The Internet Bond Market Opportunity

Staking is an important function for Proof-of-Stake blockchain protocol as it contributes to the security of the network and offers a more energy efficient alternative for achieving consensus when compared to Bitcoin, which operates under a Proof-of-Work system.

However, the energy efficiency of Proof-of-Stake comes at the cost of capital inefficiency.

Staking requires participants of the Proof-of-Stake protocol to deposit the native tokens of the blockchain protocol (e.g. Ethereum 2.0, Polygon, etc.) into a smart contract (“stake”) and validate the transactions of the network. In exchange, the validator receives rewards from the blockchain protocol in the form of newly minted native tokens which come directly from the inbuilt inflation rate of the protocol (“staking rewards”). 

Why is validating transactions is necessary?

Staking tokens can therefore be perceived as a working capital requirement for key infrastructure in Proof of Stake blockchain networks – transaction validation. Staking tokens (capital) is a prerequisite for the right to validate transactions, and transaction validation (work) is a prerequisite to achieving network consensus and security. 

Delegated Proof-of-Stake - Solution for enhancing participation and security in Blockchain protocols

As the tasks of validating transactions and providing working capital to Proof-of-Stake networks require different skills from participants and imposes different risks on them, there are several variations of Proof-of-Stake that enable network users to easily divide the responsibilities and share rewards. 

One example is the concept of delegated or nominated Proof-of-Stake, where capital providers/stakers select validators who stake their tokens in exchange for a portion of the staking rewards. In this model, the validator is often required to stake its own native tokens and, as compensation for the key infrastructure work performed, receives a fee proportional to the delegated stake received.

By eliminating the requirement for stakers to validating transactions, Delegated Proof-of-Stake is helpful in bringing more tokens to staking systems, which improves the security of blockchain protocols. However, it does not solve the inherent problem of capital inefficiency in Proof-of-Stake systems. Indeed, whenever a user stakes (directly or through delegated staking), the tokens deposited become unmovable and cannot be used in Decentralized Finance (DeFi).

Internet Bonds - Solution for enhancing participation and security in Blockchain protocols and improving capital efficiency of staked tokens

Internet Bonds, which are also referred as liquid staking, provide a solution to the capital inefficiency of staked tokens by tokenizing the value of staking rewards, which creates multiple benefits, such as:

• Enhanced liquidity for stakers, as Internet Bonds can be traded on decentralized exchanges, which eliminates the opportunity cost of immovable staked tokens due to staking lock-up periods (which range from 2 days for Solana, to 28 days for Polkadot to the duration of time prior to phase 1.5 of Ethereum 2.0)

• Increased capital efficiency by enabling multiple layers of rewards to be earned in DeFi on top of staking rewards, including:

a. Trading fees from providing liquidity in decentralized exchange, with very low impermanent loss,

b. Using lending to earn additional staking yield (e.g. using ETH 2.0 Internet Bond as collateral to borrow ETH and staking the ETH, so long as the borrowing interest rate of ETH is lower than net staking rewards from ETH 2.0), and

c. Arbitrage opportunities, by exploiting pricing inefficiencies among primary market (stake/unstake at fair value in exchange of Internet Bond), secondary market (trade Internet bond in decentralized exchange) and DeFi OTC market (i.e., auction marketplaces).

• Simplified staking by:

a. Making the staking experience as simple as a swap,

b. Facilitating access on Ethereum to staking rewards earned on different blockchain networks such as Binance Smart Chain or Polygon

4. Scalable staking infrastructure, as exchanges providing one-click staking experience are not necessarily required to run their own staking nodes or integrate with staking providers. Rather, the exchanges may incorporate Internet Bonds into their platforms.

Not all Internet Bonds are the same as each Internet Bond provider might design the staking/unstaking mechanism in different ways in line with the specificities of the underlying blockchain protocol (e.g. blockchain protocols have different lock-up periods for unstaking) and staking user base (DeFi user or institutional clients).

The Decentralized Finance Fixed Income ecosystem

Decentralized Finance offers multiple sources of passive income beyond staking rewards, such as:

• lending interest

• trading fees from providing liquidity to decentralized exchanges

• farming rewards rewarding liquidity provision to certain platforms

• compounding effect from combining multiple sources of passive income into specific strategies (referred as yield farming in DeFi), which can be automated through yield aggregating platforms (referred as vaults in DeFi)

The most important element of passive income in DeFi is its composability, meaning that you can add several layers of staking rewards using the underlying token value and you are not necessarily forced to choose among staking rewards, trading fees, and/or farming rewards.

Composability of passive income is often reserved to a very small part of banking clients due to the high minimum amount required to structure such tailor-made products (Ultra High Net Work Individuals or institutional investors) and regulatory restriction in selling complex products to non-qualified inventors. As such, some investors can require their bank to structure for them a tailor-made Structured Product such as a Credit-Linked Note of Goldman Sachs, issued by UBS, denominated in Russian Rubles, where the investors benefits from 3 layers of income through its structured product yield:

• Yield from Goldman Sachs credit-default swaps (CDS)

• Bond yield from UBS as the issuer of the structured product

• Benefit from higher interest rate from the Russian Ruble vs. U.S. Dollar

   

The Staking and DeFi Fixed Income Market Opportunity

Asset managers such as UBS Asset Management (excluding Wealth Management) manage approx. $1.1 trillion under management and generate approx. $3bn in operating income before tax and $1.5bn in operating profit before tax in 2020 (17.84% of UBS Group total operating income before tax, which has a Market Cap of $56.314bn as of 22.08.2021). As such, we could estimate that the value of UBS Asset Management would be approx. $10bn.

The staking infrastructure provider market has the opportunity to generate approx. $1.2bn in staking provider fee (assuming 10% average fee) with the 12 selected blockchain protocols below, which is almost as much as UBS Asset Management operating profit before tax. 

The purpose of the comparison is only to highlight that the staking market is large enough to be ignored and as staking node infrastructure will likely become commoditized sooner than later, this industry is strongly incentivized to innovate to stay relevant (e.g. Internet Bonds). However, as staking rewards are likely to decrease, so is the likelihood of staked tokens value to increase, likely leading to a Winner-Takes-All outcome where a limited number of staking infrastructure providers will remain relevant, either by successfully attracting institutional volume, and/or being at the fore-front of innovation in the staking industry.

Innovation is a key element here as the DeFi Fixed Income Market is about 4 times larger than the 12 selected blockchain protocols staked value, and as mentioned earlier, Internet Bonds enable users to benefit from those additional rewards available in DeFi.

Conclusion

As the staking infrastructure market is likely going to become increasingly commoditized, Internet Bonds seem the most promising path moving forward for staking infrastructure providers to innovate.

Internet Bonds offer multiple benefits for both DeFi and non-DeFi institutional investors willing to benefit from the growing DeFi Fixed Income ecosystem, while enjoying the benefit of receiving staking rewards, which can be considered as the base rate of each blockchain protocol. 

As the technical barriers to entry to benefit from staking rewards decrease, staking should become as easy and obvious as depositing money in a bank account and receiving a positive interest rate. For those willing to benefit from additional opportunities using the value of staked tokens, Internet Bonds should become the most preferred vehicle for stakers, which can be compared with Government or Corporate Bonds, but with the major difference that Internet Bonds are not based on debt as staking is a working capital requirement and not a loan, assuming that the staking infrastructure provider is decentrally governed.