Institutional Staking and its Broader Impact

Institutional interest, and therefore institutional capital, in crypto continues to grow as infrastructure technologies and tools mature and sizable crypto markets become more appealing to investors. Institutions wield power from a position of leverage as their substantial capital enables them to participate in network governance such as voting on protocol upgrades, fee structure adjustments, and treasury allocation, ultimately making a significant impact in the long-term trajectory of the network.

Yet, the broader corporate adoption of crypto brings with it stronger government oversight. Given the rate at which new frameworks and entire companies emerge, regulatory bodies have historically lagged in legislating crypto products. Established legal frameworks are not exactly equipped to address the characteristics of cryptocurrencies, such as decentralization, global transactions, and pseudonymity. In fact, the borderless nature of crypto introduces another layer of complexity for authorities from various jurisdictions to develop coordinated standards. Therefore crypto projects must balance compliant privacy in a way that satisfies both regulators and proponents of decentralized technology to promote mainstream adoption, combat illicit activity and acquire institutional investment.

Innate to permissionless blockchains is privacy, which exists in tandem with compliance, the adherence to established regulatory frameworks. In many instances, this equates to doing due diligence on users to remain compliant, and failure to do so leads to legal consequences. While decentralized technology purists may oppose regulatory oversight over concerns of inhibiting proliferation, it is important to recognize that the route to greater utility requires a collaborative effort between legislators and protocol developers. In essence, the combination of heavier government involvement and more established DeFi platforms, which enable larger markets with significant liquidity, has strengthened the appeal for corporate entities to invest in this space. It is also worth mentioning that large volumes of liquidity, whether that is due to the presence of institutional activity or otherwise, can increase the likelihood of greater fiduciary responsibilities.

Government Interest

Governments have already implemented steps to regulate crypto, particularly as an asset classification. In the US, exchanges are considered money transmitters and must register with the Financial Crimes Enforcement Network (FinCEN) as money services businesses. This consists of providing information on the business and its structure and activities, implementing AML programs and KYC checks, transaction monitoring, and recordkeeping. The SEC’s classification of certain cryptocurrencies and ICOs as securities means they belong to the regulatory framework of securities laws and regulations, which are designed to protect investors and promote fair markets. Once labelled a security, they are subject to stringent regulatory oversight involving anti-fraud provisions, disclosure of material information, and investor protection laws.

The EU has also formed the basis for new regulatory frameworks for crypto as assets with the Markets in Crypto-Assets Regulation (MiCA) and the Transfer of Funds Regulation (TFR). MiCA seeks to create a unified legal framework by differentiating between types of crypto-assets and mandating service providers (ex. custodians, exchanges) to be licensed in order to operate within the EU. They must also implement measures to safeguard client assets as well as prevent market abuse. The TFR focuses on tracing crypto-asset transfers to combat money laundering and other illegal activities by having operators collect and send information on transactions that exceed a certain threshold.

Many other governments around the world have their own approaches to regulating crypto, and this should only bolster the legitimacy of crypto and the belief that the goal of wider adoption necessitates a joint effort between the industry and government.

Institutional Demand

As PoS ecosystems mature and modularity supports a more interoperable user experience, institutions see staking as an investment strategy for various purposes, amongst them portfolio diversification, inflation hedge, and yield generation. Whilst there are risks in staking, as crypto remains a volatile market with regulatory uncertainties abound, the decentralized nature and staking characteristics lend themselves to incentives that are especially appealing at the scale of these investments.

Being able to stake assets as collateral mitigates risks associated with asset holding, with the possibility of staking rewards to hedge against inflation. These rewards can attract a wide range of investor profiles, from asset managers and custodians whose clients are hedge funds, venture funds and corporate treasuries, to foundations that may employ staking as part of their effort in supporting network decentralization and growth. Institutional clients may also be blockchain infrastructure providers, staking pools, and exchanges, with restaking being a value proposition particularly with economies of scale. Even regulated financial institutions such as banks and insurance companies are increasingly exploring opportunities in digital assets, but unsurprisingly, they are risk-averse and are slower adopters in comparison.

Since Ethereum’s transition to PoS, there have been protocol-level improvements that have reassured institutional investors, namely elevated security and scalability, a lower environmental impact for those with ESG principles, and of note, now that staking is available, the ability to earn staking rewards and to participate in governance processes. Many concurrent events have happened to stoke intrigue in and facilitate institutional staking, one of which being the adoption of traditional finance concepts into DeFi. Stricter regulation enforcement combined with a constant need to prevent criminal activities have led the industry to adapt in ways that prioritize risk management and investor rights in an effort to establish legitimacy. Such concepts DeFi projects may integrate are smart contract audits, KYC procedures, or establish insurance funds in an effort to promote trust and draw corporate capital.

Essentially, institutions seek ecosystems with institutional-grade infrastructure and services, particularly as introducing more liquidity to a network is a test of its performance, and scalability is critically relevant. Under greater scrutiny, institutions must feel confident in a staking solution that has strong security, is compliant with regulations, and has a reliable reputation.

As mentioned, the selection of staking solutions on the market continues to proliferate, and this means that interested stakers have a calculated choice to make. In order to understand the most suitable product, there are some assumptions to make about the institution itself. Aside from requiring strong security and regulatory compliance, the entity should discern its risk tolerance, preferred asset to stake (whether that is a high-yield or low-risk asset for instance), and the level of custodial control they feel comfortable with, where a non-custodial strategy is appropriate for those who are technologically proficient enough to manage their stakes themselves for potentially higher rewards.

Hence, for a risk-averse institution prioritizing asset security, the ideal staking solution would culminate in a custodial platform known for its robust security measures, transparent governance processes, and regulatory compliance tools, all while ensuring scalability to accommodate growth. One such provider is Anchorage Digital Bank, which claims to be “the only federally chartered crypto bank.” They provide detailed reporting for compliance purposes and use hardware security modules to secure keys to the digital assets, which are insured throughout their life cycle. Part of their staking offerings are automatic re-delegation of staking rewards, custodial staking, and liquid staking through their partnership with liquid staking protocol pSTAKE.

Their weakness would be their lack of an open governance model, although it can be argued that there may be less transparency (or decentralization) in institutional staking providers in general, as a trade-off for more robust security practices and legal compliance. For a more transparent governance, users may have to look towards non-custodial options or DAOs, as custodial approaches carry an inherent counterparty risk. However, even if transparency is lacking, understanding staking decisions and fee structures as well as inspecting security audits and reports may assuage investor concerns. Ultimately, compromises in staking priorities are inevitable, but the rapidly evolving landscape can assure enterprise clients that more competitive offerings will become available, if not already.

Lido’s Stance

Lido’s non-custodial liquidity staking solution, security audits, and DAO that provides transparency into its governance processes are solid foundational concepts that can interest institutional investors. With the institutional market still rife with opportunity, it is prudent for Lido to take measures to bolster its usage across corporations by considering services that tailor more closely to institutional demand including enterprise-level integrated custody solutions, perhaps including regulatory compliance tools such as tax reporting capabilities and KYC/AML procedures. It might even be worthwhile to incorporate a custodial option in addition to Lido’s current non-custodial services in preparation for staking on Lido to become a mass market solution.

In another vein, the introduction of the Bring-Your-Own-Validator (BYOV) concept emphasizes user control and security over their staked assets. Technical complexities notwithstanding, BYOV could amplify institutional adoption and decentralization by diversifying operator sets on Lido. Under examination, the idea can pose certain security risks as Lido would have to rigorously vet such validators and adapt the governance model to be able to accommodate them. The proposal is still in its infancy, but it represents a burgeoning approach using modularity as a mode of expansion.

Risks Posed by Institutions

The presence of a large volume of institutional capital entering the space is bound to have substantial impact throughout the network. While it creates market opportunities, it can have extensive influence over the protocol and the ecosystem at large. At a protocol level, while institutional investments will garner more earning opportunities, it would also request more sophisticated functionalities, which lead to greater smart contract complexities and possibly vulnerabilities. Meanwhile, the large volume of capital can also attract malicious actors looking to exploit those vulnerabilities. This coupled with infrastructure performance concerning the increased activity load can be a very legitimate test of the network’s scalability and security.

Where there is a centralization of validators, the risk of slashing, whether that is due to having periods of downtime or double signing, heightens as those validators can more easily misbehave and compromise network integrity. The worry over protocol violations can just as well extend to governance manipulation, as in the case of token-based governance, where centralized validators may exert disproportionate influence over governance decisions by controlling a significant portion of the network’s staked assets or voting power.

Across the ecosystem, concerns over centralization of stake are inevitable, with the concentration of power threatening the security and decentralization of the network. Stake owners can then manipulate the market by rendering illiquid the circulating token supply available for trading on the open market, applying pressure to the token’s price.Thus, the inverse relation between liquidity and privacy cannot be understated. A market with high liquidity generally attracts institutional investments, which are followed closely by legislation. Stricter compliance requirements are a means of systemic risk mitigation to protect broader financial markets. Therefore, balancing individual privacy with the need for regulatory compliance is a continual fundamental challenge plaguing the DeFi space today. The influx of institutional capital can further complicate this issue by inadvertently exchanging privacy for regulatory compliance, a precarious path for crypto if developers, researchers, and regulators don’t work collaboratively to navigate this problem.

Looking Forward

The designs to incorporate distributed validator technology and permissionless nodes help Lido advance towards achieving the blockchain trilemma, by virtue of having more validator nodes, a strengthened fault tolerance, and a distributed workload of validating transactions. The more diverse the validator set, the less staking power is concentrated amongst a few large entities and the more resilient the protocol is. While Lido’s liquid staking solution has high utility, it may behoove the protocol to consider adopting a hybrid model of minimum stake and permissioned node operator. Doubtless this has the likelihood of affecting accessibility and stETH liquidity, yet it is a method to enhance security and decentralization and reward the community. The permissioned node operators can be maintained for security and a wider pool of decentralized validators can participate via the minimum stake requirement.

The institutional market remains unveiled, and institutional staking will have large scale influence in advancing the technology and culture further. The industry will have to co-orporate with regulators to define the trajectory of crypto in a way that is secure for users and preserves their privacy. With how quickly the crypto landscape evolves, the future will see more effective and customizable products tailored to staking needs, retail or institutional.

References

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