I understand there’s a lot of in-depth research around this, and almost all proof-of-stake L1s are fundamentally designed around the assumption that staking issuance is net neutral. It does seem to make sense once you consider base L1 assets as analogous to equities or currencies, but I believe L1 assets are a completely new breed that’s a combination of currency, equity, store-of-value, speculative asset, economic bandwidth and defence budget. As such, I believe we need heuristics rather than academic research to understand why staking issuance is actually net negative. To be clear, I’m an observer, not a researcher, so please don’t take what I say seriously, this is 100% speculative, but too many things I have seen in the crypto space has convinced me this model isn’t working, and will fail long term.

Stakers are not fully protected

Firstly, even if we assume that staking issuance is net neutral, only block producers are fully protected from this dilution. This is a small number of users, somewhere between 20 and 2,000 for all alt-L1s, and probably less than 10,000 for Ethereum proof-of-stake (though Rocket Pool alone has 1,150 unique node operators in ~6 months, so this can exceed 10,000 long term - but a lot of work needs to be done to enable this). Because it’s a plutocratic election in some way or another (you either directly delegate to a block producer, or you more generally choose a staking derivative or service), there are extremely strong centralization/oligopolist pressures, so what usually happens is you have a very small number of entities dominating. For direct delegation based systems (which is everything other than Ethereum & Algorand AFAIK), there’s a long tail of validators who are barely profitable. So, even if there are 2,000 validators on paper, 1,500 have too little stake delegated to them, and actually have so little profits that they may have to sell most or all of their revenues to cover costs of operation. It’s worth noting that many of these types of networks also have higher running costs. So, what do they do? The answer is a centralized entity often subsidizes delegations. For example, even though Solana has 1,700 validators on paper, only ~150 are significantly above this subsidy. This is a complex matter with many moving parts, there’s also the matter of MEV, priority fees etc. - but the point is - only validators are fully protected.

What about the average staker then? They have to pay the block producers a commission. In some protocols this is as large as 50%, though ~10% seems to be a general average. Because of strong brand value for top block producers or staking services, they can charge a premium, while some of the newer players may even offer negative commission (and hope to make back money in MEV and priority fees). Either way, the conclusion is that a vast majority (>99%) of stakers are not actually fully protected from dilution, but on average, 90% of the way there.

Inflating asset isn’t good money, requirement to stake isn’t good money

The argument is that everyone will stake anyway, so everyone is protected from dilution. I showed above that this isn’t quite true. But even if it was, that’s just a ponzi (in the broader sense of the term) game, and counter to what makes these assets actually useful in the first place. There are plenty of smart contract scenarios which are unsuitable for staking derivatives, and adding this friction will significantly hold back usage of the network. So, to put it simply, for the asset to be good money (again, in the broad sense) it should not inflate away, and there shouldn’t be a requirement to stake it (or worse still, in some protocols, lockup periods). For sake of simplicity, I’m defining “money” in the broadest sense - something people use to exchange, store or represent value in a confident and stable manner. The best money is one that’s most frictionless - you hold it, stake it, use it, whatever, without any fears. Indeed, the goal should be to have as little staked as possible, preferably <10% of supply, which necessitates very low dilution. [Addendum: Of course, it needs to be economically secure enough, i.e. minimal viable issuance, and where the safety threshold lies depends on the security features of the exact consensus protocol. For Ethereum, anything between 16M-50M ETH has been considered, and an active validator cap has been proposed at ~32M ETH.]

All stakers have a selling price

Anecdotally, there are plenty of people on r/ethfinance that have discussed staking ETH as a retirement plan, and selling the rewards to cover their living expenses. I’m not claiming this is true for most people. The issuance piles up, and everyone has a selling price. The ETH supply has seen extreme churn over the years, and there’s almost no one who bought the ICO that still holds it today (this is verifiable from on-chain analysis). The average ETH holder today has a buying price of ~$1,750, holding for less than a year. Over time, I do expect there to be long-term investors who treat it like a value stock, but because of its multidimensional nature it’ll always be a small crowd rather than the entirety. What really happens is that the selling is temporarily delayed, not permanently cancelled. Were it equities, this wouldn’t matter, but it’s not.

The pernicious effects of inflation

Given a long enough timeframe, there are additional effects of dilution that are often not considered. A lot of stakers buy into these networks as a speculative asset. Anectodally, almost all 2014-18 era L1s have bled away over the long term - though one may argue that is for other reasons. But let me point to a case study that spedran this.

In July 2016, STEEM was the #3 crypto asset, behind only BTC and ETH. In just 4 months, it lost 95% of its value. So, what happened? Obviously, it was in a speculative bubble and bound to correct, and there were other factors at play. But the biggest was high inflation. Dan Larimer bought into the “staking issuance is net neutral, and might even be positive” research, and went to a high inflation (>100%) with a long 2-year lockup period. The hypothesis was that since >95% of supply is staking anyway and locked up for 2 years, there’s no issue. Yes, those <5% are diluted hard, so they will be incentivized to stake too. In reality, the market started pricing in STEEM’s inflation and high friction to stake, and bids disappeared as the market lost confidence in STEEM as money. Fewer people were willing to play the speculative game, fewer people were willing to use the network, thus kickstarting it’s just a vicious negative feedback loop. Fortunately, the community rallied against Larimer’s insanity and lowered inflation to a more standard ~8% and drastically reduced the lockup period. As you may expect, at first there was a mass exodus that absolutely cratered the price as the earlier stakers exited with a reduced lockup period. But predictably, once the reduced lockup period was over the asset went recovered, and eventually went on to make new highs (though this was more due to the bull market, of course). But even 8% inflation is too high, and on a somewhat related note, in March 2020, Steem was 67% attacked by Justin Sun, and to this date remains under attack as a defacto centralized chain owned by Justin Sun.

Even if my case above was for very high inflation, similar applies to those with 5%-10% (which is most L1s not Bitcoin or Ethereum) - just on much longer timeframes of years/decades, not months. As a side-note: Terra was the ultimate speedrun, collapsing in 2 days due to hyperinflation. The difference with 10% inflation is it’ll take years, 2% inflation will take decades, etc.

Low inflation and high value accrual are both critical to the sustainability of L1s

Because the security of an L1 is directly tied to the value of its base asset, it’s critical for L1s to increase its value over time. Low inflation expands the demand base for the asset to not just stakers playing a speculative game, but real utility with a broad diversity of usecases. Low inflation makes the asset good money, increases confidence in the asset and the network, which in turn increases revenues and value accrual, so and so forth. As opposed to the above negative feedback loop, here’s a positive feedback loop.

Why not keep reducing inflation with a hard cap, ala Bitcoin/Cardano? The problem is this keeps reducing the security budget of the network, and at some point, if there’s not enough value accrual, it becomes a very insecure network.

So, you need both ingredients for long term sustainability: low inflation with predictable security budget AND high value accrual.

The goal should be to actually reduce the staking rate - ideally only ~10% of the asset is staked, and ~90% of the asset is used to be productive. You can only do this if the base asset has low inflation - for all of the reasons mentioned above.

How do we value this, then?

It’s clear, then, that L1 assets cannot be valued as equities or currencies, and we need a more complex model that analyzes the multidimensional usecases, but I’ll stop here. But a much simpler but incomplete note is to look at the net inflation rate (issuance - accured), growth rate (of accrued) and staking rate. If there’s only ~10% staked, the network has high deflation, the base asset is almost certainly undervalued. If there’s an even growth rate, a mild inflation rate (<1%), and 30% staked, then you’re probably valued at par. If there’s high growth rate, then a mild deflation (<1%) could potentially be sustained. The alarm bells should ring when you have a high staking rate (>50%), high inflation rate (>2%) and even/low growth rate.

Summing up and final disclaimer

I strongly believe all L1s are doomed to irrelevance in the long term unless their base assets have low inflation, high monetary premium, and high value accrual through usage.* Low inflation is necessary to make the asset gain monetary premium, increase its diversity of productive usecases, and increase value accrual. A high inflation is undesirable as it commits staking and usecases compatible with staking derivatives to be the dominant usage, and thus low value accrual. In the long term, low value accrual leads to an insecure network - as people lose confidence in the asset it kickstarts a negative feedback loop, instead of a positive one seen with low inflation.

I’m aware everything I have said here goes against how L1s have been designed thus far, but I’ll continue to hold this opinion till I see compelling evidence to the contrary.

*the one caveat to this is if better consensus protocols are invented that are non-plutocratic.

I understand there’s a lot of in-depth research around this, and almost all proof-of-stake L1s are fundamentally designed around the assumption that staking issuance is net neutral. It does seem to make sense once you consider base L1 assets as analogous to equities or currencies, but I believe L1 assets are a completely new breed that’s a combination of currency, equity, store-of-value, speculative asset, economic bandwidth and defence budget. As such, I believe we need heuristics rather than academic research to understand why staking issuance is actually net negative. To be clear, I’m an observer, not a researcher, so please don’t take what I say seriously, this is 100% speculative, but too many things I have seen in the crypto space has convinced me this model isn’t working, and will fail long term.

Stakers are not fully protected

Firstly, even if we assume that staking issuance is net neutral, only block producers are fully protected from this dilution. This is a small number of users, somewhere between 20 and 2,000 for all alt-L1s, and probably less than 10,000 for Ethereum proof-of-stake (though Rocket Pool alone has 1,150 unique node operators in ~6 months, so this can exceed 10,000 long term - but a lot of work needs to be done to enable this). Because it’s a plutocratic election in some way or another (you either directly delegate to a block producer, or you more generally choose a staking derivative or service), there are extremely strong centralization/oligopolist pressures, so what usually happens is you have a very small number of entities dominating. For direct delegation based systems (which is everything other than Ethereum & Algorand AFAIK), there’s a long tail of validators who are barely profitable. So, even if there are 2,000 validators on paper, 1,500 have too little stake delegated to them, and actually have so little profits that they may have to sell most or all of their revenues to cover costs of operation. It’s worth noting that many of these types of networks also have higher running costs. So, what do they do? The answer is a centralized entity often subsidizes delegations. For example, even though Solana has 1,700 validators on paper, only ~150 are significantly above this subsidy. This is a complex matter with many moving parts, there’s also the matter of MEV, priority fees etc. - but the point is - only validators are fully protected.

What about the average staker then? They have to pay the block producers a commission. In some protocols this is as large as 50%, though ~10% seems to be a general average. Because of strong brand value for top block producers or staking services, they can charge a premium, while some of the newer players may even offer negative commission (and hope to make back money in MEV and priority fees). Either way, the conclusion is that a vast majority (>99%) of stakers are not actually fully protected from dilution, but on average, 90% of the way there.

Inflating asset isn’t good money, requirement to stake isn’t good money

The argument is that everyone will stake anyway, so everyone is protected from dilution. I showed above that this isn’t quite true. But even if it was, that’s just a ponzi (in the broader sense of the term) game, and counter to what makes these assets actually useful in the first place. There are plenty of smart contract scenarios which are unsuitable for staking derivatives, and adding this friction will significantly hold back usage of the network. So, to put it simply, for the asset to be good money (again, in the broad sense) it should not inflate away, and there shouldn’t be a requirement to stake it (or worse still, in some protocols, lockup periods). For sake of simplicity, I’m defining “money” in the broadest sense - something people use to exchange, store or represent value in a confident and stable manner. The best money is one that’s most frictionless - you hold it, stake it, use it, whatever, without any fears. Indeed, the goal should be to have as little staked as possible, preferably <10% of supply, which necessitates very low dilution. [Addendum: Of course, it needs to be economically secure enough, i.e. minimal viable issuance, and where the safety threshold lies depends on the security features of the exact consensus protocol. For Ethereum, anything between 16M-50M ETH has been considered, and an active validator cap has been proposed at ~32M ETH.]

All stakers have a selling price

Anecdotally, there are plenty of people on r/ethfinance that have discussed staking ETH as a retirement plan, and selling the rewards to cover their living expenses. I’m not claiming this is true for most people. The issuance piles up, and everyone has a selling price. The ETH supply has seen extreme churn over the years, and there’s almost no one who bought the ICO that still holds it today (this is verifiable from on-chain analysis). The average ETH holder today has a buying price of ~$1,750, holding for less than a year. Over time, I do expect there to be long-term investors who treat it like a value stock, but because of its multidimensional nature it’ll always be a small crowd rather than the entirety. What really happens is that the selling is temporarily delayed, not permanently cancelled. Were it equities, this wouldn’t matter, but it’s not.

The pernicious effects of inflation

Given a long enough timeframe, there are additional effects of dilution that are often not considered. A lot of stakers buy into these networks as a speculative asset. Anectodally, almost all 2014-18 era L1s have bled away over the long term - though one may argue that is for other reasons. But let me point to a case study that spedran this.

In July 2016, STEEM was the #3 crypto asset, behind only BTC and ETH. In just 4 months, it lost 95% of its value. So, what happened? Obviously, it was in a speculative bubble and bound to correct, and there were other factors at play. But the biggest was high inflation. Dan Larimer bought into the “staking issuance is net neutral, and might even be positive” research, and went to a high inflation (>100%) with a long 2-year lockup period. The hypothesis was that since >95% of supply is staking anyway and locked up for 2 years, there’s no issue. Yes, those <5% are diluted hard, so they will be incentivized to stake too. In reality, the market started pricing in STEEM’s inflation and high friction to stake, and bids disappeared as the market lost confidence in STEEM as money. Fewer people were willing to play the speculative game, fewer people were willing to use the network, thus kickstarting it’s just a vicious negative feedback loop. Fortunately, the community rallied against Larimer’s insanity and lowered inflation to a more standard ~8% and drastically reduced the lockup period. As you may expect, at first there was a mass exodus that absolutely cratered the price as the earlier stakers exited with a reduced lockup period. But predictably, once the reduced lockup period was over the asset went recovered, and eventually went on to make new highs (though this was more due to the bull market, of course). But even 8% inflation is too high, and on a somewhat related note, in March 2020, Steem was 67% attacked by Justin Sun, and to this date remains under attack as a defacto centralized chain owned by Justin Sun.

Even if my case above was for very high inflation, similar applies to those with 5%-10% (which is most L1s not Bitcoin or Ethereum) - just on much longer timeframes of years/decades, not months. As a side-note: Terra was the ultimate speedrun, collapsing in 2 days due to hyperinflation. The difference with 10% inflation is it’ll take years, 2% inflation will take decades, etc.

Low inflation and high value accrual are both critical to the sustainability of L1s

Because the security of an L1 is directly tied to the value of its base asset, it’s critical for L1s to increase its value over time. Low inflation expands the demand base for the asset to not just stakers playing a speculative game, but real utility with a broad diversity of usecases. Low inflation makes the asset good money, increases confidence in the asset and the network, which in turn increases revenues and value accrual, so and so forth. As opposed to the above negative feedback loop, here’s a positive feedback loop.

Why not keep reducing inflation with a hard cap, ala Bitcoin/Cardano? The problem is this keeps reducing the security budget of the network, and at some point, if there’s not enough value accrual, it becomes a very insecure network.

So, you need both ingredients for long term sustainability: low inflation with predictable security budget AND high value accrual.

The goal should be to actually reduce the staking rate - ideally only ~10% of the asset is staked, and ~90% of the asset is used to be productive. You can only do this if the base asset has low inflation - for all of the reasons mentioned above.

How do we value this, then?

It’s clear, then, that L1 assets cannot be valued as equities or currencies, and we need a more complex model that analyzes the multidimensional usecases, but I’ll stop here. But a much simpler but incomplete note is to look at the net inflation rate (issuance - accured), growth rate (of accrued) and staking rate. If there’s only ~10% staked, the network has high deflation, the base asset is almost certainly undervalued. If there’s an even growth rate, a mild inflation rate (<1%), and 30% staked, then you’re probably valued at par. If there’s high growth rate, then a mild deflation (<1%) could potentially be sustained. The alarm bells should ring when you have a high staking rate (>50%), high inflation rate (>2%) and even/low growth rate.

Summing up and final disclaimer

I strongly believe all L1s are doomed to irrelevance in the long term unless their base assets have low inflation, high monetary premium, and high value accrual through usage.* Low inflation is necessary to make the asset gain monetary premium, increase its diversity of productive usecases, and increase value accrual. A high inflation is undesirable as it commits staking and usecases compatible with staking derivatives to be the dominant usage, and thus low value accrual. In the long term, low value accrual leads to an insecure network - as people lose confidence in the asset it kickstarts a negative feedback loop, instead of a positive one seen with low inflation.

I’m aware everything I have said here goes against how L1s have been designed thus far, but I’ll continue to hold this opinion till I see compelling evidence to the contrary.

*the one caveat to this is if better consensus protocols are invented that are non-plutocratic.