Clarifying Custody: Non-Custodial Staking

Since Proof of Stake (PoS) has become the chosen consensus mechanism in the blockchain space, the attention to staking has increased exponentially. This newly garnered attention has made waves, with many players providing staking services, creating healthy competition in the market and increasing the viability of the PoS model. Everyone wants a piece of the pie, even if they are not “actual” staking providers. As is typical with any success story, some hurdles and issues have emerged. In the case of staking, its non-custodial nature is getting muddled due to the widespread misuse of the word “staking”.

What is Non-Custodial anyway?

If you have come across Luganodes or other similar validators, you must’ve noticed that we often refer to ourselves as a Non-Custodial solution. This classification stems from the way we handle ownership of funds. Staking in a PoS blockchain can be custodial or non-custodial. In a custodial staking setup, the investor has to trust a reliable custodian with private keys, distribution or rewards and funds. For example, users of Centralised Exchanges (CEXs) can opt to stake from within their platform. This form of staking is convenient but requires a well-established and reliable exchange since it involves custody transfer.

On the other hand, non-custodial solutions give you complete control over your funds, private keys and the receipt of rewards. Contrary to some misrepresentations, there is no actual transfer of funds from the investor to the validator. Validators simply handle the technical aspects of staking in exchange for a fee or cut of the rewards, usually less than 10%.

Let’s bring more clarity. Staking is a mechanism to ensure network security on a chain. Based on the PoS consensus, a validator “stakes” a certain number of coins and gets to propose blocks and validate transactions. Malicious activities are deterred since in doing so, one risks losing their funds. Anyone can invest in a chain’s security, by setting up nodes and becoming a validator.

However, becoming a validator requires significant resources and effort. It needs technical expertise in setting up and running a node. Monitoring and ensuring proper functioning of the node to prevent loss. Hence, most investors opt for a validator who will run the nodes for them.

In a non-custodial scenario, the investor, called a delegator in staking terms, never needs to share their private keys with the validator. The network simply associates their wallet with a validator machine run by the provider. Multiple delegators can share this infrastructure, separately, and funds are never pooled.

As for the rewards, reward distribution is automated through a smart contract: rewards go to delegators, and commissions to validators. Some chains require a validator action to trigger this distribution, while a few networks have a system where rewards are automatically distributed, but validator commissions must be manually claimed.

To summarize, you, the delegator, stake your tokens directly in the chain of your choice, a non-custodial validator simply assists you in doing so. There is no transfer of fund ownership.

Who is the impostor?

Why the confusion then? Why is staking still considered a high-risk investment? There is no third party, one simply stakes their tokens to get some extra return on their ownership of tokens - pretty straightforward. The issue is mischaracterization. Staking is being used as a term to refer to any form of locking crypto assets for returns. This causes problems as there are stark differences between cryptocurrency investment options.

This misuse of the word “staking” is apparent in Liquidity Pool Tokens (LP), such as those in Uniswap, where liquidity providers contribute tokens to facilitate token swaps, thus participating in a market-making mechanism and earning transaction fees. However, these providers also face the risk of impermanent loss if the price of the pooled assets changes significantly. This is different from traditional staking, which involves contributing to network consensus without actual token locking, as in the case of a non-custodial PoS validator, where tokens contribute to network security, and face no risk of impermanent loss.

Some staking-like services, which operate very differently, have also adopted the term. For example, the now-defunct digital asset lending company Celsius allowed users to deposit ETH and get it converted to ETH2. This staking pool helps generate rewards. Their approach blends staking and lending but in essence, is very different from traditional staking.

Therefore there are potential risks if the brand of “staking” is not clearly defined. The confusion can be wide-ranging, e.g.,

• Understanding Risk and Returns: Traditional staking has a specific risk profile, whereas returns from liquidity pools are influenced by market dynamics and distinct platform risks.

• Role Clarity: The term "staking" blurs roles; traditional staking involves contributing to blockchain security, while on DeFi platforms, it's more about investment, not direct network security.

• Expectations of Control and Liquidity: In traditional staking, assets are locked but controlled by the user. On platforms like Celsius, the control and liquidity conditions of assets can vary.

Real Risks

The confusion regarding the word “staking” has greater consequences when the risks associated with various types of crypto investments are conflated. This causes investors to gain a negative perception of PoS staking. Risks associated with traditional on-chain staking are relatively straightforward. They are usually well-defined and can include the potential of slashing (the penalty for validators' misbehaviour), the risk of the underlying blockchain’s performance, and the volatility of the staked asset's value.

Meanwhile, the risks associated with other DeFi services using the word “staking” can be higher and less transparent compared to on-chain staking. They often involve complexities related to the specific protocols, smart contract vulnerabilities, and the broader market dynamics of the DeFi space. The risks are not always clear-cut, and require a deeper understanding of the specific platform and its operational mechanics.

The true risks associated with staking are mainly in regards to slashing - an event where validators might be penalized for actions like double signing. Such violations lead to a portion of the staked tokens being deducted as a penalty, affecting all who have delegated to the offending validator. Slashing rules vary from chain to chain. Another issue may be software vulnerabilities, including buggy code in the frequent network updates.

These issues, however, are pretty rare. Choosing a reputable validator is hence important to mitigate these risks. A high uptime, consistent monitoring, and a good track record minimise the risk of slashing. Moreover, many validators, such as Luganodes, also opt for third-party insurance as a safety net for unforeseen circumstances.

Conclusion

While we applaud the diverse and innovative investment options available, we firmly believe that a mechanism as integral to the PoS blockchain - should have its simplicity and sanctity maintained. Being the backbone of blockchain security, there needs to be clarity on its working and attracting investment to keep the blockchain world ticking.

PoS has solved a major energy inefficiency in the blockchain sector, garnering attention from the world. Major financial players are now interested since the blockchain ecosystem looks more viable than ever. Being a simple mechanism, staking remains one of the safest avenues to invest and contribute to the future of our economy. As non-custodial validators, our goal is to facilitate the growth of this crucial sector, not only by providing reliable services but also by educating and clarifying its working. This ongoing effort reflects our commitment to the cause.

About the Author

Authored by Luganodes