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Token-specific Yields
In the realm of cryptocurrency, there exist three primary types of token-specific yields:
- Network Staking Emissions: Yields (at the protocol level) that are distributed to validators or delegators who contribute to the proper functioning of blockchain middleware
- Token Holder Rewards: Yields (at the protocol level) that are provided to individuals who stake or hold a specific token
- Participatory Rewards: Yields that are awarded to users who actively engage with and utilize a particular project (ex: DeFi or airdrops)
It is important to note that the yield properties of these token-specific yields are project-dependent and as such, realized returns can vary greatly. The yield that is accrued over time is hypothetical and denominated in the project's token price. It is only realized through the act of selling from one party to another. Therefore, there are underlying assumptions that must be met in order to realize the yield, such as the ability to sell on the open market, zero price movement, and the proper functioning of underlying mechanisms.
As an example, staking ATOM, as of January 2023, offers a nominal 22% staking reward. This sounds incredibly attractive, especially if you are bullish long-term on the ATOM token. However, that 22% ROI is not net ROI. We must account for the token inflation that is subsidizing those rewards, staking fees, lock-ups, and token price action.
Once taking into account dilution via token issuance, the net ROI on staking ATOM is closer to ~6%. So, staking rewards are closer to 6% minus the fees if a user chooses to delegate. This is competitive with other top PoS protocols like Ethereum and Solana and forces the user to take into account opportunity cost. If the ROI is similar, which crypto asset would you rather hold/will maintain its value?
This is also where a user has to determine if staking/locking up the coin for whatever period (variable across protocols) is worth dealing with the price action. Most crypto assets are down ~70-80% from their ATHs. It is probably not a stretch to assume that many of those holders would have preferred to just sell rather than get 3-7% net staking rewards. However, because staked tokens are locked up, this not only adds another point of friction in selling, it impedes a user’s ability to sell at the opportune moment.
Token Holder Rewards and Staking Emissions: A Closer Look with Ethereum
In the case of Ethereum, ETH holders can stake their ETH to help provide crypto-economic security to the network. For this act, stakers receive their proportion of the network’s inflation plus transaction fees. In Ethereum, one must stake 32 ETH to become a validator.
A validator is a person or entity who locks up (stakes) 32 ETH in order to run a validating node and secure the Ethereum blockchain. Validators are “are “entities responsible for ordering and packaging transactions into discrete data structures called blocks, which are then proposed to the network to validate.” This means rather than relying on energy/electricity for security, as is the case in PoW, Ethereum security will rely upon staked capital. With PoS and staking rewards, ETH becomes a productive capital asset with yield as well as money underpinning network transactions and executing smart contracts.
The launch of Ethereum’s Beacon Chain in December 2020 marked an enormous milestone that has been on the roadmap from the early stages of the project in 2015 and has already become the largest, most decentralized PoS blockchain with ~500,000 validators.
There are several different ways a user can stake ETH. The most autonomous and preferred method is to personally run a staking node. However, this requires at least 32 ETH plus some intermediate technical knowledge of the protocol, nodes, and computer hardware.
However, there are other types of staking:
- Centralized exchanges: High trust assumptions. Not your keys, not your coins.
- Staking as a service and LSDs: Non-custodial. Entrusted node operation.
- Pooled staking: Stake any amount, Earn rewards.
Over $26B worth of ETH has now been staked! Some stats on network progress:
- ETH deposited to deposit contract: ~16,300,000+ (~13.5% of all ETH)
- Current staking yield: ~5.5%
- Active validators: ~500,000
- Pending validators: ~50,000
- Network participation rate: 99.0%
Too Much of a Good Thing?
In some instances, token-specific yields may contribute to the downfall of a project through heavy emissions that dilute token value or act as an inflationary mechanism for a failed project structure. Conversely, in other instances, project-specific yields may help to establish real demand, leading to the growth and success of the network.
It is crucial to evaluate not only the potential returns of a cryptocurrency token but also the source and sustainability of those returns over the long term. Inflating the token's supply excessively in the long term will ultimately lead to a decline in value, assuming a fixed market cap limit. In order to ensure long-term sustainability, L1 blockchain networks must generate enough fee revenue to cover the cost of maintaining network security through validator issuance. This is also in the best interest of the users, who are often the owners of the network.
A blockchain that is unable to generate enough revenue to cover validation costs will ultimately become financially unstable and unsustainable over time. This is due in part to the fact that validation costs are proportionate to the market cap, rather than a fixed expense, making it difficult for networks to grow without also increasing revenue in proportion to the market cap.
DeFi really exploded starting in Q2 2020, sometimes called “DeFi Summer,” in which DeFi projects saw massive adoption and usage growth. The increased adoption was sparked by a new bootstrapping mechanism called liquidity mining/yield farming in which users supply liquidity to the protocol (i.e., lend their funds) and are, in turn, rewarded by the protocol in a native token. One of the first DeFi experiments in liquidity mining was by Synthetix in 2019, which later inspired a wave of yield farming projects in 2020, most notably after Compound Finance enabled liquidity mining of COMP tokens in their borrowing and lending markets. However, this mechanism only works if new users are compensated with high returns stemming from high protocol inflation.
The protocol is essentially “buying” users in the early stages with the hopes they remain sticky, and the protocol matures with a solid user base as the rewards eventually decline. As the image below illustrates, it is not uncommon for even household name dApps to inflate at 10%+ in order to entice liquidity to their project. Unfortunately, threading this needle for dApps has proven difficult as users have proven time and again not to remain loyal to the protocol. Instead, moving their funds to whatever new protocol is offering higher rewards at that moment.
On the other hand, token-agnostic yields are generally more predictable but will typically have lower return potential. It is akin to selling shovels in a gold rush as opposed to identifying a metal that appreciates in value by 1,000x.
