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Bitcoin in Review Going into 2020
Proof-of-Stake Cryptocurrency: The Game Changer for Institutional Money
Staking is fast becoming a buzzword that has heightened institutional interest in the cryptocurrency space over the past year. Derived from the consensus mechanism called Proof-of-Stake (POS), staking has been regarded as a novel approach in aligning economic incentives, and ensuring security within a distributed system. Moving away from the vast energy consumption and scalability issues of the first and most popular consensus mechanism, Proof-of-Work (POW), staking has been touted as a likely mechanism to be widely adopted.
Heightened Institutional Interest
A recent announcement regarding support for POS-based coins has caused ripples in the industry, and could reflect the new trend in institutional investing across the cryptocurrency landscape. This new facility is offered by Coinbase Custody, a subsidiary of Coinbase, intended to offer financial control for institutional players delving into cryptocurrency investing. This means that institutions would be able to participate in, and influence the decision-making process of cryptocurrency projects governed by the Proof-of-Stake consensus mechanism, allowing them to vote on key protocol and governance matters directly through their account.
This move focusing towards staking-based coins is an interesting phenomenon, which has previously passed the radar. The adverse conditions of the cryptocurrency market has more often than not hindered the participation of institutions, due to the lack of liquidity and extreme volatility. This recent announcement could represent the formalization of the initial steps that institutional investors would be looking to undertake in this nascent market.
What is Proof-of-Stake?
Proof-of-Stake (POS) is a mechanism used by a distributed blockchain that tries to unanimously agree (achieving consensus) on a single state of truth in the network, through the primary mechanism of staking the native coins. The most popular consensus mechanism was Bitcoin’s Proof-of-Work, which requires computational work to be exerted by miners in a bid to secure transactions. However, the problem with POW is the tremendous use of electricity and resources required for the mining process, which poses an environmental concern. The mining process of POW consumes so much energy that it takes an equivalent amount of electricity to power a country the size of Switzerland in a year. This is a major issue that POS attempts to solve, since far less computational and energy resources are required using the POS model.
(Source: Lisk Academy)
The POS model allows anyone to mine or validate transactions in the network, based on the amount of coins held by the participant. This means that the more native coins owned by the participant, the greater the mining power of that individual. POS runs on a randomized system where the miner is chosen at random, preventing the centralization of wealth and power by rich individuals in the network, and is as secure as POW since it theoretically aligns the incentive of participants with the security of the network. Someone trying to attack the system would be punished through either confiscation or loss of his staked coins, while accordingly, those who validate transactions will be rewarded with additional coins, calculated on an annualized basis through the expansion of the coin supply.
Obstacles Hindering Institutional Participation
The cryptocurrency market is mostly made up of retail investors, with a minority institutional presence due to numerous challenges faced by the industry. There are several core factors:
A possible major hindrance to institutional adoption is the complexity of the technologies underlying cryptocurrencies, as well as the technicalities involved in investing and securing the coins. Blockchain is an infant technology that is intimidating for the average individual, given the complex terminology, and the associated terminology. It is naturally understandable that new technology provokes a degree of skepticism and misunderstanding during its initial stages.
Given the difficulty in comprehending what a blockchain is, or how a consensus mechanism functions, institutions will tend to shy away from something so tremendously new and complex. This is both for the purpose of managing their risk profile, as well as waiting for greater stability and traction before dipping their toes into the market.
A single trait that most people associate with cryptocurrencies is volatility, pointing to the extreme fluctuations in price that scares off institutions. Although risk management plays a pivotal role for institutions, the lack of quantifiable metrics and valuation makes it impossibly hard for institutions to accurately assess the myriad of risks in the cryptocurrency market. From the point-of-view of merchant adoption, the volatility of prices compromises the promise of cryptocurrency being a stable currency that can rival fiat money. Ultimately, stability is a core factor in the adoption of any currency by merchants and institutions. The systemic risks inherent in the cryptocurrency market make it hard for institutions, both from a merchant adoption and an investment perspective.
Due to the infancy of the industry, the trading volume in the cryptocurrency market is sparse and shallow, making it extremely illiquid in relation to traditional asset markets, such as the stock markets or the foreign exchange market. The fact that institutional investors have large ticket allocations makes exploring the current state of the market cumbersome and expensive. The cryptocurrency market is mainly made up of retail investors, who cumulatively, cannot support the depth of liquidity with which institutional investors are comfortable. Currently, the volume of cryptocurrency trading stands at US $7.3 billion, while the volume of equities trading is nearer to US $74 trillion.
The aforementioned factors play a critical role in painting a bleak overview for institutions interested in cryptocurrencies. A shift in the paradigm of thought towards an institutionally-receptive environment is critical in onboarding institutional players.
Staking: Lowest Hanging Fruit
The renewed interest from institutions in POS-based investment services seem to mitigate the various challenges faced by the nascent cryptocurrency industry. Staking could yield numerous benefits to investors, especially institutional entities with a larger capital base. Let’s explore the benefits of investing in POS coins.
Attractive Rate of Returns
Staking is a passive investment process that yields relatively high rates of return. Although the rewards for staking varies between different coins, the general approximation of annual returns come to an attractive rate of between 5% to 8%. These returns are paid in native coins, through an expansion of the coin supply. Purely from a financial point of view, the returns from POS coins seem to be a comparatively similar range to the traditional stock market, which points to an average annual rate of return of 7%.
However, the stock markets are prone to numerous systemic and idiosyncratic risks that may affect investor returns, yet returns generated from staking POS coins are somewhat ‘guaranteed’. This is because the interest mechanism of POS coins is not dependent on market variables; rather, it is hard-coded into the protocol, and would undeniably provide a fixed rate of return unless there is a fundamental change to the underlying codes. In a wider sense, the rates of return for POS coins are much more attractive than conventional shares, since theirs are fixed and guaranteed.
In a POS system, holders of native coins are granted potential governance rights. This allows holders to vote on upgrades or other decisions regarding the future of the network they support. The more coins one owns, the more votes they can advance in the system, meaning that institutional investors who own large amounts of coins yield greater power and influence in the network. This is similar to the traditional stock ownership, which grants voting power and influence to major shareholders in proportion to their equity stake. The addition of influence into the arsenal of benefits is definitely an attractive aspect with which institutions are familiar in traditional markets, and this could add greater incentives for them to consider cryptocurrencies an investment asset.
Reduction of Volatility
A major deterrent towards institutional cryptocurrency adoption is the extreme volatility of the cryptocurrency market. However, the reduction of volatility through staking may not necessarily reduce the systemic risks associated with the market. This is because the coins that are staked are locked for a relatively long time and stakers would not be able to sell away their coins when the market — or the price of the coin — crashes. This notion of stability is a huge concern for institutions considering exploring cryptocurrencies as an asset class. Furthermore, although a POS-based coin is not insulated from systemic and market risks, the long-term outlook that institutions traditionally embody would facilitate mitigation of risks to a certain extent.
Institutional presence is set to rise in the cryptocurrency market whether we like it or not. The global awareness of blockchain technology as a ground-breaking innovation is steadily expanding, and it is only a matter of time before the larger institutional players jump on the bandwagon. Though there are still numerous factors yet to be resolved within the industry, POS-based coins seem to be a low hanging fruit that offer institutions excellent benefits. This may be the inaugural gateway required to awake the institutional den.