Staking in Web3: Economic Errors

Staking is the go-to method for distributing tokens to “build a community.” But not all staking is equal, and projects often seem to miss the nuance and potentially jeopardize their economics with simple errors. Outlined below are the three principal forms of staking today, and the ways builders can use them to better align with core product KPIs.

This topic was discussed in the context of Sunflower Land’s staking methodologies with their Head of Community, Steve Woody — watch here.

Source: wombo.art

Staking, or locking up your tokens in exchange for some APR, is common in modern crypto projects. Generally, projects use staking to “build a community” by distributing emissions to locked tokenholders with the implicit aim of achieving greater decentralization. Often, projects subscribe to broad-based staking without actually considering 1) how staking supports their KPIs, 2) what kind of “community” they’re really building, and 3) how implementing certain types of pools could adversely impact tokenholders.

Three Staking Variants, but One’s Not Like the Others

Of the three types of staking that exist today, one is losing relevance, and may ultimately be more problematic than projects may immediately realize.

Here’s the three types:

Consensus Staking

The first type of staking is consensus staking, in which stakers are actively supporting the computational backing of some consensus mechanism. This is common for base blockchain layers (e.g. Layer 1 protocols). Users stake their tokens using a certain node software which acts as their agent in relaying some set of computational bids for consensus on a certain block of transactions, and, as a reward for their successful cooperation, the user nets a small return.

Consensus staking is currently necessary, and arguably the purest form of “staking,” because it’s the actual computational basis by which most modern blockchains operate. It’s the OG. You could design other consensus mechanisms that do not use it (or go back to the ancient proof-of-work), but it’s undeniably important and certainly not going anywhere soon.

Liquidity Provision (LP) Staking

The second type of staking is liquidity provision (LP) staking, in which stakers first provide liquidity for the project in question by posting a combination of currencies (e.g. USDC plus the project’s own token) on some third-part decentralized exchange (DEX), and then subsequently lock their position into the project’s staking pool in question.¹ As a reward for providing liquidity and taking on increased risk with that, users earn lucrative yields.

LP staking is broadly useful, as increasing the market depth of a project’s tokens on an exchange generally results in less volatile price movements and more faith in that specific token’s market. Because it would be otherwise expensive for a project to post both sides of the market around their own token (e.g. providing both USDC plus their own project token to a DEX), it’s almost always in their best interest to incentivize their community to do so, and to reward them for taking on that risk.

Single-Sided Staking

The third type of staking is single-sided staking, sometimes also referred to as “governance staking.” In single-sided staking, users lock a project’s token in order to earn a yield for their loyalty to the project. Occasionally, such staking methods will be accompanied by certain governance rights, which may either be on-chain or off-chain. The user rewards for this type of staking are generally lower than the rewards for LP staking, but oftentimes higher than consensus staking due to the relatively higher volatility of the dApps that such single-sided staking pools are usually associated with.

Single-sided staking is sometimes useful, inasmuch that it 1) helps support token prices in the near-term because individuals may be disincentivized or prevented from selling, 2) it rewards users who are ostensibly loyal to the protocol by giving them more tokens, and 3) it allegedly drives projects towards decentralization as it distributes more tokens out to the public. These benefits are extremely subjective, and are almost never clear-cut in either direction, as opposed to the benefits of LP staking as well as consensus staking.

I’ll explain below.

A One-Sided Proposition, by KPIs

Single-sided staking is the black sheep of the bunch. Undeniably both consensus staking and LP staking have a place in the present iteration of web3 projects, but single-sided staking may be on its way out, if only because it does very little to support actual product-focused KPIs.

For consensus staking, the impact on KPIs is self-evident. Stakers validate the network, and, the more stakers there are, the more validators there should be, and the more robust the consensus mechanism becomes (& potentially² faster, too). So, consensus staking gets a thumbs-up.

For LP staking, the impact on product-focused KPIs is a bit more nuanced, but still both 1) commercially relevant and 2) in other users’ best interest. LP staking largely helps to bootstrap the trading markets around a project’s nascent token, which both gives commercial validity to a project and provides an entrance & exit for other tokenholders. While these “KPIs” are not explicitly product-focused, arguably they support the key commercial goals of a project and are certainly worthy of supporting.

So, LP staking and consensus staking both get a thumbs-up.

Because the KPIs for both consensus staking and LP staking are aligned with the actions of other non-staking users (e.g. supporting blockchain consensus & providing market depth), these forms of staking create network effects and are likely to have long-term staying power as tools for builders to scale their projects.

But, once again, at best, single-sided staking largely lacks any direct impact on specific product KPIs,³ and, at worst, is expressly against the better interests of the broader tokenholders. Here’s a few qualitative reasons why:

• The existence of a single-sided staking pool implies that if I choose to not stake, the tokens that I am holding are constantly being diluted. I have little reason to hold the tokens in my wallet or an exchange account if every other tokenholder is inflating at some high double-digit APR. Unless I believe that the project’s true valuation will grow in excess of what the base single-sided staking APR is, I should not be holding the tokens if I don’t want to stake (or am unable to, like many institutions).
• “Governance” rights, that is, suggestive off-chain rights that are simply counted as proxy votes and do not actually execute on-chain transactions, are ridiculously difficult to value and may ultimately be worthless. Asking users to lock their precious capital in exchange for such flimsy rights is likely to be a tough uphill battle for marketing teams after consumers start to catch on. No one pays Facebook for a “Like” button. Not explicitly, at least.
• Decentralization is a fantastic aspirational goal, but unfortunately single-sided staking pools simply emit tokens to individuals who are already tokenholders. The claim that it will inevitably drive further decentralization is true only inasmuch that tokens are moved out of the project foundation’s wallet(s) and into the wallets of the whale participants. But no new participants are added to the network, which doesn’t help support the case for decentralization very much.

OK, single-sided staking in its current implementation is probably not always the best option. But what should we do instead?

For Builders: Real User Incentives for Decentralization

Projects can arguably achieve a better bump on their KPIs using that same token allocation set aside for single-sided staking by actually asking themselves “what drives new users to our platform,” then rewarding that behavior. Arguably, airdrops, promotional social giveaways, educational events, and even limited-time X-to-earn loops are probably better decisions than setting up a single-sided staking pool.

Because I have a pretty serious slant towards gaming, I’ll use web3 games as an example here. They’re also the most clear-cut case. Let’s assume that a game’s core KPI is monthly active users (MAUs). Let’s also assume that this project has set aside some 10% of its tokens for broad “staking and marketing activities,” and is currently deciding on the best frameworks for their specific case.

Working through the list from the top of this article, consensus staking clearly does not work here because we are not running a fundamental blockchain protocol. However, LP staking does make sense here because we supposedly want our users to be able to trade our project’s token on a DEX, and we do not have the cash ourselves to spin up the liquidity pools. So let’s assign half of our token marketing budget to LP staking pool emissions.

But when we consider single-sided staking, and we ask ourselves what KPI we’re helping to drive here, the answer is clear — there is no KPI supported by single-sided staking that matters for a game (especially versus MAUs). So we skip it.

Instead, we take that remaining token marketing budget and we use it to run some “X-to-earn” set of promotions for the first few months, and massively drive up our core KPI of reaching higher MAUs.⁴ Now, we have actually achieved the goals that single-sided staking purportedly set out to achieve, without having to actually do it. Namely, we have:

1. Increased the decentralization of the userbase by adding new players
2. Improved the product’s core KPI of MAUs by improving retention through incentivizing greater on-app activity
3. Probably driven some nominal token price support by drumming up marketing momentum, assuming it is in excess of some token dumping
4. Rewarded true user loyalty by giving back to individuals who sacrifice their time, not just their capital, to participate in the project

In this scenario, choosing against single-sided staking was certainly correct, and nets us a stronger project with a more decentralized userbase and greater marketing presence for exactly the same cost in treasury tokens.

The Conclusion is Complex

This is not an all-out moratorium on single-sided staking. There’s still merit to the practice if you use it for very specific purposes, and really work to ensure that your core KPIs are supported by it. This is just a reminder to consider the lessons of the recent past, & ask yourself how you can better use the tools available to you to build killer KPIs and user value propositions.

¹Not all staking pools require you to lock, but most do. Some can just monitor your LP balance, or have you “commit” to the pool in some other way to prove that you are currently providing liquidity.

²This is highly dependent upon the network, as certain networks actually slow down as you add more and more nodes. Others simply gain additional bandwidth, but not speed.

³This idea of other users’ best interest is important. You do not want to incentivize each user to only perform actions that are in their own best interest, potentially to the detriment of other users. That’s a bad way to encourage network effects. You want each user action to support the actions of other additional users.

⁴Play to earn is dead, hyperinflation of tokens is bad, yes, I’ve written about it before. But that doesn’t mean we can’t use some of those tokens to kickstart loops that are actually sustainable. Will it end up like UBER & the other Silicon Valley nest eggs that only work under extremely generous economic conditions else face severe risk of implosion? Perhaps.

Sam is the CEO of Playground Labs, a web3 protocol dev organization, and Partner & Head of Interactive at Hivemind Capital, a crypto-focused multi-strategy fund. Follow him on Twitter.

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