At Grayscale, we are continuously evaluating the digital asset landscape to identify new opportunities to bring to our investors. Our team has been tracking staking, where holders of a digital asset participate in the validation of transactions on the blockchain and receive “staking rewards” – token-denominated incentives.
While we do not currently stake assets in any of our investment vehicles, our team has been working diligently to identify solutions that could allow our investors to get exposure to staking-related rewards while mitigating risks.
Grayscale’s Chief Financial Officer, Edward McGee, has been leading our team’s efforts. We sat down with him to talk through the progress we’ve made and the questions we’re still investigating.
1. Edward, thanks so much for joining us to chat. To start very broadly, what is staking? And, how is this connected to the conversation around Proof-of-Work vs. Proof-of-Stake?
Simply, “staking” is an incentive that certain blockchains provide to participants on their network. The staking process goes back to one of the key innovations of blockchain technology: the ability to participate in permissionless networks, relying on unknown parties to validate transactions and data. The two most widely-used consensus mechanisms for doing this are called Proof-of-Work (PoW) and Proof-of-Stake (PoS).
It started with the Bitcoin network’s PoW mechanism. Servers in the Bitcoin blockchain, called nodes, “add” verified transactions to “blocks” through a process that is commonly referred to as “mining.” In this consensus mechanism, miners compete to solve complex mathematical puzzles using powerful computers. The first miner to effectively solve the puzzle creates the new “block” of recent transactions broadcasted on the Bitcoin network, which are immutably placed into a digital ledger, otherwise known as the blockchain. Miners earn rewards and transaction fees for verifying these transactions and creating the block. The rewards are typically issued in the respective blockchain’s tokens (for example: Bitcoin network miners are rewarded with Bitcoin tokens).
More recently, the PoS consensus mechanism emerged to further incentivize participation of validators to engage with the blockchain in a way which could result in lower transaction fees and increased speed and efficiency of validating transactions taking place on a given network.
In the PoS consensus mechanism, instead of miners competing to complete complex mathematical puzzles to earn rewards, individual validators can stake tokens they already possess and render them into a temporarily illiquid state, or “stake” their tokens, to demonstrate their commitment to helping the blockchain verify transactions. Opportunities to add new blocks and receive corresponding token rewards are assigned proportionally to the amount staked. Here too rewards are typically issued in the respective blockchain’s tokens (for example: Ethereum validators that stake ETH are rewarded with Ethereum tokens).
2. Does Grayscale currently employ staking for any of our products?
As of August 2022, no. Although we do not currently stake assets in any of our investment vehicles, we have proactively been exploring the possibility of staking in applicable Grayscale products. Innovative technologies, like PoS protocols, can be transformative, but also carry risks that must be carefully evaluated. As a part of our exploration, our team has identified some key areas of risk and uncertainty with respect to staking digital assets within Grayscale’s product structure.
One of the most significant risks is tax treatment and liability. There is a risk that investors who are deemed to have received any benefits from the staking of digital assets through an investment vehicle like one of our products could face meaningful tax implications. To date, there has only been limited U.S. tax guidance for direct staking activity in general and no such guidance for staking within investment vehicles like ours.
There are also several technological and operational risks that could result in a loss of assets. Currently, the digital assets that back Grayscale products are held in best-in-class offline “cold” storage. In order to safely and securely stake digital assets in our products, we would likely engage institutional grade organizations to help monitor and mitigate new or emerging risks. Consequently, we are regularly evaluating developments in staking operations as part of our efforts to explore staking in our products.
Of course, this is not an exhaustive list of risks. Additional considerations exist and will continue to emerge as the PoS landscape develops.
3. Is staking possible in Grayscale’s U.S. Grantor Trust funds?
Our team and outside advisors conducted a robust analysis, and have determined that it is not yet possible. But, our team has been working diligently to identify solutions. We are committed to working with key stakeholders to protect the assets of Grayscale products while also offering investors the opportunity to gain exposure to these developing technologies in our secure, transparent, accessible investment vehicles.
Our team is fully committed to navigating uncertainty in an effort to maximize investor value wherever possible.
4. What’s the timeline for Grayscale’s possible implementation of staking in eligible Grayscale products?
Given the pace of these technological developments, we are not able to commit to a timeline, but as we continue to explore the possibility of staking in Grayscale products and navigate the ever-evolving crypto landscape, we will keep our investors apprised of any significant updates.
5. What’s next for staking? Are industry participants watching or preparing for any upcoming milestones?
There isn’t one universal next step for staking, as crypto protocols are in varying stages of utilizing or adapting staking through the PoS consensus mechanism. That said, there is a great deal of industry interest in developers’ progress transitioning the Ethereum blockchain to PoS, sometimes referred to as “the merge.” If this is successful, it would open the door to staking for people who hold ETH directly. This would be the first time such a well-established blockchain has undergone such a fundamental change. It’s a serious undertaking with a lot left to do.
Later this month, the third of three major “test net” merges is planned. Our readers involved with software development might be familiar with the concept of a test environment. For anyone else, perhaps think of it as a dress rehearsal for a play, with the final “mainnet merge” as the opening night. If the test net merge is successful, it would be a positive sign for the eventual transition of the main Ethereum blockchain to PoS, which itself would be a positive sign for the proliferation of staking as a consensus mechanism. It’s an exciting time.