Misunderstood Risks in Staking

Misunderstood Risks in Staking

The Resilience and Challenges of Staking in the Blockchain Industry

Blockchain Technology

As the blockchain industry continues to evolve, staking has emerged as a prominent activity in the crypto space. Staking allows token holders to participate actively in securing and maintaining a blockchain network by locking their tokens and supporting the network’s operations. Despite the ongoing bear market, staking has shown remarkable resilience, with a substantial amount of value staked on various blockchains. In fact, the value staked often surpasses the total value locked on-chain, indicating the trust and confidence placed in this activity.

However, the public perception of staking has suffered due to the misuse of terminology and deceptive marketing practices by some crypto lending firms and exchanges. Many of these platforms falsely advertised their services as “staking,” leading to confusion and loss of trust among users. Consequently, regulators have taken action against these misleading practices, further discouraging the adoption of staking. It is essential to address these misconceptions and evaluate whether the actions against staking are justified.

Will the Real Stakers Please Stand Up

To truly understand the risks and benefits associated with staking, it is crucial to differentiate between “staking” and actual staking. Staking, in its genuine form, involves locking tokens directly on the blockchain with trusted operators or validators. Stakers retain ownership of their tokens throughout the process, while validators secure and perform necessary work on the blockchain with the delegated stake.

The misuse of the term “staking” often stems from liquidity pool (LP) token locking and lending services. These platforms falsely present themselves as staking services, making it challenging to assess the associated risks accurately. Unlike on-chain staking, where activities can be observed and monitored transparently, these imposter services introduce higher levels of ambiguity and potential risks.

Realistic Risks of Staking

Staking, like any other investment or engagement in the blockchain space, comes with its own set of risks. Understanding and mitigating these risks is essential for users considering staking as a participation option. Here are the four major risks associated with staking:

  1. Slashing and penalties: Validators can face slashings when they attest to conflicting blockchain histories, as well as penalties for extended periods of offline behavior. These measures exist to deter malicious validators from attacking the blockchain network. While it is not a frequent occurrence, the loss from slashing can be significant. For instance, the recent slashing on Ethereum resulted in a loss of 1 ETH, representing approximately a 3% loss on a 32 ETH stake deposit.

  2. Validator risk: Stakers, who do not run their own validators, need to carefully select a trustworthy third-party validator. Although stakers do not give up custody of their funds, they must assess the reputation and integrity of the chosen validators to prevent potential harmful behavior that could result in slashing or penalties.

  3. Client software bugs: Blockchains are not immune to software bugs, especially when undergoing frequent upgrades or enhancements. Ethereum, for instance, faced issues related to achieving finality due to a client software bug. The best approach to mitigate this risk is to have multiple implementations of the blockchain, ensuring diversity and redundancy among client teams.

  4. Unstaking periods: Blockchains implement buffer periods during which stakers can unstake and withdraw their funds. This delay prevents malicious actors from performing attacks and escaping before their funds are slashed. However, this can create a duration mismatch for custodians or exchange platforms that stake assets on behalf of their users.

Compared to other activities within the blockchain industry, the risks associated with staking are relatively clear-cut and minimal. Slashing, which presents the most plausible concern, has been a rare occurrence, affecting less than 0.04% of Ethereum validators and resulting in losses of less than $1 million. In contrast, hacks in decentralized finance (DeFi) protocols have caused approximately $5 billion worth of losses over a similar period. Therefore, the perceived risks of staking are often overestimated, and its benefits outweigh these concerns.

Short Side Note on LST

Liquid staking protocols (LST) have gained popularity, offering users a convenient way to earn staking rewards. LSTs act as wrappers around staking, aggregating validators and pooling stakers’ tokens through smart contracts. These platforms introduce additional risks that must be considered alongside the risks associated with traditional staking.

  1. Smart contract risk: LSTs involve multiple layers of smart contracts to pool and represent staked assets. To ensure safety, these contracts must be developed and audited by competent developers to mitigate any potential security risks.

  2. Operator risk: The decentralized autonomous organizations (DAOs) or entities managing the LSTs must also be assessed for their competence and ability to operate the protocol effectively. Stakers should trust these entities to manage the operations of the LST transparently.

Progress needed within Staking

Staking, when properly understood, does not pose significant risks like the ones observed in the lending sector. It is considered one of the lowest-risk activities for crypto users to participate in. In fact, staking reward rates have the potential to become the benchmark rate for each blockchain ecosystem. As seen in the convergence of borrow rates with staking reward rates, staking is already gaining prominence as a fundamental form of engagement in the crypto space.

However, while staking holds great promise, misconceptions and mischaracterizations hinder its wider adoption. The staking ecosystem requires more products and tools to help users securely engage in staking while fully comprehending the associated risks. Currently, compared to the DeFi and non-fungible token (NFT) sectors, staking lacks behind in terms of educational resources and user-friendly interfaces. Initiatives like CoinDesk Indices, Rated, Stakingrewards.com, and Observatory Zone have paved the way, but further investment and development in this area are crucial to onboard and educate non-crypto individuals about staking.

Staking remains at the forefront of the blockchain industry, offering participants the opportunity to actively contribute to the ecosystem’s growth and earn rewards while minimizing risks. By addressing misconceptions, improving transparency, and providing comprehensive educational resources, the staking ecosystem can continue to thrive and facilitate wider adoption of blockchain technology.