CoinDesk: proof-of-stake could lead to “crypto banking”, which should be avoided

Proof of stake is an alternative process for transaction verification on a blockchain that aims to achieve distributed consensus in which mining power is based on factors, commonly how many coins a person holds (i.e. stake).

PoS will drive new business and financial models for cryptocurrencies, which will, in turn, give rise to a new regulatory and security challenges, writes Michael Casey, chairman of CoinDesk’s advisory board and a senior advisor for blockchain research at MIT’s Digital Currency Initiative.

Viewed through the prism of traditional finance, a consensus model in which owners of cryptocurrency earn block rewards when they stake, or deposit, their holdings to “vote” on ledger validation starts to look a bit like an interest-earning function. And when third parties, such as those that are starting to provide “staking as a service,” do this on behalf of coin-holders who trust them to provide custody and exchange functions, it starts to look like banking.

That assessment would rightly alarm crypto traditionalists. And it’s one reason why some warn against these attempts to improve on the proof of work model on which bitcoin is founded, arguing that POS will diminish security and incentivize centralization.

But although the Lightning Network and other “Layer 2” solutions may help bitcoin and other proof of work (original consensus algorithm in a blockchain) coins resolve scalability and cost problems, PoW faces real challenges both in terms of computational efficiency and in its public perception as an environmental threat.

As such, it’s hard to imagine there won’t be continued and growing support for chains using proof of stake and its cousin, delegated proof of stake (DPoS), which draws from notions of representative democracy to increase efficiency at the cost of some centralization.

In assessing a report from the European Securities and Markets Authority (ESMA) on regulating crypto assets, blockchain entrepreneur Maya Zehavi made the point that while ESMA is recommending that crypto exchanges now employ systems of segregated accounts, in the future there will also be a need for “exchanges to explicitly inform clients whether their funds are used for staking purposes” and to “get specific consent.”

That makes staking-as-a-service unavoidably appealing for all the exchanges managing people’s trading in PoS coins. There are no clear signs that any are actually doing this with crypto tokens in their custody – and if that is happening without users’ consent, it needs to stop. But the idea of helping their clients earn revenue on their otherwise dormant coins, and charging a fee for doing so, is surely an attractive one for both sides.

A bitcoin utopia in which “everyone is their own bank,” with complete control over their private keys, may well be desirable from a decentralization and security perspective. But millions have shown that they are happy to have an insured third party handle custody for them rather than have sole control over their assets. The success of Coinbase and other such custodial exchanges and wallet providers speaks to this.

Now, add to that the prospect of having that exchange or dedicated custodian manage staking rewards on people’s behalf and it’s easy to see many people going for it.

There’s a fiat equivalent: most of the world’s savings in dollars, euros, yen and all other traditional currencies sit in either interest-bearing bank accounts or are pooled into funds whose portfolios are managed by third parties. People find it both convenient and more effective to pool their monetary power with others and have an outsider invest it for them.

But, hang on a second. Aren’t we just recreating the old banking world with all of its attached system and counterparty risks? Maybe, yes.

As Viktor Bunin, formerly of Token Foundry, points out, if we can envisage staking-as-a-service becoming so popular that pretty much all coins permanently reside with the most trusted of these custodians, constantly earning rewards, then we can also imagine those entities issuing tradable, interest-bearing depositary receipts based on the coins held with them.

Given the unlikelihood that all users’ coins will be withdrawn from that institution at the same time, those receipts would trade at par, which could mean they’re treated as a unit of exchange equivalent to the value of the underlying deposited coins, essentially allowing for off-chain monetary creation.

“Congratulations!” writes Bunin, “We’ve come full circle to reinventing fractional banking! You now have an asset AND a financial instrument that’s a claim on that asset.”

Anyone who’s studied the history of banking, specifically of bank runs, of systemic risk and all the panics that have led to repeated crises in our financial system, and who’s also watched how governments have stepped into the crypto space in the name of protecting consumers, will know that this scenario will inevitably invite another layer of regulation. And for a host of reasons, including for keeping the cost of entry down for breakthrough startups, that can be problematic.

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