Staking, or bonding, is the act of delegating one’s tokens to a network validator in order to secure the blockchain. In Cosmos app chains, there are 150 validators in the active set. These validators actively run software that contains the consensus mechanism to confirm new blocks, and in return for the compute power and uptime receive tokens that are part of the long term inflation/emissions schedule.
For many new Cosmos app chain investors, staking is a way to generate passive income. Typically, the networks that have the most activity (active users, transactions, useful applications, e.g.) will yield the best returns as the underlying capital appreciates while also providing yield, which is similar to a stock dividend.
Staking yield is different from a dividend because it is rewarded on an epochal basis (e.g. once per 24 hours). Many investors are unfamiliar and have questions about what to do with staking yield (tokens) once it’s been received or claimed.
In the following article, I’ll lay out some simple strategies to consider that can be tailored to any investor’s particular situation.
Basic Cases
Hold (HODL)
The simplest thing to do is ignore your daily rewards. Since you are required to claim your yield through an on chain transaction, you have a choice about whether to recognize the yield (taxable event). If your investment thesis about the network changes, you can leave the yield there and not be responsible for paying taxes on the yield. However, should the blockchain have activity and growth, those rewards are likely worth something and you can claim them at your leisure. These claimed tokens are taxed like ordinary income.
Typically, price agnostic investors with a longer investment horizon may prefer this strategy. A ‘set it and forget it’ passive investor likely ignores the daily price volatility.
Regular claims (every day)
Claiming regularly gives an advantage over a less frequent strategy because it provides immediate liquidity. Liquid holdings allow one to trade in and out of other assets. A very basic reason to claim and trade every day is illustrated here:
So holding reward for 20-22 hours before selling will increase yield rather than trying to fight with bots that claim and sell immediately (front run). Buying an hour or two after rewards can be claimed also allows investors to get in at a discount.
Active trading can be an interesting strategy until the market gets big enough that daily yield doesn’t make a material impact on the price. Early networks and yield farmers may utilize this strategy.
Sell rewards
Selling the yield is how staking ‘APR %’ is calculated. It’s either an average or instantaneous calculation of (annual tokens earned*price)/initial investment. Keep in mind the number of tokens earned is very likely decreasing as the network grows and more stakers share the emissions, so in order to maintain a constant APR, the price must increase.
In a “risk off” environment (e.g. bear market), you are better off selling the token rewards for stablecoins because the price may decrease in the near term. Even if you’re long term bullish on the project, you may be able to buy back the same or more of the token you’re earning by holding stablecoins until a more favorable market (risk on).
This is incredibly difficult to predict, even for the most seasoned investors, so it can be frustrating and stressful to try and time changes in volatility.
Compound
Compounding is usually a great strategy for investors with very high conviction in the investment. Its major disadvantage is it restricts access to liquidity. In a “risk on” environment, during a bull market, or when you really want to capture as many tokens of the network you’re staking on as possible, you can compound your rewards. This is an effective way to build your stack for no increase in capital required (you don’t have to buy more tokens).
Unstaking/unbonding in Cosmos requires a 14 or 21 day wind down period where your tokens are illiquid. More on how to get liquidity from bonded positions in the next section.
Combination
Rotating between selling, holding, and compounding is typically what most investors do, and it’s frequently the result of chasing changes in the trend. E.g. if the price has been going down, we have an urge to sell, or vice versa holding/compounding when things are good.
A 33% split between sell/hold/compound makes things simple and can be beneficial in any market conditions.
My Strategy
I try to remove the guess work from predicting future prices. Even sophisticated models are extremely uncertain for cryptoassets, let alone well understood traditional markets. My strategy for investing in speculative blockchains revolves around a thesis, and I only stake capital in networks I believe have the potential to grow and appreciate in price.
A question I often ask myself is “How long will it take to ‘de-risk’ your investment (return 100% of the initial capital outlay)?” It is oftentimes better to work backwards and figure out how much yield (stablecoins) you need from your capital staked, first.
The challenge with a simple ‘break even’ calculation in order to return your capital is there are dynamic variables like price and yield. Yield decreases as more stakers participate in validating the network and token emissions drop, and price is highly volatile. Plugging in current yield and price is often a good start, but using a range of outcomes is usually the better (lower yield/constant price, lower yield/lower price, etc.). If you want to get fancy, you can come up with ranges for price and yield, run a Monte Carlo simulation, and see what comes out! Might be overkill due to the high uncertainty of investing in digital assets.
In summary, there’s always a possibility the initial capital isn’t recovered and would eventually consider the investment a loss. But, this is a good strategy for de-risking early, liquid blockchain investments, and allows for a flexible pivot following recovering the capital.
DeFi Cases
Provide Liquidity on a decentralized exchange (LP)
Oftentimes, decentralized exchanges reward liquidity providers with incentives, typically in the form of a governance token. Providing liquidity can be done by selling half of your staking yield for another asset (e.g. OSMO or WETH), then adding both tokens to a pool on Osmosis to earn rewards and swap fees. There’s currently, an incentivized pool is available on Osmosis for EVMOS/OSMO 14-day bonding that yields $OSMO tokens and is releasing 600,000 additional EVMOS over 90 days.
Lending
Decentralized money markets have been a significant catalyst for the growth of DeFi liquidity. Secure, over-collateralized, smart contract based loans allow wallets to get instant liquidity without selling their assets (collateral). Lending can often be very lucrative when the asset is in demand. Unfortunately, liquid staked tokens (liquid staking derivatives) aren’t yet prevalent across Cosmos app chains yet. These staked (locked) positions will be made more capital efficient with an exciting Cosmos app chain called Quicksilver, which will allow bonded (staked) positions to be tokenized as qAssets.
Other lending app chains and DApps to watch are:
Advanced strategies
Delta Neutral Hedge and collect yield
This is only possible if the token you’re staking has a perpetuals or a liquid lending market available. A number of major L1s are available on dydx, an excellent decentralized perpetuals platform. In the Cosmos app chain ecosystem, only $ATOM is available currently, but dydx may add new markets once they deploy on Cosmos.
The goal of this strategy is to remove the price risk (downside) from your invested and staked capital by opening a short position equal in size. The yield you generate from staking rewards earns money without exposing your underlying capital to price. Perpetuals platforms take a fee, typically paid hourly, called the ‘funding rate.’ This is the cost of borrowing the capital you are short selling, so keep this in the equation when setting up a hedge and collecting yield.
In conclusion, any new L1 chain in the Cosmos ecosystem comes with significant risk, so the old adage of “only investing as much as you can afford to lose” rings true. However, new Cosmos app chains are unique as they provide immediate and liquid yield that can de-risk an investment quickly. I hope this article inspired some thoughts around options for what to do with the yield.
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