The Missing Piece: the Need for Risk-Adjusted Rewards in Staking

To Make Sounder and Safer Staking Decisions, It's Time to Move Beyond Reward Rates and Consider Risk-Adjusted Rewards

Proof of stake is growing rapidly, representing a combined market cap of over $334bn with the total ETH locked in staking increasing by 22.9% over the last three months since Ethereum's Shapella upgrade. Despite the rapid growth of this new asset class, most participants don't have a clear understanding of the risks associated with staking.

The crypto ecosystem has been focused on hunting yields alone for too long, at the detriment of the industry's overall health and stability. If we are going to build a new financial system we must outgrow this way of thinking. Staking participation should be evaluated on the basis of risk alongside reward. We need a shared framework for assessing risk holistically across the ecosystem, to mature the expectations of DeFi participants and unlock the next phase of growth for Ethereum participation.

Today, the staking industry has a common baseline for assessing and comparing performance across networks, providers, or solutions: the widely adopted annual reward rate (ARR) metric. However, looking at ARR alone fails to account for the comparative risks involved with different staking solutions. Participants need to see how risks affect rewards to have an accurate and holistic perspective.

So why hasn't risk assessment become a critical factor in staking? Too often, DeFi participants chasing yield brush these kinds of important factors off as irrelevant carryovers from TradFi. To continue advancing proof of stake's responsible growth we need to evolve this mindset as an ecosystem. Crypto has developed as a bottom-up, decentralized and grassroots movement, and, as a result, we share a responsibility in advancing our practices to upgrade the financial system we all envision.

For institutional investors coming from the traditional finance (TradFi) world, risk is part of the equation. In TradFi risk assessment is a cornerstone of decision-making, often represented through standardized and uniform metrics like the Sharpe Ratio. This approach recognizes that higher returns are not inherently better if they come with a disproportionately higher level of risk. A risk-adjusted perspective allows participants to compare diverse assets and commodities objectively.

Without the ability to uniformly compare risk factors across a variety of options, risk analysis alone cannot facilitate sound decisions. Entrants from TradFi won’t build these tools for us—they just won’t participate in the technology if the tools aren’t available.

The first step is to acknowledge risk assessment’s significance in shaping responsible and sustainable staking practices. Only then can we, the staking industry, adopt a cohesive framework for assessing staking risk. We can only manage what we measure.

How does a risk-adjusted reward rate apply to staking?

Today, many staking solutions offer similar estimated annual reward rates. However, stakers have to rely solely on information provided by staking operators and protocols to measure any other success vectors, and the lack of standardized approach or quantifiable risk vectors makes a relative comparison challenging.

Consider two staking providers, A and B, both offering a 5% reward rate. If B incorporates a distributed set of node operators with security measures like slashing protection and multi-regional failover to prevent against slashings, while A does not, their long-term reward rate will likely look different through a risk-adjusted lens.

With a common means of evaluating risks that affect the risk-adjusted reward rate, stakers can make more informed decisions based on their risk tolerance and objectives. This would not only enhance the overall transparency and integrity for staking providers in the market, but also ensure stakers make more educated decisions.

The need for uniform risk assessments is also heightened by growing staking participation from institutions. Regulated entities require comprehensive risk assessments that meet their high standards and strict mandates. I hear about this need for comprehensive risk assessments from institutional and enterprise participants consistently, as they discuss their desire to offer staking to their customers.

Rising protocol teams and staking service providers can find themselves unprepared for rigorous evaluations when attempting to attract institutional capital. A shared risk measure can equip the industry with better practices and a broader development framework, which is particularly crucial to attract institutional investors, a significant growth catalyst for the staking ecosystem as a whole.

Measurable risk criteria and scoring methodologies are a step toward risk-adjusted reward rates

We need to identify the specific and measurable risks associated with staking to define a holistic and uniform risk evaluation framework. This analysis should consider the categories of risk—security, infrastructure, and operational—that can lead to correlated failures, key compromises, or liveliness failures. All these types of failures can impact the probability of missed rewards or slashing losses for stakers.

Based on the assessment, each identified risk factor may be assigned a numerical score. The scores should reflect the relative severity and likelihood of each risk factor and may be weighted according to their perceived importance or impact on the overall risk profile.

The risk score, combined with the identified weightings, are the key inputs to determining a risk-adjusted reward rate. This adjustment can then be applied to the base rate of return. The specific method for deriving the risk-adjusted rate may vary depending on the approach chosen.

Companies like ConsenSys have already pioneered the introduction of risk assessments in the DeFi lending space, evaluating factors such as pool liquidity, backing amount, and default risk to create sector-wide and comparative metrics.

Rated Labs, a web3 infrastructure and data startup working on reputation for machines, in collaboration with Liquid Collective and leading node operators including Coinbase, Staked and Figment, is taking a first stab at defining this type of uniform risk standard and methodology for the broader ecosystem.

The past year has shown us the importance of proactive self-regulation in the crypto industry. Developing a shared standard for risk-adjusted rewards benefits stakers and staking providers, while fitting perfectly into a self-regulatory approach, ensuring a safer path forward. Such a method would not only highlight best practices but also allow staking providers to showcase their existing security measures.

Establishing a foundation for innovation and growth

Normalizing risk-adjusted reward rates for staking extends beyond merely bridging and expanding adoption into the traditional financial sector. It also provides a solid, secure foundation for the cryptoeconomy's growth.

It shifts the focus from offering stakers the highest possible reward rate, irrespective of the cost, to allowing protocols and service providers that promote strong and transparent security practices to measurably differentiate their offerings.

Technically complex concepts, like validator set diversification and infrastructure security practices, can be made more accessible to all participants if these concepts are incorporated into frameworks that inform how we evaluate reward opportunities.

A shared risk evaluation standard enhances the industry's educational base, enabling more informed decisions about playing an active role in participating in securing proof of stake networks. Transparency into staking provider security factors promotes better market outcomes and accountability for operators.

Establishing measurable metrics will not only help inform users but will also encourage protocols to adopt a self-regulated standard, uplifting the entire market.

Overall, developing and adopting a risk-adjusted reward rate for the staking ecosystem is an opportunity to establish a secure basis of staking participation—one that the entire $273b PoS economy can be built on top of.

EXECUTIVE BIO

Mara Schmiedt, is CEO and Co-Founder of Alluvial, the development company behind Liquid Collective. She previously worked at Coinbase as Head of Sales for Coinbase Cloud, managed Business Development at Bison Trails, and served as Strategy Manager at ConsenSys. Mara is a board member at Obol Labs, a leading DVT provider, and a strategic angel investor in over 20 projects. Passionate about open-source technology, she has published research on liquid staking and led a working group with the Ethereum Foundation that developed the Ethereum Launchpad and the first DVT proof of concepts.