energy consumption of bitcoin mining intensifies. In this piece we delve into the consensus mechanism by focusing on the different staking classes together with their potential risks. Staking is a type of consensus mechanism utilized by blockchains to verify transactions and secure the network, this is known as Proof-of-Stake (PoS). Bitcoin on the other hand utilizes a Proof-of-Work (PoW) consensus mechanism where hardware is required to solve the block hash that verifies and secures the network. Contrary to PoS, the PoW consensus mechanism is energy intensive as it is hardware driven.

When getting into the technical side of things, it is important to note that the PoS consensus mechanisms works differently than PoW and is not energy intensive at all. The process of staking can be summarized as follows – to stake, a user delegates their digital assets to a staking node thereby locking the assets in a staking contract which increases the nodes staking power. As payment, the user then receives staking rewards depending on their percentage of stake compared to the over-all assets staked to the node. Staking might seem simpler compared to the other consensus mechanisms; however, there are still risks involved which digital asset Funds should consider before actively participate in staking activities.

THE TYPES AND RISKS OF BLOCKCHAIN STAKING

With a better understanding of what the consensus mechanism entails, we can now look and the different types and protentional risks Funds should consider.

Staking wallets:

The first challenge any party participating in staking will face is whether the asset they want to stake are supported by custodians/exchanges or they will have to custody and stake assets themselves. There are limited options when using central parties for staking with high fees in some instances which may lead users to decide to run a self-hosted wallet for staking.

Funds that perform self-custody will need to implement a hot wallet solution to delegate assets to a node for staking. The best solution will be to utilize a Ledger or other hardware wallets with appropriate security and segregation of duties implemented in the wallet operating procedures. Depending on the Funds risk tolerance and technical capabilities this may pose a significant initial hurdle to entry. Additionally the fund needs to consider how much exposure they allow in hot wallets and how the process will be monitored and rewards claimed/converted.

Staking Nodes:

Each staking blockchain works in a different way and Funds must differentiate between the two major Node staking mechanisms:

Delegated PoS:

    • This staking method is ownership driven as delegators keep control of the assets and lock them in a staking contract that points the voting power of the assets to the specified node; and
    • Each delegated PoS blockchain has its own un-delegation period. This is the period that it takes to remove the delegated funds from the staking contract, on average its between 12-21 days and is built into the staking blockchains as a security layer to prevent bad actors from performing unwanted actions and quickly withdrawing assets.

Custodial PoS:

    • This staking method is operator driven as delegators send the assets to the staking node and do not control them.
    • In essence, custodial staking is higher risk than the delegated staking in that the Fund must weigh the risk of giving up ownership of the assets to these node operators.

Staking Blockchain Slashing

Most staking blockchains have a built in slashing mechanism to punishes bad actors on the network. Slashing rates vary across different blockchains but are normally a percentage of the total assets staked to a specific node.  Funds must have a clear understanding of the slashing criteria for the staking blockchains they plan to take part in. In general, the main slashing events for staking nodes are:

Down time:

    • A staking node should be operating 24/7 but in the event that the node is offline the node can be slashed, and a fund can lose some of their delegated funds;
    • This may not seem like an issue, but some blockchains are very aggressive in their slashing policies and may penalize a node for extended downtime at a percentage per hour for every hour past a specific point. Therefore node uptime is extremely important and fund need to consider the regulatory risk, power supply issues and redundancies that a node operator has in place when selecting a node to delegate to.

Bad actors:

    • When a staking node attempts to double spending a transaction, the node will be slashed, and the fund will lose a percentage of the funds delegated to the node; and
    • In some in some instances double signing of transactions may not be malicious as it can be caused by a temporary loss in connectivity and a number of other factors. A fund should consider whether a node operator has sufficient controls in place to avoid these events.

Staking Node Selection

The Fund should follow a risk-based approach when assessing which node to use for staking activity. A policy needs to be developed to perform the necessary due diligence by researching the respective nodes to identify the ideal one that falls within the fund’s risk appetite.

When looking into staking nodes a Fund needs to consider the following factors:

Node uptime:

    • Funds should start their due diligence on the average node uptime and whether the node has ever had extensive downtime; and

Node redundancy:

    • Node operators should always have redundancy solution that will take over if the main node goes down, this prevents down time of the node operator and mitigates any slashing events;
    • This is an important consideration, especially for nodes based in countries with unstable power supplies or uncertain regulatory environments.

Staking node operator fees:

    • Funds should always be aware of how much fees the node operator take as compensation for running the node;
    • On average node operators take between 10%-20% of the rewards won by the node.

Previous slashing events:

    • Where the node has previous slashing events is should serve as a warning sign for the fund.

Node operator’s location

    • This is an important consideration due to potential regulatory risk as well as tax liability. Countries may change regulations or update tax laws on earnings produced in the specific country. It is important to choose a stable regulatory climate and tax neutral territory if possible.

Fund operating their own staking node

Funds that have a strong IT team and the minimum amount of assets required to operate the specific blockchain’s staking node can sometimes operate a staking node on their own. This is the preferred option as the fund will receive all the income from the staking rewards and if other users across the globe want to delegate assets to the Fund’s node, the Fund would receive a portion of their staking rewards as well.

Operating a node individually requires a lot of work from a regulatory perspective, but even more so in the IT environment as intense around the clock security and monitoring is required to run the node smoothly. It is therefore paramount that a Fund conducts proper risk assessment and tech due diligence to ensure the fund can operate the node in a profitable but safe manner.

TAKEHOME

It is always good practice to know what you are getting yourself into by understanding the tech and associated risks. It might be even more beneficial to have an independent data and development partner to guide you through the blockchain stacking labyrinth. At HASH Consulting we pride ourselves on delivering in depth reports for clients to assess staking node operators for specific blockchains through a risk-based approach.

 

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