Stake Your Booty
Vol #78 - April 22, 2022
Capital in crypto is mercenary.
Billions of dollars moves about the ecosystem every day plundering poorly designed tokenomics and mercilessly selling newly minted tokens into the ground. For every brilliant new design and innovation, there are a dozen miscalculations a protocol can make that will quickly evaporate the heady valuations on paper.
When it’s as easy to create new “money” as spending a few hours copying and pasting boiler plate code and tweaking a few parameters, it’s hard to ascribe much “value” to the product. If I mint one billion TillCoins, how am I going to convince anyone to pay me anything for them?
One way I could kick start the flywheel would be to “airdrop” or give away the coins to everyone who is a current subscriber to the newsletter. Now all my loyal readers have some free money in their wallets. Without any clear value proposition behind why a blog is minting currency, most holders would (rightfully and reasonably!) sell that coin at the first sign of a bid.
Because I want to bring value to the TillCoin, I might come up with plans for how this might be useful in the future. Special webinars for holders. Premium content. Maybe even merchandise! While we’re still at a rounding error on a penny, this starts to give people reason to hold their TillCoin.
The coin now has a billion units of supply, and an extremely marginal demand. If I can’t convince people to raise their demand, I could consider restricting the supply. Early investors are often given lockup periods on their coins, so when Harvested Digital Asset Management sponsors the launch and gets 5% of the supply, they have a vesting period before they can sell.
For coins that are already in circulation, I can create a staking mechanism that bribes people not to sell. Staking an asset is pledging it to a smart contract, such that its value can be tapped for some economic purpose. A yield is then paid back to the staker, usually in the native token.
Now readers, you can opt in to not selling your TillCoin, and get rewarded with more TillCoins. By promising not to sell today, you’ll get more in the future! Since I just printed this money earlier this morning, I’m happy to pay you hundreds of percent in APY to just hold it a little bit longer.
Cynics will say staking is just a way to support price long enough for the early investors to get past their cliff. They’re not wrong, and much of this borders on a late-stage ponzi scheme. There’s an economic purpose to this staking, but it’s mostly benefiting early stage VCs, and me.
When staking is simply a lock-up mechanism for bribing limited supply so early investors can pass the bag - even the Jolly Roger wouldn’t support that. Pirates were actually known to be quite equitable dividing up their plundered booty.
Well designed, staking does have an interesting and useful economic purpose. We talked last week about flywheels and how it’s necessary to kick start an ecosystem with some kind of spending and initial momentum for it to become self-sustaining.
Staking that supports liquidity development is a good and useful implementation. Automated Market Makers (AMMs) are the decentralized exchanges that allow users to permissionlessly swap one token for another, without explicitly matching a buyer and seller. The pool always takes the other side of a trade, and suppliers of assets to that pool are rewarded with trading fees.
The more assets are in the pool, the lower the slippage on the trade, and better customer experience. More customers trading means more fees for liquidity providers, and more capital will migrate to the AMM, spinning the virtuous cycle.
Early suppliers are often rewarded with additional incentives beyond the fees, where the protocol pays out additional tokens to liquidity providers who commit to supporting the protocol through staking. The protocol is using its treasury to buy liquidity to grow the business.
Staking can also be used as an incentive mechanism to secure an entire blockchain. One of the major upcoming events for Ethereum is the transition of the block validation method from Proof of Work (PoW) to a Proof of Stake (PoS). Very broadly PoW chains are energy intensive, while PoS chains achieve consensus not through brute force, but through trusted validators who have pledged assets and risk penalties for foul play.
In PoS systems, validators are required to stake their assets in exchange for a chance at validating the next block and earning those fees. The chain is paying its validators for security and accounting, which encourages more participation, and raises the bar for everyone.
Staking plays an important role in the development of new chains and protocols. When the incentive mechanisms are well established and support long term growth and not just price support, it’s a way to trustlessly create value the same way that fiat based companies invest in projects and enterprise.
It is difficult however to fit into the current financial and regulatory system. Staking is ultimately a question of custody. While in most cases you get some kind of receipt back for your staked asset in the form of another token (e.g. stETH for staking ETH, which trades almost exactly at 1:1), your original asset is pledged to someone or something else.
For registered investment advisors and regulated financial services providers, custody is a big deal. Who holds the keys matters, because there’s a lot of risk for funny business. If a financial advisor accidentally receives a check intended for their clients, by statute they must forward that along within 72 hours.
Custody of digital assets is difficult because they’re designed as bearer assets, and custody is enforced by who has the private keys, not who has rights upheld by a court of law. I believe this is a major reason why the Bitcoin ETF has not been approved - if someone breaks into the cages below the NYSE1, we have ways to reconcile how many shares of MSFT Blackrock owns. If a bitcoin ETF gets hacked or compromised, there’s no jurisdiction that can change the blockchain.
With staking being such an integral part of decentralized finance, yet self custody being completely at odds with current financial regulation is building tension. There is demand for access to the innovation taking place on the frontier, but no service providers want to operate in a regulatory gray space.
Reconciling this will be difficult. Walled garden implementations go against the ethos of DeFi, yet it is unlikely that staid institutional capital migrates to the ruthless world of smart contracts without some kind of protection.
These records are actually held by the DTCC in a big database, but the old cages where share certificates were held are still on display at the Big Board.