Coinbase, Binance and other exchanges hold at least $2.25 billion of shadow ether, as the latest lucrative innovation in digital assets ramps up.
Cryptocurrency exchange Coinbase is sitting on a $1.5 billion pile of phantom cryptocurrency pegged to the price of ether. Binance has a similar $750 million stash. These tokens, created to be used in what are essentially lending programs, are just entries in the exchanges’ computers, but to outside observers they appear as assets sitting in their corporate crypto wallets.
Binance’s 400,000 tokens would suddenly come to life if investors decide to use the exchange as an intermediary in posting ether (ETH) collateral to the Ethereum blockchain through a process called liquid staking. But until they do, anybody seeking to determine the amount of Binance’s assets would have to subtract the value of the spectral crypto from the visible total, now $2.77 billion, according to data from Arkham Intelligence. Things might be clearer if Binance actually published its balance sheet, which would be expected to show a corresponding liability. However, despite 70 million customers worldwide, it doesn’t share financial details with the public.
“Those [tokens] not in circulation are held in a specific reserve account with strict controls and multi-party approval,” says a Binance spokesperson.
Coinbase–which declined to comment for this story and is facing a likely enforcement action from the Securities and Exchange Commission related to its staking offerings–does not count its unreleased assets on its balance sheet, but does disclose them in its SEC filings.
Welcome to the fast-growing world of liquid staking. Staking in crypto parlance involves posting a digital asset like ether to a blockchain as collateral in exchange for the right to process transactions and earn in-kind rewards like tokens. Staked tokens are normally locked up for a period of time so they can’t be immediately withdrawn and cause a run on the platform. Liquid staking, by contrast, allows holders of tokens like ether the opportunity to use a tracking token of sorts for trading while the underlying token is still sitting “staked” on the blockchain, continuing to earn yield. In some ways it allows crypto investors the chance to have their cake, or “stake,” and eat it too.
There is already more than $18 billion committed to platforms that offer the service, according to data from Dune. Investors can earn annual returns of 2% to 12% depending on the platform, according to Staking Rewards, and they keep control of their crypto. But they have to trust the integrity of the intermediaries and the security of the platforms to safeguard their assets.
In December of 2020 Binance minted an astounding 100 million Binance ETH, known as “beths”, each representing one ether at a time when there were only 120 million ETH in existence. Until June 2022, if counted, that hoard would have added about $483 billion to Binance’s visible wallet assets, multiplying them fivefold. However last year it started destroying these phantom tokens and now only 1.5 million remain according to Binance’s own BNB Smart Contract (BSC) Chain explorer.
It’s almost as if Charles Schwab manufactured a massive amount of an ETF like Invesco’s QQQ Trust and simply held the shares on its books without acquiring the corresponding stocks in the Nasdaq 100 index and putting them in a trust, the way ETF shares are normally created. And since there is no SEC or regulator involved, no one would care if those ETF shares fluctuated in value or amount or were simply discarded. This is effectively what Binance and Coinbase have been doing with the special staking ether they have created since 2020.
A Binance spokesman would not say exactly why so many tokens were minted in 2020, other than it was cheaper to manufacture them in bulk.
“There are no accounting standards that speak to any of this stuff specifically, and even the related standards are not specific,” says Francine McKenna an accounting lecturer at the University of Pennsylvania’s Wharton School of Business. Staking can take many forms, she adds, and existing rules do not contemplate “all the details of all these different variations on all these products.”
Creating billions worth of staking tokens out of thin air and then destroying them, is just the latest example of a crypto company playing by its own rules. Disgraced former crypto exchange FTX, played fast and loose with disclosure rules, and more recently Binance has come under scrutiny. A civil complaint by the U.S. Commodity Futures Trading Commission in March claimed that Binance consists of “an opaque web of corporate entities.” Last February, a Forbes investigation showed that the exchange appropriated more than $1 billion of collateral meant to back stablecoins in August, shifting the assets to other uses without alerting the customers who were affected.
Liquid staking joins a long list of dubious crypto industry innovations that have included initial coin offerings, algorithmic stablecoins and decentralized finance. Like its predecessors, liquid staking is a creative solution to a key pain point: the illiquidity that comes with staking ether.
Although digital assets–like traditional currencies–do not generate income by themselves, there are ways that investors can earn passive revenue from their holdings, similar to making a loan. Posting assets to blockchains such as Ethereum, Solana, Algorand and Polkadot as collateral, give lenders (known as stakers) the right to earn fees by processing blockchain transactions. Ethereum for example, currently brings about 4.8% of annual return, and there is always the chance that a digital asset you have staked appreciates, magnifying your return. But this process has drawbacks.
Depending on the platform, it could take weeks to withdraw crypto once it has been staked. The situation has been even more extreme with Ethereum. Although staking was enabled for the blockchain in December 2020, withdrawals were not permitted until a major upgrade, known as the “Shapella update”, was completed on April 12, 2023.
BINANCE-ASSET BALANCE HISTORY
In $billions, Ethereum and BNB Chains
This chart erroneously shows the value of Binance’s digital assets, which were inflated by BETH tokens despite little actual ETH staking – only 2% of the value claimed. SOURCE: ARKHAM INTELLIGENCE
This illiquidity has been a major impediment for many would-be stakers and in response, a cottage industry of service providers, including Coinbase and Binance, have surfaced, willing to exchange an investor’s staked ether for a different tracking crypto token (such as beth). The ether is locked on the blockchain, while the new token is available for use in applications such as decentralized finance; it also can be sold. The blockchains available for liquid staking vary by geography and provider, with some like U.S. regulated Coinbase accepting Cardano, Cosmos, Ethereum, Solana and Tezos, while international investors using exchanges like OKX exchange and Huobi exchange can stake dozens of tokens.
Exchanges like Coinbase profit by taking a cut of the fees earned by staking customers. This has been a lucrative and growing business for Coinbase. In its quarterly filings, it includes staking fees within “blockchain rewards.” In 2022 these fees amounted to $275 million, or nearly 9% of revenue, up from $223 million or 3% of 2021’s top line.
While the idea seems simple, the reality is more complex, which can create risks for investors. For one, stakers have to trust centralized exchanges not to use these pools of new tokens themselves, effectively adding duplicative cryptocurrency to the market.
Then there is the issue of exchanges making up new rules as they go along. Until April 24, Binance limited the use of beths to deposits on its Binance Launchpool, essentially an initial public offering platform that allowed users to participate in unproven crypto-related projects that the global cryptocurrency exchange was endorsing. Now Binance offers a way for users to use beths for a wider variety of investments on the Binance Smart Chain and Ethereum, bringing the currency more in line with other liquid-staking tokens but in a unilateral action that can create additional security risks.
Coinbase has been told it is likely to face enforcement action by the U.S. SEC that may involve its staking service. Like Binance, it minted a token for staking, this one called Coinbase wrapped staked ETH (CBETH). But in contrast to Binance, it began with a modest 500,000 units.
Some of the spare tokens minted are essential for an exchange’s liquidity. Exchanges need to keep a reserve available to satisfy regular daily staking volume. There are minor costs involved in minting tokens, and without a supply on hand it might not be possible to immediately provide liquidity to potential stakers. But having too many can create questions for customers and regulators.
How many is enough?
“If I’m an exchange with $1 billion in staked ether and I’m minting my internal tokens in $10,000 batches that’s not material,” says Paul Brody, principal and global blockchain leader at Ernst & Young. “I would want to know, are they sitting on $1 billion in undistributed tokens or $10,000, $50,000?”
An alternate approach to liquid staking does away with the temptation to misdirect spare tokens, but creates problems of its own. Smart contracts–agreements that are automatically executed under specified conditions–address the problem of too many tokens on hand. There are decentralized liquid-staking providers such as Liquid Collective, Lido, Stakewise and RocketPool that exist almost entirely as sets of smart contracts. Lido is the world’s largest liquid staker, with $11 billion in deposited assets.
LIQUID STAKING TOTAL VALUE LOCKED
TVL in ETH staked, May 1, 2023
Select firms providing staking services ranked by total value locked, measured in ETHs, May 1, 2023SOURCE: FORBES, DUNE
Smart contracts can automate the process, staking the original token on the appropriate blockchain, then minting the liquid version for the customer. “The transparency that is associated with more decentralized staking protocols is definitely a plus because users can verify for themselves that the protocol has a corresponding amount of ether for its liquid token supply,” says Christine Kim, vice president of research at Galaxy Digital, a New York-based investment management and technology firm. Among the drawbacks is that the immediate minting of staking tokens is that the process is more expensive than minting the tokens in advance the way “centralized” exchanges Binance and Coinbase have.
An even larger issue is that decentralized finance protocols are more susceptible to hacks. According to Chainalysis, DeFi hacks accounted for 82% of all stolen digital assets last year, totaling $3.1 billion. Of this sum, 64% was taken from software programs known as cross-chain bridges, which allow users to move assets between decentralized-finance protocols. They work by having owners lock up tokens in smart contracts in exchange for a new corresponding token replica. Although there are key differences between bridges and liquid-staking protocols–such as the locked up tokens sitting in a blockchain rather than crypto wallets–this type of arrangement can expose liquid staking holders to more risks. This is especially true when tokens are moved from Ethereum validators into other wallets for distribution.
With the Shapella update to Ethereum complete, the metaphorical stakes are going to rise. The ability to withdraw funds is bound to make the market more attractive to institutional investors. Nikos Panigirtzoglou, managing director for global market strategy at JPMorgan told Forbes that “Over the medium to longer term we expect Ethereum staking to grow and converge with that of other blockchains.” Cardano, Solana, Algorand and Polkadot have 35-70% of their tokens staked. Ethereum is at 15%, so even just doubling this percentage would add $35 billion in staked tokens at current prices. A good portion of those funds would likely be liquid staking protocols because of the ability to put these tokens to other uses while the underlying asset is staked.