Considering Third-Party Staking Services? Read About These Risks

Investing Jimmy Song Staking

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Simon Chandler

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Simon Chandler

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Simon Chandler is a Brighton-based writer and journalist with over ten years of experience writing about crypto, technology, politics and culture. He has written for Cryptonews.com since late 2017,...

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June 25, 2023

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SaaS platforms will be subject to the hacking risk. Custodial services require you to hand over control of your coins to a third party.

One of the biggest trends in crypto right now is for proof-of-stake (PoS) cryptocurrencies, with the likes of Cosmos, PIVX and EOS being some of the more recent examples. And with this trend, there has been an almost parallel growth in third-party staking services, platforms which stake coins on behalf of users who don’t have the time or inclination to stake coins for themselves.

However, while such ‘Staking-as-a-Service’ (SaaS) platforms are in many respects good for investors who want to earn a return on their money without doing much technical legwork, the practice of placing coins with third parties comes with risks.

Third-party staking = big returns?

In contrast to proof-of-work (PoW) coins, PoS cryptos reward miners with new coins depending on how much they stake relative to other miners. While this can be a simpler process than calculating the correct hash for a block, it still requires a level of expertise beyond most ‘laypeople.’

“Most staking coins make it non-trivial to stake your coins and ‘earn’ the transaction and block reward fees,” says Bitcoin Core developer Jimmy Song. “Much like the tax code, PoS coins optimize on technical competence required so that only the ‘worthy’ get some of the coins.”

As Song explains to Cryptonews.com, SaaS platforms have appeared precisely because they help the average investor “optimize stake rewards without all the headache of running the software.” This would account for why the industry is now home to the likes of Staked, Anchorage and Coinbase Custody, all of which launched their staking services within the last 12 months.

Even more recently, Battlestar Capital launched at the end of March, with its co-founder and chief of research, Jason Stone, telling Cryptonews.com that investors can expert handsome returns, depending on the cryptocurrency.

“The growth in portfolios of Battlestar clients is directly proportional to the coins they deposit with Battlestar,” he explains. “Some coins, like Zen, deliver 25-35% yield in Zen token, paid by the Blockchain to the staker of Zen.”

Risk of centralization

However, there are worries that the SaaS system carries several risks. Most prominent of all is the risk of centralization, and as NEM Ventures co-founder Kailin O’Donnell tells Cryptonews.com, this has implications for security as well as for the concentration of voting power.

“Any new custodial service introduces risk into the system,” he says. “Historically, exchanges have always been a primary target for hackers in the space and SaaS platforms will be subject to the same or similar level of risk.”

Likewise, Jimmy Song explains that custodial services require you to hand over control of your coins to a third party, and that if they “go bust for whatever reason (hacking, gov’t intervention, founder dying with the only private key), you’re out of luck.”

Perhaps more urgently, Song points out another risk. “The other thing is that a lot of PoS coins use some form of voting for features,” he adds. “The third parties could potentially use the voting power to influence the coin’s development. Much like mining pools, the policy may end up being determined solely by the SaaS platforms.”

Staking services acknowledge this risk, yet they also affirm that it will be slight compared to the risks witnessed with PoW currencies and mining pools.

“I think there’s some concern about centralization but I don’t think it will get anywhere near as centralized as mining,” Tim Ogilvie – the CEO of Staked – tells Cryptonews.com. “There simply aren’t the same cost efficiencies that have forced mining pools to become so dominant.”

Protection against fractional-reserve banking

One other potential danger of third-party staking is that they could end up infecting crypto with a form of fractional-reserve banking, something which cryptocurrencies like Bitcoin were designed to avoid.

“Staking-as-a-Service platforms absolutely run the risk of creating a de-facto system of fractional reserve banking,” warns Robert Viglione, the CEO of privacy-focused blockchain platform Horizen. “It lets investors who do so not only earn returns on their staked funds, but also gives them the ability to redeem their staked tokens whenever they choose.”

Viglione adds that SaaS “gives the service platforms incentive to lend out the value of the staked holdings to generate further revenue.” This could be dangerous if the users of these platforms, perhaps wanting to take advantage of arbitrage opportunities, decide to withdraw their staked tokens, something which could result in a ‘run’ on one or a number of SaaS services.

However, the staking services themselves don’t think this is a real risk.

“These claims are silly and suggest that the person doesn’t understand staking and/or fractional reserve banking,” says Staked’s Tim Ogilvie. “Staking is backed entirely by a staked asset, there’s no concept of rehypothecation or other forms of fractional reserves whatsoever.”

Jimmy Song agrees with Ogilvie’s assessment, noting that staked coins generally have to be locked up with the corresponding PoS system and therefore can’t really be loaned out to anyone else. Nonetheless, he warns that a much bigger risk is that of inflation.

“With staking, it’s going to be very difficult to limit inflation as block rewards run out,” he states.

“Most of these coins assume a perpetually increasing price, which is an inherently stupid assumption. The only way to keep people staked is to continue to pay out a decent amount for block rewards and the only way to do that is to inflate.”