The Proof-of-Stake Protocol and Run Risk

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.

Ethereum is the second most valuable crypto asset, with a market capitalization of over $310 billion. This crypto asset switched in 2022 from the Proof-of-Work (PoW) protocol to the Proof-of-Stake (PoS) protocol. This change is part of a bigger trend, as more crypto assets are adopting the PoS protocol. It also brings trade-offs for the blockchain and the cryptocurrency it supports. While PoW is more energy intensive, PoS requires more capital; and because more capital is at stake, it has a higher risk of runs. During a run on a crypto asset, investors rapidly exit their holdings in a fire sale, which can undermine security for that blockchain and disrupt broader crypto markets dependent on that protocol. In their working paper, “Does lock-up lead to stability? Implications for runs in the Proof-of-Stake protocol,” Federal Reserve Board of Governors Senior Economist Samuel Hempel, Williams College Associate Professor of Economics Gregory Phelan, and OFR Research Principal Thomas Ruchti examine different scenarios that increase run risk.

Once a new block is proposed to a PoS-enabled blockchain, a staker receives rewards for doing so. Previous work shows that, in theory, low rewards improve the security of PoS by reducing the incentive for neutral parties to participate in co-opting the blockchain by nefarious actors. These low rewards increase security because there are more validators maintaining the chain. In this paper, the authors demonstrate that lower staking rewards mean a higher risk of runs because stakers are less willing to stick around when other stakers may be incentivized to exit. In sum, while lower rewards generally require less capital and have more consensus, they also have a higher risk of runs.

The authors find that lock-up periods can reduce the risk of runs, but they do not eliminate them completely. If, during a lock-up period, some event occurs that reduces the value of the crypto asset, investors would not be able to sell their holdings until the end of the period. This could prevent more severe price declines.

The authors also show that the use of margin only exacerbates run risk during price declines. If a price decline is steep enough to cause a margin call for investors, those investors must either post additional collateral or sell crypto assets, which could further depress prices.

A run on a major PoS blockchain, like Ethereum, could undermine security for the crypto asset and disrupt broader crypto markets that rely on that blockchain. As crypto asset markets become more interconnected with traditional financial markets, the vulnerabilities associated with crypto asset protocols will matter more for the financial system’s stability.