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Differentiating as a Validator

As we begin the institutionalization of the cryptoasset industry, asset managers, investment funds and custodians are competing for Assets Under Management (AUM). At the same time, a new class of service providers is emerging along with a new type of capital management.

Whereas miners bootstrapped the security of Proof-of-Work (PoW) blockchains, Proof-of-Stake (PoS) chains will depend on the participation of their token holders. Such participation will be encouraged and almost made mandatory in some cases as high inflation rates will punish inactivity. Although more efficient than its counterpart, validating on PoS networks requires a secure server infrastructure, expert knowledge of the underlying blockchain being validated and commitment to its governance. As such, most token holders and investment funds will turn to professional service providers to outsource these responsibilities.

Enter professional validators, providers of what is commonly called Staking-as-a-Service (StaaS). Validators operate full nodes on these networks but their responsibilities and staking mechanisms vary between pure PoS and DPoS. In a pure PoS setting, there is not necessarily a limit on the number of nodes participating in the consensus, so that anyone can join if they have the minimum amount of tokens required to stake. StaaS companies can offer to run the nodes and sign transactions on their behalf if the user deposits the required amount of collateral. Instead, in a DPoS setting, there is a maximum amount of validators that are selected based on the amount of tokens/voting power that has been delegated to their nodes. Delegation allows token holders to transfer their staking power to an elected validator while keeping ownership of the assets.

Professional validators on PoS networks are developing and are looking to improve their brand awareness within blockchain ecosystems while competing for the same pool of assets available for delegation. While StaaS companies simplify the staking process, provide secure staking infrastructure and participate in the governance of those ecosystems, Assets Under Delegation (AUD) will become the key metric in this race as their main business model gravitates around a commission fee based on the delegators’ rewards.

Many stakeholders dismiss validation-as-a-service as a viable business model as they state that it will become commoditized and profit margins will tend towards 0%. We believe that similar to the asset management industry, winners will succeed based on AUD, which will pave the way for additional revenue streams.

To become one of those brand names, validators will have to compete on factors that cannot be standardized and that bring tremendous value to the different stakeholders within their ecosystem. As such, we will identify what validator characteristics will become common practice among top players in order to understand where it will be worth competing.

Early advantage — Long-term standard

Security

A blockchain’s security will be one of the most defining success factors and will greatly depend on the gatekeepers — the validators. Proof-of-Stake as an incentive layer will only work if the stakers’ funds are safe, which will require validators to deal exclusively with Tier 1 datacenters, maintain a redundant architecture to prevent DDOS attacks and minimize the interactions with the hardware security modules (HSM).

Currently, security is not a priority for validators and bakers (validators on the Tezos mainnet) as lower fees help attract more delegation. With low-cost infrastructure, these validators are effectively lowering the standards in those networks, which in our opinion could soon backfire when rewards will be lost, servers hacked and nodes slashed. Smaller token holders who trust these amateur setups may get burned in the process, which will push away engaged delegators and reduce networks’ security in their early days.

Professional validators will thus come out on top as they will offer redundant server infrastructure, a “cold” HSM system and mitigate double-signing risks. Though, there will be an upper limit to the security setup, such that every professional service will soon offer near 100% uptime and significantly limit hacking risks. As such, we expect security to become standardized instead of a differentiator.

Fees

The main revenue stream for validators is the commission fee they take on the network rewards attributed to their delegators. Most networks will have lower and upper bounds for possible fees in order to assure competitivity among participants while giving them enough flexibility in their business model.

On a network like Tezos, delegation fees requested by validators currently vary between 3% to 20%, depending on the size of a delegator’s stake, the guarantees they provide and their uptime. On the other hand, staking and masternode services, where users have to buy the tokens while the node infrastructure is handled by the provider, currently charge fees varying between 15% to 70% of monthly rewards.

These high fees are still acceptable today because of new PoS networks’ high inflation rates and the relatively small pool of service providers. Though, as network participation increases and inflation falls into the 1%-5% range and incumbents such as Coinbase enter the market, we expect to see fees drop significantly. Thus, validators will not be able to rely on high fees over time and should not expect to find a competitive advantage on this front over the medium to long term.

Guarantees/Insurance

When delegating, token holders should prioritize one factor; what are the odds the validator will get slashed? In PoS, getting slashed refers to the loss of staked tokens as punishment for bad behavior, which can be poor uptime, double-signing, lack of governance participation or intentional attacks on the chain. Although they all have different degrees of punishment, the impact they will have on a delegators’ stake should not be taken lightly be delegators.

Validators are already starting to differentiate by taking on the entire slashing risk for their delegators so that they can assure predictable returns for their clients. Insurance on lost funds will also be a major selling point early on, as is the case with custodians right now. This standard of excellence will definitely help professional players surpass their counterparts as staking should represent a safe alternative to savings.

Though, as the industry matures, we tend to agree with Cryptium Lab’s founder Adrian Brink that, similar to banks, professional validators will guarantee the funds and rewards of their delegators. We expect to see StaaS companies gain momentum with strong guarantees and insurance partnerships but this should not become a long-term advantage over other major players.

Building a lasting competitive advantage

Although some fundamental elements of a validators’ business model will be shaken up during the race for AUD, core factors will help the best and most engaged providers rise to the top in this winners-take-most scenario.

Community engagement

PoS networks are trying to dislodge the incumbents and gain developer mindshare but will first need a passionate community of early adopters who can contribute to its future. As most validators are coming out of stealth and are still relatively unknown within each ecosystem, becoming an extension to the foundations and an engaged community member will be vital to differentiation.

Right now the top validators are creating various tools for each community they are part of, such as Hubble, a validator explorer created by Figment Networks. Many grants are available from foundations in order to stimulate developers and most token holders will trust those that provide them with the right tools to make staking a seamless experience.

Thus, we believe that creating content and tools for communities might be one way to create goodwill with token holders and offer a “boutique” experience compared to larger institutional players. It also represents a great way to get closer to foundations and leverage the exposure they can provide.

Software — UI/UX

Most DPoS chains have on-chain mechanisms for delegation but they require to download specific software and can be complicated for the average user. These dashboards are also very basic and do not provide any performance indicators for the validator or for users’ stake. For each chain users desire to stake on, they will need to download different software and go through another education process.

PoS chains don’t have on-chain mechanisms for validation-as-a-service and require users to go through a technical setup to then be able to send their tokens to a node that will be operated by a third-party. The process is not transparent or specialized at this time and is a completely different setup for each chain. Therefore, staking’s success as a security layer will depend on its simplicity and performance.

We expect user experience and gamification to play a major role in the adoption of PoS networks. Therefore, validators who provide simple but powerful interfaces for their delegators will attract sticky assets under delegation and will create long-lasting relationships with their users.

Governance

Governance will be a major concern but also a major opportunity in PoS chains. Most of them are now aiming for on-chain governance which can accelerate decisions but also create attack vectors or even affect the underlying blockchain if critical parameters are altered.

While it is still early days for on-chain governance, we have already seen highly debated decisions on DPoS networks. EOS has been under the spotlight after its block producers reversed multiple transactions based on a controversial constitution dictating the “laws” of the main EOS blockchain. Foundations will need to work closely with validators to find the right balance between power and decentralization in order to see the networks thrive.

Funds and token holders investing in blockchain projects will want their opinions to be heard concerning the future development of those networks, but on-chain governance is very time-consuming. Validators who prioritize governance and allow their delegators to signal their voting intentions will definitely have an edge over time as these networks capture more value. Hence, we believe there is an opportunity to build a brand seen as the voice for funds and token holders.

Partnerships

Delegation brings back the need for trust in blockchain ecosystems. Aside from metrics verifiable on-chain such as uptime and proper distribution of funds, external endorsements will help increase the community’s confidence in a validator’s brand.

Currently, no validator has publicly announced any partnership with custodians, wallets, foundations or insurance companies. We have seen great collaboration and assistance within the community but the support from incumbents will be necessary to legitimize the StaaS model and push the industry forward.

Therefore, we believe partnerships should be an early focus for validators as it represents one of the less replicable differentiating factors. They will allow them to offer additional services to their customers, gain more funds under delegation and get closer to communities of whales and stakeholders. Collaboration and coopetition between industry participants will be necessary if PoS is to succeed.

Additional services

Validators are hard at work deploying on as many chains as possible with a secure infrastructure but akin to the asset management industry, they will need to develop new ways to monetize their assets under delegation and provide more value to their delegators through additional services.

Those services will likely be high margin solutions available to premium clients who wish to obtain more than the basic staking service, such as data analytics, actively managed funds, lending, and more.

Thus, we think it will be vital for validators to prepare for the commoditization of validation services by developing new solutions that will complement their core offering. Customers will quickly expect more than simple staking and those that will be able to leverage their AUD to innovate will likely come out on top.

Developing a professional ecosystem

As PoS networks are still in their infancy, it will be vital for thought leaders to institute standards among validators and delegators. Without secure and fair validation services, it will be difficult for Proof-of-Stake to take over Proof-of-Work as the main incentive layer. Once these benchmarks become normalized, validators will have the opportunity to compete on highly differentiated characteristics such as community engagement, governance, proprietary tools, and powerful partnerships.

Although it is still early, the industry has already been gifted with great leaders that are greatly accelerating the development pace of these ecosystems. We expect more players to join in and push the adoption of those networks forward, as coopetition will drive innovation. In the words of Nick Tomaino from 1Confirmation, “2017 was the year of the ICO. 2018 is the year of stablecoins. 2019 will be the year of staking. It is already starting with Tezos and a few others, but in 2019 the category breaks wide open.”