Coinbase Is Getting Into the Proof-of-Stake Business. What Does That Mean?

Coinbase announced this morning that it will provide custodial staking services for its larger clients, allowing them to benefit from owning proof-of-stake-based cryptocurrencies without some of the risks that has previously entailed. The service will roll out first for the Tezos network, and Coinbase says it will soon add support for staking on the Maker stablecoin system.

Other custodial staking services already exist, but Coinbase (despite the egregious Neutrino acquisition misstep) enjoys an undeniable trust premium in a sector rife with exit scams and other custodial failures. In its announcement, Coinbase emphasizes the importance of a trusted custodian for institutional crypto investors, many of whom aren’t able to custody their own assets but still want to benefit from staking.

But what exactly is staking? It’s essentially comparable to the “mining” that secures so-called “proof-of-work” networks like bitcoin and Monero. Proof-of-work miners rely on demonstrated computing effort to earn the right to add transactions to the blockchain, and earn associated rewards in the currency they’re administering. Proof-of-stake-based blockchain networks, including Tezos, Qtum, and EOS, grant similar rights and rewards to participants who “stake” each network’s native token. (Some of these use a variation called delegated proof-of-stake, or DpoS, a distinction we won’t dive too deeply into here.)

Rewards for staking vary, but generally amount to a roughly five to eight percent annualized return, paid in each network’s native token. Some reports, including one from the Wall Street Journal, have referred to this reward as “interest,” but that’s inaccurate since staking isn’t a loan. And the rewards, just as in proof-of-work systems, are made up of newly-minted tokens.

Capturing some of that inflation is the most obvious reason custodial staking is appealing to the large-scale investors Coinbase is targeting. But staking systems also, increasingly, grant various governance rights to stakers, letting them vote on upgrades or other decisions about the future of the network they support. Tezos, for instance, recently held an on-chain vote on a protocol change known as Athens. Those rights make staking look a lot more like traditional stock ownership, which also, in many cases, grant influence over the underlying entity.

Staking may also help reduce short-term speculation and volatility, because stakers—also often referred to as validators—agree to lock up their tokens for relatively long periods of time. This essentially demonstrates that they can be trusted as custodians of the network because they’ve made a long-term bet on the value of its tokens. If a token crashes, stakers are less able to quickly trade out of their positions, providing something of a price floor. By making staking easier for large-scale investors, Coinbase’s new product could amplify those effects.

Though specific implementations vary, the headline advantage of proof-of-stake systems is speed. The hashing algorithms underlying proof-of-work systems are specifically designed to take time to execute. As mentioned in the bitcoin whitepaper, proof-of-work was substantially inspired by Adam Back’s “hashcash” system, which was intended in part to slow down industrial-scale email spammers.

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By contrast, proof-of-stake has no such inherent slowdown mechanism, allowing transactions to be cleared faster—sometimes much faster. But that comes with some tradeoffs, some of them still not fully understood. There are still questions, for instance, as to whether proof-of-stake systems provide the same level of network security as proof-of-work systems like bitcoin. Among other risks, negligence or collusion on the part of validators (particularly in DpoS systems) can have devastating consequences. In a recent example, one negligent validator let more than $7 million worth of EOS tokens go astray. Proof-of-work systems don’t have this potential failure point.

On a more philosophical level, there remain serious debates over whether proof-of-stake systems foster true decentralization, either in clearance or governance. Voting rates in many blockchain governance systems have been measly so far, giving disproportionate power to a few players. Similarly, only 21 validators are in control of the EOS network at any given time, and their status is determined through an explicitly social process. In essence, validators on many systems must constantly campaign for the trust of other network participants, arguably costing them the “trustlessness” that makes proof-of work systems like bitcoin so resistant to manipulation.

Nonetheless, there are signs that proof-of-stake systems will only become more prominent in the blockchain industry, as their advantages may counterbalance their risks for many applications. In the most important example, Ethereum—the second largest blockchain network by market value—has been working towards a transition to its own version of proof-of-stake, though that process has been slow. If and when it’s completed, Coinbase could benefit hugely by enticing Ethereum stakers to simply let the huge exchange hold onto their tokens long-term.