STAKING

Is Staking an Effective Hedge Against inflation, Given the Current Downturn in Crypto Markets?

The Interest in Crypto as an Asset Class

2021 was the year that crypto as an asset class boomed, with record inflows from both institutional and retail investors driving a culture of mass adoption. Some investors bought into the underlying technology of blockchain, some investors were speculating on upward price action, while other investors saw crypto as an effective hedge against turbulent market conditions.

2022 presented an entirely different challenge; suddenly crypto was inextricably linked with the macro economy and offered investors a less effective hedge against the global bear market. Despite this, interest is still there; the daily trading volumes on Ethereum alone often surpass $15bn and, week-on-week, the inflows into the world’s largest proof-of-stake (PoS) token exceed the outflows, with investors more than willing to ‘buy the dip’.   

The Benefits of Staking

Almost half of the top ten cryptocurrencies already operate on a PoS model; tokens are put as a collateral to verify transactions in the blockchain, and holders of those tokens that are staked earn a reward in the process. Crucially, regardless of the underlying value of the cryptocurrency, staking allows investors to earn a passive yield on their assets while improving the security of the blockchain network they invest in. These yields can be fairly lucrative, especially when compared against the interest offered by traditional financial institutions when there is pressure on the economy at a macro level. Where you would struggle to return more than 1% Annual Percentage Yield (APY) with a normal savings account, the annual yield on staking can return anywhere from 2-100%. 

The Importance of Staking

Staking not only generates returns for investors, it is also essential to the function of blockchain technology. It enables the efficient selection of validators and, as blockchain becomes more and more decentralised, it becomes even more vital to ensure that enough crypto holders are participating in staking in order to secure the blockchain network. The relationship between staking and investment are symbiotic; investors want their crypto assets to be secure, and so there is a real incentive to stake their tokens and protect their investment.

Going forward, there will also be more of an emphasis on self-governance in crypto, and this will require more participation from holders of tokens to execute governance  such as proposals and votes. Staking could be seen as the precursor to this move towards creating more decentralised autonomous organisations (DAOs) in the future, and encourages good practice to futureproof blockchain technology as communities begin to move fully into Web3. 

The Role of Inflation in Staking

Crypto is unique in that every PoS protocol has an inbuilt inflation mechanism in its code which means, unlike the wider macro markets, inflation is predictable. This is an inflationary hedge in itself and, by staking, investors are able to directly participate in this inflation by earning an allocation of those extra tokens that are generated. Not participating in staking is a double-edged sword; you not only lose out on passive yield, you are also subject to the pressure of the inflation created from those who are staking, as they generate more tokens by doing so. Whereas inflation in fiat currencies will only devalue the value of your currency, not participating in staking will, at the very least, reduce your percentage share of the tokens in circulation, as well as reduce the value of your tokens. 

The Issue of Liquidity

One concern that investors may have is on the issue of liquidity; after all, staking is very much a buy-and-hold principle. Most participants aren’t speculators and, just like high-frequency traders in traditional finance, those with shorter-term investment strategies may be discouraged from participating in a passive income product. This is where liquid staking comes into play; derivatives are created attached to these staked tokens that can then be freely traded on the market or put to work in other DeFi protocols. Of course, these derivatives won’t affect actual liquidity as they don’t give holders access to the underlying asset until it is un-staked.

The trading of derivatives can also be seen as a way of monetising crypto as an asset class, offering a product to investors who wish to speculate on price movements rather than participate in the underlying technology. The recent bear market has exposed the shortcomings of such products, and we have seen a number of high profile collapses where crypto assets have been pooled to generate higher returns, contravening the entire principle of blockchain technology. 

Crypto assets may also be pooled in the form of crypto ETPs. A fairly new financial instrument in the crypto industry, they certainly offer a convenient product for investors; lowering the barrier to entry for those not already investing in crypto as an asset class and creating fewer points of failure in the blockchain which should, in theory, mitigate some security risks. While these ETP providers are trying to facilitate staking, a recent study did find that investors in single-asset crypto ETP forfeit $64.9m of potential staking yields every year.   

Staking as a Hedge Against Inflation

It remains to be seen whether crypto as an asset class will decouple itself from macro market conditions, at least in the short term. Loss of value on underlying PoS tokens presents its own challenges, as the downward price pressures may outweigh the yield generated from staking. With that in mind, it’s important for investors to be cautious if choosing to use staking as a hedge against the wider economic downturn; at this moment in time, that simply isn’t effective.On the other hand, as many PoS blockchain technologies do have inflation mechanisms built into their technical code, not participating in staking would mean diluting your share of the token pool as well as suffering from the loss of value on your tokens. The bottom line is that staking is a great way to accumulate more crypto assets and, for both existing and new investors, the prospect of the economic (and price) recovery in the long-term makes now the perfect time to participate in staking.

By Christopher May, Co-Founder & Co-CEO of Finoa

Traciwininger
Author: Traciwininger

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