Staking will help ‘bring the next billion users on-chain’ – Northstake CEO

(Kitco News) – In September of 2022, the Ethereum network successfully completed its transition from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) consensus mechanism. The move was done in an effort to bring greater efficiency and scalability to the network as its ecosystem of decentralized applications (dApps) continues to grow and evolve.

Several months after the “Merge” took place, the network underwent its Shanghai upgrade, which for the first time enabled the withdrawal of staked Ether – some of which had been locked on the beacon chain since it first launched in December 2020.

This event ushered in a new era for the top smart contract platform and gave the Ether token an added value proposition in the eyes of institutional investors, as staking rewards can be loosely compared to dividends that are distributed to stockholders.

To gain insights into the world of staking from an institutional standpoint, Kitco Crypto had a conversation with Jesper Johansen, founder and CEO of Northstake, a regulated, custodial, virtual asset service provider focused on helping institutions participate in crypto staking while mitigating the risks involved.

“If you are an institutional investor and you have a long position on proof-of-stake crypto assets like Ethereum, then we can support you in the process of staking those assets long term, but done so in a way where we observe KYC/AML legislation, as well as the incoming Markets in Crypto Assets (MiCA) regulation in Europe,” Johansen said.

He noted that there are a variety of obstacles early adopting institutional investors face on this front, including dealing with the travel rule and “a number of other regulatory challenges.”

Johansen said that, for the most part, institutional investors are currently focused primarily on Bitcoin and Ether, saying that “everything else is just too early.”

“We know that there are a plethora of other projects out there, but from our point of view, ensuring that institutional investors have a way to securely and compliantly hold their investments in the top crypto assets is what we specialize in,” he said.

To do this, Northstake handles the infrastructure side of things, operating validation nodes on the networks they provide services for and serving as a virtual asset service provider under EU Law. The firm is also a regulated custodian.

“On top of the typical custody and staking services that people are familiar with, we then lay on top of that compliance monitoring, tax reporting, and a number of additional services that comprise a product that, from an institutional point of view, can be allocated towards,” he said. “There is only one known counterparty, which is Northstake.”

Northstake first launched in November 2021 – which coincided with the end of the last bull market – and has steadily grown over the years, recently surpassing $80 million in assets under management.

“I think our company and our business model have shown resilience in the face of that,” Johansen said. “Since launch, we’ve onboarded approximately 25 institutional clients and accumulated $80 million in AUM, so we are still in the early stages. But asset volume has grown over the past four months, primarily on Ethereum.”

“So we do see a lot of institutional interest,” he said. “However, for the larger institutions, sovereign funds, endowments, and pension funds, it’s still very hands-off. But investors in large family offices, hedge funds, crypto hedge funds, venture capital, crypto VC, and liquid funds have shown a great deal of interest.”

Johansen said the lack of a clear regulatory framework in the U.S. has been one of the biggest hindrances to adoption, as well as multiple “blow-ups” in the crypto space that have led to some reluctance by larger firms to engage with the asset class.

Assets with the highest level of interest

Northstake currently offers staking support for 12 tokens including Ether, Solana, Avalanche, Cardano, Cosmos, Polkadot, and Polygon.

Johansen said that part of their business involves supporting projects early on by offering staking and running validator nodes. This is a valuable service for early projects as it provides an avenue for institutional investors to make an investment. “We then can onboard institutional investors with a cap table who need custody and staking services,” he said.

As far as which tokens Northstake has seen the most interest in, Johansen said that Ethereum and layer-two (L2) projects like Polygon, Optimism, and Arbitrum have seen a lot of demand, but the firm has yet to offer support for the latter two networks.

Outside of the Ethereum ecosystem, he said that the Near protocol and Solana have received a lot of interest.

Staking services and regulation

When asked how regulators are going to respond to staking services and whether they will carve out specific regulations that apply to staking, Johansen said that will depend on the jurisdiction.

From the perspective of the European Union (EU), the Markets in Crypto Assets (MiCA) bill will take effect by mid-2024, he said.

“This will establish legal definitions in the crypto space, most notably defining rules for crypto-as-a-service providers, how they should act, and what requirements they should meet,” he said. “This includes staking providers, so that will provide a lot of clarity.”

Johansen said the EU is already working on updates to MiCA – which he referred to as “MiCA 2.0” – which will include specific references to staking. “MICA in its current form will support other regulatory frameworks and provide definitions they can use,” he said.

“In the U.S., there is currently a gap in terms of crypto regulation,” he said. “The E.U. spent four years drafting MiCA. The U.S. now needs to play catch-up to close that gap, which will only increase as time progresses.”

“So when we see Coinbase and Kraken being sued by the SEC for their staking services, that’s something that Europe will address in their upcoming updates to MiCA,” he said. MiCA 2.0 “is another iteration ahead of where the U.S. is just starting from. The first version of MiCA is already being implemented and the second version is being developed. But in the U.S., they haven’t even started on legislation for the crypto industry, and consequently, they are trailing behind.”

“Until that gap is closed, from a U.S. perspective, there will be regulatory uncertainty about how to define staking,” Johansen said. “This includes issues around metadata, running nodes, as well as lending, borrowing, and earn programs, which are also sometimes referred to as staking.”

The question regulators will need to clarify is how do you actually differentiate between those things, he said. “The answer to that question will have significant implications for crypto exchanges, centralized exchanges, and node infrastructure providers who are based in North America. They will be under increased scrutiny until we have regulatory clarity from lawmakers in the U.S.”

Based on these facts alone, Johansen suggested that the U.S. will be at least a couple of years behind Europe in establishing crypto regulations. “And with the current political climate and an upcoming presidential election, I think it’s unlikely that you will be able to put meaningful crypto regulation forward within the next 12 months,” which will only extend the gap further.

“And that’s to the detriment of the crypto industry, broadly speaking, because we need the U.S. on board,” he said. “But also for the crypto projects and companies that are dependent on the U.S. because they are based in the U.S., have investments from the U.S., or have users in the U.S.”

Staking as a way to attract investors

When asked about staking’s role in attracting more institutional investors, Johansen said he believes “staking will be conducive for bringing in the next billion users on-chain.”

“The reason for this is that the current way for institutional investors to invest in the underlying technology of blockchain is by owning tokens on the networks,” he said. As institutional adoption rises, “This will cause the overall market cap of crypto to appreciate, which will invigorate the ecosystem.”

He said that institutional capital tends to have a “longer perspective,” and any “buy-and-hold strategy is likely to include staking because no institutional investor, no professional investor, would risk leaving extra yield on the table once they understand the risks involved with actively participating in the networks.”

“The majority of institutional capital coming in will be long, and therefore, will find its way into staking positions, and by that mechanism, support growing the broader crypto ecosystem,” he said. “Regulatory uncertainty is one of the main things holding back the realm of staking and not allowing it to progress forward.”

As for staking yields and Bitcoin, Johansen said, “Anything that has to do with ‘staking’ on Bitcoin is most likely a borrowing or lending product, which introduces credit risk, informal counterparty risk, and liquidity risk.”

While Northstake doesn’t offer any of these types of products as they focus on “staking that involves actively participating in the network,” Johansen said there has been “an increased demand for those types of yield generating services for Bitcoin in whatever shape or form simply because there has been a flight to quality during this bear market.”

“From an institutional point of view, the first asset that you would consider in your digital asset portfolio would be Bitcoin and then Ethereum,” he said.

“Institutional investors are just getting acquainted with Bitcoin and Ethereum to the point where they feel comfortable holding those assets,” Johansen said. “Now we need to teach them about the risks of actively participating in the network if you hold Ether. And they need to understand how that works and be able to price that risk into their investments. There’s a big difference between running a validator node on Ethereum as a way to protect your investment long-term, compared to lending out your Bitcoin. It’s a completely different risk profile and includes credit and liquidity risks.”

“This is the next step of the educational journey that institutional investors will need to go through,” he said. “I think that they will gradually get there because Bitcoin, as well as Ethereum, work in a similar fashion as traditional commodities or assets that institutional investors are familiar with.”

Johansen said he sees “a new breed of companies coming in now focused on serving institutional investors by building on the foundation that’s already been laid down.” Similar to how Levi’s was established by serving gold miners, some of the biggest opportunities will be found by creating products and services that facilitate access to digital assets and staking.

“We need a new guard of crypto companies that operate on the technology and infrastructure that has been laid down and introduce the layers of regulatory compliance and risk management that infrastructure and technology providers do not,” he said.

“From an institutional point of view, although you can be excited about the visions, prospects, and traction of blockchain technology, it is still a very high-risk investment, which means that you want to make sure that you are on the right side of regulation and the law when you do that,” Johansen said. “So the differentiation is not about how much APY or yield you can generate; it’s about providing the safety and assurance that your investment is kept safe and in compliance with current and future regulations.”