28 Nov 2023

A Strategy For Private Wealth Managers For Diversification

Key Takeaways

Crypto staking offers new diversification opportunities outside traditional assets.
Staking provides passive income and acts as an inflation hedge.
Managing risks like illiquidity is key for wealth managers.
Assessing client risk tolerance and staking expertise is crucial.
Portfolio rebalancing continues to be important when staking.

Decades of declining interest rates have left wealth managers struggling to deliver attractive risk-adjusted returns. With stock and bond valuations stretched, many are considering alternative investments like crypto staking for portfolio diversification.

Staking strategies allow clients to earn passive income on crypto holdings while supporting blockchain networks. However, wealth managers must address inherent liquidity and volatility risks.

This article explores using staking to diversify client portfolios.

Understanding Staking

Proof-of-stake (PoS) protocols are an alternative way to validate transactions and achieve consensus on blockchains like Ethereum. Instead of mining, PoS protocols allow participants to stake their crypto holdings to become validators. The network randomly selects validators to add the next block of transactions, rewarding them with newly minted tokens.

To become a validator, you deposit a set amount of the blockchain's crypto tokens into a staking wallet. The size of your stake determines the chance you'll be chosen to validate the next block. Validators that behaves dishonestly run the risk of getting their stake slashed -an effective deterrent.

This approach offers key benefits over proof-of-work mining:

More energy efficient as it avoids intensive computations
Better security as attackers must own large stakes to compromise the network
Allows crypto holders to earn passive income on existing assets

a.Process of staking crypto assets

The actual staking process is quite straightforward:

Select a PoS blockchain like Ethereum, Tezos or Polkadot and acquire its native crypto tokens.
Transfer tokens to a designated staking wallet. Depending on the protocol, the minimum stake can range from 1 token to 32 tokens.
Initiate staking on the network according to its rules. Some require running validator software while others allow delegated staking through a pool.
Leave the staked tokens in the wallet to participate in validation. Tokens remain under your control.
Receive staking rewards in the form of newly minted tokens added to your wallet at regular intervals. Rewards vary based on factors like the total staked.
Withdraw your staked tokens by ending the validation process. Your initial crypto assets will be accessible again, along with any rewards accrued.

b. Types of staking options

There are a few ways you can stake crypto assets:

Solo staking involves running your own validator node. This requires more technical expertise but allows you to retain full control over your staked assets.
Pooled staking allows delegating tokens to a validator node run by a third party. Less hands-on but you cede control.
Exchange staking is staking through a crypto exchange. Convenient but your assets are in the exchange's custody.
Cold staking keeps staked tokens offline while delegating validation rights to a hot wallet. Adds security.
Liquid staking utilizes derivative tokens to free up staked assets. Solves liquidity issues but adds complexity and risks.

The optimal approach depends on factors like technical skills, asset size, and risk tolerance.

Solo Staking as a Portfolio Diversification Tool

Low correlation to traditional assets

A key benefit of crypto staking is its low correlation to stocks, bonds, and other traditional assets. Crypto often moves independently of wider market moves. This makes it an ideal way to diversify client portfolios beyond mainstream securities for greater balance.

For example, data shows that large cap cryptocurrencies like Ethereum have essentially no price correlation with US stocks over a multi-year period. This means staking rewards can bring portfolio diversification even during times of stock market volatility.

Cryptos also have low correlations with real estate, commodities, and currencies in general. So staking returns may remain steady even when prices in other alternative assets fluctuate. This unique profile versus other asset classes makes staking attractive for managing risks.

Generates passive income

Staking offers wealth managers an avenue to generate passive income for clients on existing crypto holdings. Instead of assets laying fallow, staking puts them to productive use while validating valuable blockchain networks.

Annual staking returns currently range from ~3%-4% on networks like Ethereum and higher for smaller cap cryptos. This steady stream of staking rewards provides an income flow similar to dividends in equities or bond yields.

Passive staking income can fund client needs like lifestyle spending, while the underlying crypto assets may appreciate. Think of this extra yield as getting paid to wait as the network and token value grows.

Acts as inflation hedge

Staking yields are also an excellent inflation hedge in times of rising prices because staking rewards are typically denominated in the native crypto token. As crypto prices rise with inflation, so does the underlying value of the rewards.

For example, if annual staking yields are 10% on a crypto trading at $2,000 per token, the nominal reward amount stays fixed at 0.1 tokens. But as the token value inflates to $4,000, the nominal reward value doubles to $400 per year.

This dynamic allows staking income to potentially retain its real purchasing power. It's an alternative to Treasury Inflation-Protected Securities for hedging inflation.

Allows clients to retain full ownership of assets

With solo staking, clients remain the sole owners of their crypto assets. There is no need to delegate custody to an intermediary like a staking pool. Your staked tokens never leave your crypto wallet.

This retains the core benefit of cryptocurrencies - independence from third party custody and control. Clients have full flexibility to manage staked assets as they wish.

Solo staking also avoids potential lockup periods or liquidity constraints imposed by pools. And all staking rewards go directly to the staking wallet holder rather than being shared.

Provides flexibility and control over staking process

Clients who solo stake have granular control over the staking process. You can choose when to deposit and withdraw tokens from staking. There's no need to rely on someone else's staking operations.

Solo stakers also decide exactly which validator software to run. You can customize the setup for optimal uptime and security. Geographical location of the validator node is under your control as well.

This flexibility allows tailoring the staking process to fit an individual client's preferences and circumstances. They retain full autonomy instead of relying on a third-party provider.

Suitable for larger asset holders

Solo staking can be a good fit for clients holding larger crypto allocations because the minimum staking amount is higher. For example, Ethereum currently requires 32 ETH to be a solo staker - significant upfront capital.

Larger holders are also better equipped to handle the operational complexity and risks like slashing penalties. The costs of setting up the staking infrastructure can more easily be absorbed.

Wealth managers who have clients with sizeable crypto holdings should consider offering solo staking services. It allows maximizing control and returns for suitable clients.

Managing Risks and Drawbacks of Solo Staking

Technology requirements and setup complexity

Running a validator node for solo staking requires more specialized hardware and networking gear than staking through a custodial third party. Clients need servers, fast and reliable internet, backup power sources, and robust security.

The validator node software also needs proper configuration and regular maintenance like security patches and upgrades. There's certainly a learning curve for clients to become proficient solo stakers.

Wealth managers should thoroughly assess if clients have the required technical skills before recommending solo staking. It may be wise to start with partially managed services until clients build expertise.

Susceptibility to slashing penalties

As network validators, solo stakers are directly accountable for any downtime or malicious behavior by their nodes. Negligence can result in harsh slashing penalties that confiscate a portion of the staked assets.

Penalties for multiple validator offenses can cascade, quickly decimating a client's stake. Solo stakers must be diligent about maintaining nodes and carefully follow protocol rules to avoid slashing risks.

Managers should educate clients on potential penalties and incorporate slashing risk into portfolio stress testing. Proper validator node redundancy and fail over procedures are a must.

Lack of liquidity during lock-up periods

Some network protocols usually mandate a lock-up period before staked tokens can be withdrawn (fortunately not Ethereum, where you can withdraw whenever you want). This helps secure the network but leaves clients exposed to liquidity events.

For example, an emergency expense may arise while a client's assets are locked for staking. Or staked asset prices may plunge before the client can sell.

Solo staking clients must be financially equipped to withstand lack of access to staked capital for weeks or months. Managers should align lockup periods with client cash flow needs.

Overall, solo staking is best suited for larger, long-term crypto holders who grasp the risks and possess the technical abilities. Managers can mitigate risks by thorough client vetting, staking governance, and partially managed services.

Implementing a Solo Staking Strategy

Assessing client technological proficiency

The first step is gauging whether clients have the required crypto asset knowledge and technical skills for solo staking. Clients should comprehend key concepts like wallets, private keys, validator nodes, staking protocols etc.

They should also be able to perform tasks like installing software, configuring networks, monitoring servers, and troubleshooting issues independently. Clients lacking expertise may struggle with solo staking complexities.

Wealth managers should have an open discussion on proficiency. A managed staking service may be better for novice clients until they build skills.

Selecting user-friendly staking platforms

For clients with moderate technical abilities, wealth managers should identify staking platforms that simplify the process while retaining client control.

Choose platforms requiring only key tasks like signing smart contracts with private keys and monitoring dashboards. Complex back-end management should be handled by the platform.

Platforms with robust documentation, assistance and clear instructions will be most beginner-friendly. However, ensure they have strong security protections.

Monitoring operations and security

Ongoing monitoring is crucial even when using managed staking platforms. Clients should check dashboards frequently for issues like low validator uptime or pending slashing penalties.

Having alert systems in place to notify clients of problems is also important. Wealth managers should define monitoring tasks and cadence clearly for clients.

Periodic staking infrastructure security reviews should be conducted as well. Update validator software, firewalls, API access controls and other protections regularly.

Following defined staking governance and security protocols is key for wealth managers to implement solo staking successfully for clients.

The Future of Solo Staking

Projected growth as staking becomes more accessible

While still nascent, solo staking adoption is expected to grow significantly as blockchain protocols progress. User interfaces and managed services are making self-staking more accessible for investors lacking technical expertise.

As the barriers to entry reduce, more mainstream wealth management clients will likely seek solo staking services to maximize control and returns on crypto holdings.

Improved staking features like liquid staking derivatives and staking governance automation will further propel adoption by solving liquidity and risk issues.

Implications for wealth management client offerings

As solo staking gains more traction, wealth managers have a big opportunity to differentiate their advisory services by providing staking support.

Firms that build managed staking capabilities early can grab market share as investor interest accelerates. They can also expand earn rates and deepen client relationships.

Wealth managers should proactively gauge client appetite for self-staking and develop partnerships with reputable staking infrastructure providers.

Training advisors on staking protocols, operations and risk management will also be crucial. Wealth firms that can provide clients seamless access to solo staking are poised to reap benefits as this method gains popularity.

Conclusion

Crypto staking presents unique portfolio diversification opportunities for wealth managers through low correlation and passive income. Solo staking specifically allows qualified clients to maximize control and returns.

However, solo staking involves risks like technical complexity, liquidity constraints, and slashing penalties. Wealth firms must perform due diligence in assessing client suitability.

Partnering with experts like ChainLabo to provide managed infrastructure and staking governance allows securely offering solo staking services to clients.

Ongoing monitoring and robust security protocols are still essential. As solo staking accessibility improves, it can become a key differentiator in wealth management offerings.

In conclusion, solo staking is a compelling strategy for large crypto asset holders who meet the technical proficiency and risk tolerance criteria. Wealth managers should thoroughly evaluate client suitability.

By partnering with reputable managed staking providers like ChainLabo, firms can tap into robust infrastructure to confidently provide solo staking services.

As more protocols enable self-staking, wealth managers have an opportunity to stand out by offering clients direct access and control. Overall, solo staking is poised to grow as a niche diversification strategy for suitable clients.