Over 80 blockchains now offer incentivized network participation through Proof-of-Stake mechanisms. The increasing popularity of these protocols has captured regulatory attention, and centralized staking programs have come under particular scrutiny.
The Securities and Investments Commission in the U.S. has issued multiple rulings against centralized staking programs, and the UK’s Financial Conduct Authority has stated that ‘centralised pooled staking’ presents consumer risks.
Some centralized staking programs offer a guaranteed rate of return in exchange for permission to stake tokens on behalf of consumers. Regulators understandably want to ensure any risks associated with this type of staking are appropriately mitigated, and that companies running these programs obtain relevant licensing.
Although the discussion of consumer protection is important and relevant, there has been unintended conflation between centralized staking programs and the technical process of staking directly to a protocol. Clear definitions and delineation between these two activities is crucial to finding the right regulatory balance.
Here are a few key differences between these concepts.
1. Staking Is A Network Security Function
Staking is about network resilience and not yield generation. PoS blockchains use staking to secure their network by incentivizing a large and distributed group of ‘Validator’ nodes (configured servers connected to the network) to actively produce blocks on the network. Distribution of block production increases resilience, because if a node stops working or is compromised, the network can continue to function.
Unfortunately, the cost of participation is high – you need to pay for hardware, software, cloud hosting costs, data centers, utilities, and protocol engineers. In Proof of Work blockchains like Bitcoin, the participation costs became so large that it is now a numbers game dominated by well capitalized companies.
PoS blockchains take a different approach. Any token holder can contribute to the network’s consensus without running hardware themselves. Staking directly to the protocol is referred to as “delegation”, where the token owner (delegator) uses a validator to connect the network. Validators enable participation in the blockchain network, but do not control access to it. A delegator is free to choose (and ‘unchoose’) any validator on the network.
If a validator is chosen to produce a block, the protocol will acknowledge their efforts by providing tokens to both the Validator and any wallet address associated with that Validator. It’s the crypto equivalent of putting your name on a work roster in the hope that you’ll be chosen to work a shift.
This incentivization model is also designed to align behavior across all network participants, and to ensure adherence to the network’s rules. Penalties for breaking these rules are covered below in the discussion of risks associated with staking.
2. You Can Stake Directly To A Blockchain And Control Your Own Private Keys
In centralized staking, the program operators control the private keys and the tokens. However, if you stake directly to a blockchain, you maintain control over your private keys at all times and there is no actual transfer of the tokens to the validator. The network recognises that the tokens held in the delegator’s own wallet are being staked and the delegator is simply saying to the network: “you can associate me with this validator machine.”
To compensate for the cost of running the server, the delegator will pre agree to pay the validator a small percentage of any rewards distributed from the network. Provider data on stakingrewards.com suggests this amount is usually less than 10%.
Multiple delegators can also choose the same validator. This doesn’t involve the pooling of the tokens – they remain individually controlled and segregated in different wallet addresses on the blockchain ledger – it is just sharing infrastructure in a similar way to how virtual machines operate in a cloud environment.
3. Rewards Can Be Distributed Automatically Via The Blockchain’s Smart Contracts
In a centralized staking program, the program operators also control reward distribution.
If you stake directly to the protocol, the delegator maintains control of the tokens, and the rewards are distributed directly from the network. For example:
● Automatic on-chain distribution: the network uses a smart contract to automatically distribute rewards to the delegator, and commission to the validator (e.g. Ethereum, Cosmos, Osmosis, Solana, Aptos, SUI, NEAR, and Polygon).
● Triggered on-chain distribution: rewards and commissions also get distributed directly from the network, but the validator must first message the network to trigger that distribution (e.g. Polkadot, Kusama and, Vara).
● A few blockchains distribute rewards directly to the delegator, but don’t automatically calculate and send commission to the validator operator. (e.g. Flow and Helium).
4. The Risks In Direct Staking Are Different To Centralized Programs
In direct staking, validators can’t access tokens in a delegator’s wallet. This removes a significant amount of risk that is associated with custodial or pooled services.
The risk in direct staking comes via “slashing” events. If the validator’s performance breaks a rule set by the network (e.g. double signing of a transaction) the blockchain will automatically impose a penalty called “slashing”. A recent example is the validator configuration issues that caused 20 slashing events on the Lido protocol.
When this happens, a small amount of the staked tokens will be automatically removed from the wallet of any delegator that is associated with that validator. This is entirely controlled by the blockchain’s smart contract.
Most companies that operate validators have insurance to cover any slashing events, but it may only apply if you have a contractual relationship with them. It is important to check the performance record of a validator and to confirm whether delegations are covered by an insurance policy.
In summary, there is a fundamental difference between direct staking models and the centralized programs that have been the main subject of regulatory scrutiny. Direct staking involves participating in a protocol-level incentive model that rewards token holders for their part in securing the network. This incentive model is core to blockchain’s decentralization ethos and a crucial aspect of tokenomics. It increases network resilience, encourages broader and more diverse participation, and fosters a more engaged protocol community.
This news is republished from another source.