This document is a summary of a longer article — “The financialized staking economy” — published in Chorus One’s ‘Annual Staking Review’ for 2022. Click here to read the entire report.

Cryptocurrencies can be used in three kinds of yield-bearing activity. These have cumulative trust assumptions -

• Base layer: Staking income is generated by the chain itself to incentivize its liveness & security.
• Smart contract layer: Protocols run on the chain and may pay incentives for capital. At a minimum, these carry risks associated with protocol security (e.g. hacks), and protocol design (e.g. collateral management).
• Off-chain: Centralized parties may offer interest on cryptocurrency assets. Complex trust assumptions are involved here including counterparty prudence & sophistication, technical security, and legislative risk.

We believe staking yield is the most attractive risk-adjusted source of yield in crypto for two reasons:

1. Firstly, yield enabled by the base layer, i.e. staking yield, carries by far the least risk. Specifically, it does not carry significant idiosyncratic risk beyond the priced-in chain risk, as a failure for staking yield to materialize, or a reduction of the notional for an appropriately operated node would be equivalent to chain failure. There is some tail risk associated with improper operation of validator nodes (e.g. double signing, downtime), but this can be minimized by choosing a professional validator like Chorus One.
2. Secondly, it delivers competitive returns, even if compared to riskier sources of yield. For example, using Uniswap (the largest DeFi App of all) as a proxy, liquidity provisioning on Uniswap is a losing proposition for as much as 50% of users due to “impermanent risk”. A second example is Binance Earn as a stand-in for off-chain yield generation — it currently pays 4.3% on Ethereum, vs. a 7.5% staking yield! Especially in an environment with limited organic on-chain activity, staking is a very competitive source of return. If on-chain activity increases, staking yield adjusts to this, via increased transaction fees and MEV rewards. It’s a call option on on-chain activity.

Why staking is an attractive source of yield beyond crypto

Proof-of-stake ecosystems do not have an anchor in the real world. This means that the staking yield rate denoted in native terms is completely decoupled from any kind of factor in the wider economy. For staking, endogenous capital (e.g. ETH) is the only factor of production.

This is a difference to proof-of-work (PoW) systems, where electricity and hardware costs serve as an unbridgeable anchor to the real economy, directly affecting a miner’s yield rate. It is also different from most CeFi and DeFi yield sources, which depend more heavily on user activity.

The above implies that staking can be an uncorrelated yield source for two kinds of investors — those that are bullish long-term and denominate their holdings in native units, and those that are hedged against the price risk of the staked asset.

Hedging the staking yield

The token price risk may be hedged out through on- or off-chain solutions. The former case has the advantage of transparency, reflected in an improved counterparty risk assessment and iron-clad terms. With some of the largest lending desks in the space embroiled in a liquidity crisis, this is a significant factor. Validators are ideally positioned to execute on-chain hedging, as they directly interface with the staking yield source and thus no custody transfer, i.e. additional risk, is required to interface with a hedging solution.

One increasingly popular on-chain hedging solution is a “staking yield interest rate swap”. This allows validators to swap token-denominated staking yield for a stablecoin, typically USDC, locking in a stable and predictable income for a staking client. The associated risk is very minor as neither the validator nor the swap counterparty takes custody of the principal — the worst case, a counterparty default, would reduce to the price risk on the yield earned on the staked notional. Chorus One can leverage Alkimiya, the leading protocol for on-chain capital markets, to execute this type of hedge.

A second way to hedge is by using the staking yield to finance classic options-based strategies. For example, a zero-cost collar options package may incorporate the staking yield in a way that enables an asymmetric pay-off.

Chorus One is invested in & advises a range of solutions optimizing staking yield for return (i.e. MEV) and risk (i.e. hedging). Reach out to us at sales@chorus.one to learn more about how these can be tailored to fit your use case.

About Chorus One

Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 35+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures. We are a team of over 50 passionate individuals spread throughout the globe who believe in the transformative power of blockchain technology.

For more information, please visit chorus.one

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