Understanding Pledge-as-a-Service: Opportunities and Risks, Current Status and Future

Written by: Rasheed Saleuddin & Chase Devens, Messari Analysts

Current leading blockchain networks are undergoing a massive transition from Proof of Work (PoW) to Proof of Stake (PoS) consensus mechanisms. The PoW model, initially advocated by Satoshi Nakamoto, has fallen out of favor, with critics pointing out that the security model of PoW and the trend of centralized mining pools create negative externalities.

In contrast, PoS designs are experiencing significant growth due to their energy efficiency and better commitment to decentralization. If Ethereum 2.0 (Eth2) had completed its PoS merge today, PoS-based blockchains would account for 44% of the total market capitalization of current Layer 1 (L1) blockchain networks; if we exclude Bitcoin from the calculation, the market cap share of these PoS chains would soar to 91%. This shift from a PoW-dominated network to PoS has generated second-order effects in new business models that earn profits by securing PoS networks.

Bottom-up: Changes in market capitalization of Bitcoin, Ethereum, and the top five PoS blockchain networks since 2021.

Since the inception of Bitcoin in 2008, PoW chains have helped numerous businesses establish mining reward-maximizing business models. Early mining companies understood that they could benefit from economies of scale and began to build "server farms" in areas with low energy costs to maximize their chances of earning mining rewards. In just 13 years, crypto mining has evolved into an industry valued at approximately $31 billion.

Meanwhile, PoS consensus-based blockchains provide similar business opportunities for individuals and companies seeking PoS rewards. JPMorgan estimates that the Staking industry based on PoS has already generated $9 billion in revenue annually and will grow into a $40 billion industry by 2025. Given this lucrative forecast, understanding the nuances of staking and how they interact with the emerging Staking-as-a-Service (STaaS) industry is crucial.

Note: To avoid confusion with the SaaS (software-as-a-service) abbreviation already used in the tech industry, we will refer to "Staking-as-a-Service" as STaaS for the remainder of this report.

Introduction to PoS

For a permissionless blockchain network to operate normally, only one entity can update the shared ledger of the network at any given time. The consensus mechanism is a set of rules that security providers in the blockchain network use to determine which participant's updates the network should adopt. The entity responsible for adding a series of transactions (blocks) to the ledger at any time is referred to as a block producer. In return for producing new blocks and thus maintaining network security, block producers can earn block rewards from the network (which will be explored in more detail below).

As mentioned earlier, PoW and PoS are the two most widely used consensus engines in today's blockchain space. In a PoW system, "miners" compete to become the next block producer by consuming physical resources (time and energy). This consumption of external resources provides security to the PoW network. If a malicious participant wishes to stop or alter the state of the network, they would need to control more than 50% of the network's hash power.

In a PoS system, the competition for physical resources (hash power) is replaced by competition for the blockchain's native cryptocurrency. This key difference allows PoS networks to operate without consuming large amounts of electricity and enables broader participation in the consensus process (allowing the network to achieve better decentralization). Participants wishing to become network validators must stake (lock up) a certain amount of the blockchain's native cryptocurrency as a commitment to their honest participation in the consensus process. The total value staked in the network provides security, making different forms of 51% attacks in PoS networks more costly than in PoW.

In addition to serving primarily as a security barrier, the staked funds of validators are important for two additional reasons. First, the amount of stake a validator has is proportional to their probability of being selected to add new transactions to the ledger, thus affecting how much reward that validator can earn. The staked funds also act as collateral to deter bad behavior: if a validator acts maliciously against the network, they typically risk losing a portion of their stake or losing the right to participate in the consensus process for a period of time. In summary, PoS systems incentivize healthy network behavior. Validators will stake more collateral to earn a larger share of block rewards. The more collateral staked, the more likely validators are to comply with network norms (to avoid penalties), thereby ensuring the security of the blockchain.

The Rise of STaaS

Motivations for Participating in Staking

With a basic technical understanding of how PoS consensus works, we can explore the economic opportunities it creates. PoS networks incentivize stakers to contribute to the network's security by rewarding validators with block rewards (composed of the network's native currency inflation and transaction fees). Inflation rewards can be seen as the local incentive mechanism that PoS networks use to encourage users to stake their assets in the network. For those who choose to hold the native currency of the PoS network without staking their assets, they will face dilution effects from the asset's inflation supply schedule. If 100% of the native currency is staked in the network, ownership of the network will not change relatively, as all inflation rewards will be distributed to all existing holders; however, this scenario is highly unlikely as it would mean no one is actually running applications or transacting on the network.

Therefore, each PoS network presents different active staking rates, as shown in the figure below, with each PoS network's staking rate depending on the level of activity and incentive mechanisms within their respective networks. As can be seen from the figure, most PoS networks have active staking rates exceeding 50%.

Above: Active staking rates of major PoS networks as of November 25, 2021.

The constantly changing staking rates in PoS networks result in dynamic returns for network stakers. As more staked funds enter the network, the reward rate for stakers will decrease, as staking rewards will need to be distributed among a larger group of stakers, and vice versa. The overall staking return in the network is referred to as the nominal staking rate, which includes transaction fees and inflation. The nominal return minus the rewards generated by the network's overall inflation is known as the real rate. While many PoS networks may have nominal returns as high as double-digit percentages, real returns are often single-digit percentages. A major exception to this trend is Binance Smart Chain (BSC), as its block rewards consist entirely of transaction fees (with no inflation). The staking yields of various major PoS networks are shown in the figure below:

Above: Staking yields of major PoS networks; while many PoS chains offer an attractive nominal yield, the real yield is much lower.

Barriers to Participating in Staking

If participating in staking is the native revenue channel of PoS networks, then why doesn't everyone run a validator (node)? Several factors are at play. First, becoming a validator typically has a minimum capital requirement, which ultimately deters most retail users. The figure below shows the upfront capital and hardware requirements for running a validator node across various PoS networks.

Above: Upfront capital and hardware requirements for running a validator node across major PoS networks.

Even for PoS blockchains like Solana that have no minimum staking requirements, other forms of capital are still needed, such as high-end computers, fees to participate in consensus voting (currently estimated at 2 SOL or about $500 per day), and sufficient capital to stake to be selected as a validator.

Second, if a participant has enough capital to meet the minimum staking threshold of a PoS network, they must also take on the responsibility of ensuring that the validator is always online and operating correctly. Most PoS networks use slashing penalties to punish offline or misbehaving validators.

Finally, participating in PoS staking also comes with opportunity costs, meaning that assets are locked for a period and cannot be used for other purposes (such as lending in DeFi). This issue applies to most PoS networks that use collateralized staking mechanisms, but is avoided in networks like Cardano that support native liquid staking.

In summary, these issues are precisely what the Staking-as-a-Service (STaaS) industry aims to address for its users.

The initial purpose of creating the STaaS industry was to provide the economic benefits of participating in staking to the masses while solving the ongoing challenges of maintaining validator nodes for non-technical users. As the industry matures, we have begun to see the emergence of liquid staking derivatives (e.g., users can stake ETH through the liquid staking protocol Lido Finance and receive a 1:1 liquid derivative stETH) to help users mitigate the opportunity costs associated with staking (locking) assets.

STaaS is a relatively simple business model—users transfer or delegate their assets to a STaaS provider that manages a group of validators. This allows smaller users to enjoy the benefits of participating in staking. By using a STaaS provider, users can easily stake almost any PoS asset with just a few clicks. The table below shows the PoS assets supported by current major STaaS providers:

Above: Overview of PoS assets supported by current major STaaS providers.

In return for maintaining the necessary validator services for their clients, STaaS providers charge their clients a fee. This can be a fixed monthly fee, but more commonly, it is a percentage of the rewards generated from the client's staking (these commissions typically range from 5% to 20% of the client's staking rewards). Over time, we can expect this fee percentage to decrease as more STaaS providers enter the ecosystem and compete. Additionally, as PoS protocols mature and reduce their reward schemes, the nominal fees each client brings to the STaaS protocol are expected to decline.

STaaS Classification

Similar to today's wallet and exchange products, we can classify today's STaaS businesses into custodial or non-custodial. Regardless of these classifications, all STaaS may offer a liquid staking feature.

Custodial STaaS

Custodial STaaS providers are characterized by controlling and maintaining clients' assets throughout the staking process. The most common centralized staking providers are centralized exchanges (CEX), such as Coinbase and Kraken.

Above: Staking services offered by Coinbase. Source: Coinbase

Custodial STaaS typically targets retail users who wish to earn returns from their held assets through a simple method without worrying about the backend staking process. Any returns generated from the staked funds will first be allocated to the staking provider and then passed on to the clients. This is similar to how banks operate: banks charge fees on the interest paid to depositors while retaining custody of those deposits, thereby maintaining power over clients. Since clients already trust these third parties to safeguard their assets, participating in staking through these third parties does not require any additional trust assumptions, other than the STaaS provider's ability to manage the validators (nodes) or outsource this responsibility to another third-party provider. However, the risks associated with custodial wallets and exchanges also apply to custodial STaaS providers—after all, if you don't control the private keys, then it's not your crypto (not your keys, not your crypto).

Custodial STaaS providers often collaborate with backend Node-as-a-Service (NaaS) providers to outsource the staking infrastructure to the latter. In this case, the NaaS infrastructure provider is responsible for maintaining hardware facilities and daily validator node operations, while the STaaS provider focuses on custodial aspects (including key management and cold storage). Popular white-label providers include Blockdaemon and Staked.

Additionally, large enterprises or venture capitalists that want to own their own validators (nodes) but lack the internal expertise to host or manage validator nodes also use NaaS providers. These NaaS providers can bear the additional costs of specialized expert teams focused on ensuring that validator nodes have maximum uptime and security. In early 2021, Coinbase acquired Bison Trails for $80 million, marking the first significant acquisition of a NaaS infrastructure provider. Given the synergies between these two businesses, this may not be the only acquisition we see.

Non-Custodial STaaS

If there is no ability to participate in and maintain asset custody, STaaS is not a true Web 3.0 service. The process of sending staked funds to non-custodial STaaS providers is referred to as delegation, and most PoS networks support "native delegation," meaning this delegation process is built into the network. Any user who has already run a validator node can accept asset delegations from other users to increase the proportion of staked assets in their validator node, thereby earning more staking rewards.

These validators will charge a commission to users delegating assets (the delegators), similar to custodial STaaS providers. However, the distribution of rewards is slightly different. Since PoS networks support delegation, the network can directly allocate the delegators' share of rewards to them, rather than having the validator node pass the rewards to the delegators. This helps reduce some of the counterparty risks associated with custodial STaaS business models.

While supporting "delegation" at the network level may sound simple, there is always the risk that staked funds may become overly concentrated among a few validator nodes in the network. Therefore, unlike PoS networks such as Solana, Polkadot, Avalanche, and Cosmos, Ethereum decided to remove this delegation feature from its Eth2 PoS design to allow the market to build delegation functionality on top of the network. As shown in the figure below:

Above: Unlike other PoS networks, Ethereum 2.0's PoS model does not support native staking delegation.

This makes Eth2's STaaS itself an interesting subcategory. This is also why some of the largest STaaS providers (whether based on the value of their staked assets or the number of PoS networks they support) do not support Eth2 staking. For example, Everstake is the STaaS provider with the highest value of staked assets, supporting staking services for 27 different PoS networks, but does not support Eth2 staking. This may be due to the lack of a built-in native delegation feature in the Eth2 network, making it impossible to accept delegations without any additional steps while running a validator node using one's own assets.

As of the time of writing, among the top 10 STaaS providers ranked by total value of staked assets, 7 are non-custodial STaaS providers, and 2 are custodial STaaS providers, as shown in the figure below. It can be seen that non-custodial STaaS providers currently dominate.

Above: Top 10 STaaS providers ranked by value of staked assets.

Overall, we can see that non-custodial STaaS is the clear leader in today's market. Given the decentralized nature of these networks, this is not surprising. An important factor to note is that most of the NaaS (Node-as-a-Service) infrastructure providers mentioned above run public validator nodes that allow anyone to delegate: since these NaaS providers have already specialized in providing infrastructure for their large institutional clients, offering generic services to smaller participants is a simple addition.

Liquid Staking Solutions

Since participating in staking (staking) means making a commitment to the security of the PoS network, the staked assets need to be locked to prevent "bank run" scenarios, where all staked funds are quickly withdrawn, leading to a collapse of network security. Each PoS network has different lock-up periods. For example, in the Solana network, unstaking takes only 2 days, while in Eth2, staked funds will be locked indefinitely until the transition to PoS is complete.

Liquid staking provides stakers with a derivative asset that represents their staked position and generates staking rewards, which can be used for trading or as collateral for DeFi activities. While liquid staking is a feature that both custodial and non-custodial STaaS providers may offer to their clients, it is most commonly used in decentralized staking pools. These staking pool protocols do not run validator nodes themselves; instead, they accumulate users' staking deposits and allocate these deposits to validators already operating in specific PoS networks. Therefore, in staking pools, rewards and penalties are typically shared among all depositors (stakers).

Current major decentralized liquid staking pools include Lido Finance, Marinade Finance, Stakehound, Ankr, Rocket Pool, and Stakewise, with their respective Total Locked Value (TLV) growth shown in the figure below:

Above: Growth of Total Locked Value (TLV) of various decentralized liquid staking pool protocols since 2021.

Liquid staking solutions are still in the early stages of development. Lido Finance's first-mover advantage and support for multiple PoS networks (including Eth2, Terra, and Solana) have allowed the protocol to lead in the early stages, with its stETH (the liquid derivative users receive after staking ETH through the protocol) being the most liquid staking derivative in DeFi, usable in protocols like Maker, Yearn, and Curve. Over time, other liquid staking protocol derivatives should become trusted collateral options.

Additionally, we expect more liquid staking derivatives to emerge on various blockchains. On blockchains such as Ethereum, Solana, and Terra, liquid staking is already a deployed tool, while some protocols on other blockchains are also launching their first liquid staking derivatives; for example, recently, Acala released its LKSM derivative, allowing people to engage in liquid staking on the Kusama network.

Critical Evaluation of STaaS

• Risks

While STaaS democratizes the staking process for crypto users, it is not without risks. As we discussed earlier, staking itself is not risk-free. Any validator can be penalized due to slashing events (such as validator downtime or double signing that prevents the network from reaching consensus). Downtime refers to the time when a validator node is offline and fails to fulfill its duties in the consensus process; double signing occurs when a STaaS provider keeps a backup validator running (to prevent downtime) and both of its validator nodes vote (sign) on a block using the same private key. Slashing refers to the PoS network protocol depriving a validator of a portion or all of their staked funds due to the aforementioned events. Some PoS network protocols, especially those in their early growth phases, have relatively lenient slashing policies to maximize network growth, but these should be viewed as temporary measures that will change as more validators join the network.

While STaaS providers leverage their own staking expertise to help mitigate slashing risks, it is important to note that this risk will always exist in some non-zero form, and it is up to the STaaS provider to decide whether to compensate users for any potential losses. Current STaaS providers have a variety of policies. For example, when Staked discovered a vulnerability that caused multiple validators it operated to double sign on the same block, the staking pool chose to compensate delegators for $30,000 in losses; Blockdaemon provides 100% insurance for potential slashing events; Coinbase states in its terms that it may or may not compensate delegators, depending on the reason for the slashing penalty. As the STaaS industry matures, we can expect that participants seeking to mitigate risks will demand slashing insurance to alleviate any losses not compensated by STaaS providers.

Meanwhile, the emergence of liquid staking derivatives has led to a series of intertwined risks. First, since these derivatives are synthetic assets, they need to maintain their peg to the underlying staked assets, which is not an easy task. For instance, while Lido Finance's stETH is the most reliable liquid staking derivative, stETH sometimes struggles to maintain a 1:1 peg with ETH (as shown in the figure below). This is because stETH cannot be redeemed for ETH at a 1:1 ratio through Lido Finance until Ethereum completes its transition to PoS. Until then, stETH must rely on decentralized exchanges for actual price discovery. The figure below shows the peg situation between stETH and ETH:

Above: Peg situation between stETH and ETH since January 2021.

This increases the risk of using such derivative assets in DeFi, as sudden price changes could trigger a liquidation domino effect. The second risk regarding liquid staking derivatives is their liquidity issue. If staking derivatives cannot be exchanged for any other assets in the market, they effectively serve no purpose other than as a deposit receipt. The liquidity of these derivatives is also directly related to peg risk: the further a staking derivative deviates from its peg, the worse its liquidity will be.

The final risk concerning the STaaS industry applies only to decentralized staking pools, which aim to aggregate staked funds and allocate them to different validators. While these staking pools may mitigate any associated counterparty risks when selecting specific validators, they increase smart contract risk, as the staking pool protocol must route these staked funds within its already approved validator network. Recent DeFi attack incidents indicate that hackers will go to great lengths to find vulnerabilities in protocols. Only time will tell whether these contracts can withstand the attempts of malicious attackers.

Decentralization

A common criticism of the PoW mining industry is that it encourages resource centralization, leading to the centralization of network security providers. Any centralization in the blockchain network security system makes the entire network more vulnerable to attacks. While PoS networks do not benefit from economies of scale like PoW networks, the STaaS industry is a key variable affecting the decentralization of PoS networks.

To quantify the degree of decentralization in blockchain networks, Balaji Srinivasan (former CTO of Coinbase) introduced the concept of the Nakamoto Coefficient, which measures the number of entities an attacker needs to control to attack at least one significant subsystem (as shown in the figure below); the higher the Nakamoto Coefficient, the greater the degree of decentralization of the network. Given the consensus characteristics of PoS networks, the minimum threshold that jeopardizes the network is controlling 1/3 of the staked funds in the network.

Applying the "Nakamoto Coefficient" to leading PoS networks paints a different picture: attacking a large PoS network (like Cardano, Solana, and Avalanche) requires a highly coordinated effort; whereas taking over other PoS networks (like Tron, Polygon, Elrond, or Fantom) would be simpler: just attack the top two or three staking pool providers, and the entire network is yours. Again, this concentration of staking pool distribution is partly due to the immaturity of these PoS networks; as these networks mature, we can expect their "Nakamoto Coefficient" to slowly increase.

The crypto industry needs to ensure that large STaaS providers are kept in check to prevent this centralization issue. Delegating to smaller validators and encouraging STaaS providers to maximize the number of validators they manage are two ways the community can help these PoS networks remain as decentralized as possible.

Outlook for the STaaS Industry

The crypto market has made one thing clear: PoS is replacing PoW as the dominant consensus mechanism for public blockchain networks. Bitcoin will continue to keep PoW relevant, but any general-purpose smart contract network will need an alternative consensus engine to support its widespread adoption. Early STaaS providers recognized this opportunity and are already positioned for continued success as more investors seek a way to earn reliable returns from their PoS assets.

In the above discussion, we have detailed the emerging product-market fit of the STaaS industry. But what does the future hold?

It can be argued that staking is the closest thing to a "risk-free rate" for blockchain networks. In traditional economic systems, the risk-free rate is represented by the yield on government bonds, which are the foundation of a country's economic system. Similarly, the security of a blockchain is foundational to the blockchain economic system. The maturation of the crypto economy should attract more long-term investors seeking this network-native form of yield for their PoS assets. As we see now, we can expect continued growth in the STaaS industry.

Within the STaaS industry, liquid staking solutions will benefit the most from this continued growth. We have already begun to see the first large custodial providers catch up with this trend. For example, Binance has introduced a liquid derivative BETH to offset the opportunity costs associated with the indefinite lock-up of Eth2. As liquid staking pools grow their network effects across different blockchains and staking providers, this trend should continue.

We can expect that STaaS commission rates will follow a pattern similar to the bank fees consumers have paid over the past 20 years: increased competition from fintech companies will force banks to offer increasingly lower fees to retain customers; similarly, the growth in the number of STaaS solutions will exert downward pressure on the commissions customers need to pay. Of course, one variable that may keep these rates high in the short term is the high switching costs, which can be attributed to the immaturity of liquid staking solutions. If a new STaaS competitor enters the market offering lower commissions, customers of STaaS who do not use liquid staking solutions will have to wait for the lock-up period to end before they can switch to the new provider; by the time they can switch, another new STaaS provider may offer even lower commission fees, triggering a bottom-up fee competition.

Finally, given the simplicity of the STaaS industry business model, STaaS providers may compete primarily based on brand and reputation, much like we see with consumer banks today. The services offered by Wells Fargo and Chase Bank are actually quite similar. These banks win customers primarily through marketing channels and providing a streamlined user experience.

Source: Bank of America

Similarly, STaaS providers with the highest security, best risk management, and reliable liquid staking derivatives may accumulate the most customers in the long run. We can already see this argument reflected in the cross-chain growth of Lido Finance.

As always, it is important to remember that we are in the early stages. A new breakthrough consensus mechanism could emerge tomorrow that renders PoS irrelevant. However, given the years of research into consensus mechanism design, it is highly unlikely that this will happen in the short term. Meanwhile, as PoS continues to evolve towards widespread adoption, the outlook for the STaaS industry remains one of "only going up."