Staking and Inflation Explained for Crypto Investors

In the world of crypto investing, we typically think of ROI as the difference between the purchase price and sale price of an asset. Many investors may not realize they can capture returns from some digital assets simply by keeping the asset active on the blockchain — and that if their investments are stored inaccessibly in cold storage, the assets may depreciate, leaving significant yield uncaptured over time.

From Proof-of-Stake mechanisms (Tezos) to inflation mechanisms (Stellar) to dividend reward systems (Neo*), old and new chains are including active participation in their protocols. Below, we provide a friendly introduction to staking and inflation, and why they are important for maximizing returns on crypto investments.

What is Proof-of-Stake?

Most of the best-known digital assets, including Bitcoin and (as of this writing) Ethereum, use a model called Proof-of-Work to validate new blocks of transactions. In a Proof-of-Work model, miners compete to solve difficult math problems, and the winner validates the next block and receives a reward. Proof-of-Work is widespread, but some argue that computing these math problems is too costly at scale, and a small number of mining organizations who can afford the cost will steadily accrue greater network control over time. Recently, some blockchains have adopted an alternative model called Proof-of-Stake (PoS), which is designed to address some of these perceived problems.

In a Proof-of-Stake model, you stake some of your assets via a “node” (a server running your asset’s blockchain software) to validate a new block. If the block turns out to be illegitimate (e.g. transfers assets that don’t exist) or if your staking node is offline, some or all of your staked amount will be taken or “slashed.” If legitimate, you’ll get back your staked assets and an additional reward. The stake deposit requirement, reward, and slashed amount vary per chain. This system of rewarding and slashing incentivizes participants to validate only legitimate blocks.

Your chance of finding a new block is proportional to the amount you stake, so the more you stake, the more you’ll be rewarded. Most chains require a minimum amount when staking, and while assets are staked, they cannot be accessed or sold — so investors should be sure they are comfortable with at least the minimum deposit amount becoming temporarily unavailable.

Note: The above describes how PoS is applied to blockchain consensus mechanisms. However, staking and Proof-of-Stake are concepts that can apply to other mechanisms of a digital asset as well. For example, even though Ethereum is (as of this writing) a Proof-of-Work blockchain, some ERC-20 tokens employ PoS mechanisms like staking and slashing that aren’t tied to how the underlying blockchain validates new blocks.

What is inflation?

Some chains that do not use PoS still allow for yield generation via active participation. For instance, Stellar uses a consensus protocol, in which a majority of all servers running Stellar need to agree on a transaction for it to go through. Separate from the consensus system, Stellar has fixed inflation (1% each year) written into the protocol. If you hold the minimum requirement of lumens (Stellar’s currency) and inflation is run, you will receive the inflation amount plus transaction fees proportional to the amount participated each week. Often there is a minimum holding requirement to run inflation; if this minimum is greater than your holdings, then you may lose out on the opportunity to generate yield. As a result, Stellar allows asset holders to delegate their assets to an inflation destination, which is an address that you nominate to receive inflation on your behalf, and will in turn provide you with your share of the inflation.

Why participate in staking and inflation?

As an institutional crypto investor, it is your right to actively participate in the system. There are two main reasons to do so:

Short-term financial gain

By staking or participating in inflation, you receive a reward that is proportional to the amount staked or held. This reward may include a block reward or transaction fee proportional to your participation. One notable exception is EOS*, in which stakers do not get a financial reward for staking but do help secure the network, reserve resources for making transactions, and allow voting. Conversely, by holding a PoS asset in cold storage or otherwise neglecting participation, the asset could depreciate at a rate of 5% to 20% per year.

Long-term financial gain

For PoS systems, staking is how the system secures the network. As an investor in such assets, it’s in your best interest to participate as a staker yourself. This will reduce the set of possible attackers and help keep the network secure.

Systems with inflation use this mechanism to redistribute lost assets. By participating in the inflation, you help to ensure that your assets retain value in the long run.

Why custody Proof-of-Stake or inflationary assets with Anchorage?

Anchorage is designed to enable active participation for all assets we support, and to keep assets both secure and accessible at all times. This helps you capture more yield from your investments.

To learn more about Anchorage, please get in touch.

*At Anchorage, we strive to support all assets and are asset agnostic. Starred assets are not yet supported on our platform. If you’d like to find out whether we plan to support an asset of interest to you, please email us at contact@anchorage.com.