Kiln, a Paris-backed company that validates nodes on the Ethereum network, is opening its first non-European office in Singapore as it plans to tokenize those validators and transform them into new DeFi products.
Ultimately the company wants to do something similar with stablecoins: turn them into yield-bearing instruments – although this might blur the regulatory lines with deposit-taking banks.
It’s business ambitions reflect the quickly expanding opportunities in blockchain-based finance, and how Asian hubs such as Singapore and Hong Kong are increasingly driving them.
“We see Asia as the fastest-growing region because of its retail demand,” said Laszlo Szabo, Kiln’s CEO and co-founder.
Kiln was founded in 2018 to participate in crypto protocols based on Proof of Stake (as opposed to Bitcoin’s Proof-of-Work) to validate and confirm blocks.
Staking is core to these blockchains. Asset owners holding the network’s coin agree to lock up their assets for a period of time, to be used to help validate new blocks, in return for a reward. These yields incentivize the network’s participants to support its functioning, and to keep the network decentralized.
Staking yields looked attractive when interest rates were zero. Today, they are modest. Kiln’s node operations currently yields an annualized 4.01 percent. Therefore many players in the ecosystem are trying to find ways to either increase returns, or bring in new participants.
Validators and nodes
The PoS ecosystem has its own layers. At the bottom are the validators, who add transactions to the blockchain blockchain and check others’ transactions to agree that they are correct; they are the engineering workhorses who guard against double-spending or fraudulent trades. At this level, Ethereum operates like Bitcoin in that the validators are using computing power in a lottery for the rights to get their transaction approved; the more assets staked, the greater the likelihood of success. For their trouble, they are rewarded with slices of newly minted ETH as well as transaction fees (‘gas’).
One level up is the node operators, which includes Kiln. These players verify transactions and keep copies of the blockchain. They are not ‘at the coal face’ but play a useful role by distributing transaction data across the network, so the healthier the nodes, the more efficient transaction processing.
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Kiln serves this function for nearly 37,000 validators, whose work represents about 4 percent of the Ethereum network. It has $4 billion worth of stake under management.
The next-higher level is the pool operator, which includes node operators (including Kiln) that manage assets for ETH holders who do not wish to operate their own. These aggregators dominate network penetration: Lido, the biggest, has 32.20 percent of the network, followed by Coinbase with 15.47 percent; the other pools are small.
The big reason why people participate in staking is that they believe the PoS system is designed to increase the value of the token. In Ethereum’s case, since it shifted to PoS in 2022, the overall supply of ETH has declined. The mechanism of paying transaction fees is realized as burning ETH tokens, and so long as the number of burned tokens is greater than the number of newly validated tokens, then the supply is moderated.
This scarcity feature only works if one assumes demand remains steady. That’s more of a macro, existential risk. There are more prosaic risks, though: asset owners must lock away their ETH for a period of time, unable to redeem if market conditions change. The yield must be enough to compensate for this. (There’s also the risk of ‘slashing’, ie, a validator or node can lose their rewards if there’s an error when trying to confirm a transaction.)
One way of dealing with these drawbacks is the introduction of exchange-traded notes (ETNs). By allowing non-crypto investors to invest in these products, they add their weight to staking pools, and get rewarded. They also bring much-needed scale, because validators need a minimum amount to participate. With ETNs, investors are responsible for custody.
The rise of ETNs registered in Europe brings a dynamic similar to how exchange-traded fund managers can on-lend the underlying securities they hold for extra gains. But ETNs have not solved the risks of gating liquidity and slashing. Some ETN providers have tried to compensate by pledging collateral to investors, but these structures get cumbersome. Furthermore, notes use financial engineering and leverage to bump returns, which brings more complexity and risk.
One way to improve the situation would be if providers could launch Ethereum ETFs, which track baskets of instruments; although these can be leveraged, ETFs are usually plain vanilla instruments. Under European Union rules, however, ETFs must track multiple assets; a single-asset product like an ETH ETF has not yet been allowed. There are, however, ETF futures ETFs.
Things are changing. This month, the US Securities and Exchange Commission approved ten Bitcoin spot ETFs. Szabo says he expects this will pave the way for Ethereum spot ETFs too, at least in the US.
Not everyone shares this view. The SEC only approved the Bitcoin spot ETF because courts overturned its resistance. Even so, one interpretation of why the Bitcoin ETF was allowed was because Bitcoin isn’t regarded as a security by US regulators. The same may not hold true for Ethereum, now that it has moved to a PoS system. On the other hand, big players such as BlackRock are agitating for the Ethereum ETF.
But the DeFi world is moving ahead regardless. Kiln is about to launch a Validator NFT, tokenizing the work of validators its node interacts with. This non-fungible token (itself a smart contract) represents ownership and the withdrawal credentials of a specific validator. That could be an individual, a pool operator, a cloud computing player like AWS, or TradFi banks and asset managers – any entity running a node.
Szabo argues this augments staking by introducing liquidity into the system and making validators more efficient. While an investor’s ETH remains locked up in the network, the NFTs can act as fractionalized slices of that asset, free to transact elsewhere.
“Tokenization acts like a coupon, it’s like a bond,” Szabo said.
This makes that ETH more efficient, and gives investors a better reason to keep their ETH staked. This in turn contributes to the security and robustness of the entire blockchain.
These NFTs are also moveable. They can be used as collateral in other DeFi protocols, helping generate additional rewards – similar in concept to how stocks in an ETF basket can be on-lent to hedge funds or the interbank market. They can also be transitioned among wallets, so an actor with multiple wallets can move assets between accounts.
Importantly for Kiln, it doesn’t take custody of the underlying ETH. That’s still with the validators or with the ETNs (or ETFs) pumping money into the network.
Rather, it is trying to add money-market fund-like revenues on top of ETNs or ETFs.
Its target audience is retail investors – the usual destination for NFT products. And the biggest and most active NFT retail investor bases are in Asia. This is why Kiln is opening an office in Singapore, and is looking to add one in Hong Kong.
The company has just closed a $17 million equity funding round led by 1kx, along with Crypto.com, IOSG, Wintermute Ventures, KXVC and LBank. Those assets are going to Kiln’s Asia expansion as well as product development.
Szabo says the company is looking to attract clients in Asia, including crypto exchanges, custodians, and wallet operators. Now that Kiln has established itself as a major operator of Ethereum validator nodes, its team feels it can integrate that community with the investors and traders, bringing NFT-driven exposure to validators to the retail hordes in the Asia crypto scene.
One likely user is Crypto.com, which is now a shareholder in Kiln, and operates staking wallets registered in both Singapore and Hong Kong.
Szabo says the next product he is considering is to turn stablecoins into a stakeable asset. For PoS blockchains, up to half their coins are used for staking, but less than 1 percent of the $135 billion market for stablecoins is used this way.
Stablecoins were invented to maintain a one-to-one price relationship to an unrelated asset (eg the US dollar). They don’t have a yield. The only way to make them earn something is to put them to use in a DeFi lending protocol, like Aave or Compound, but this is complicated and risky.
Stablecoins have various uses, in payments, for example, but they tend to sit around for extended periods of time. DeFi companies have launched tokenized US money-market funds to meet this demand. But Szabo reckons there is space for a product like the Validator NFT, to collateralize stablecoins so they can be used for staking – thus expanding the available capital for PoS staking,
Szabo argues that an independent technology vendor such as Kiln could connect the dots, offering the smart contracts, the security, the distribution, the data and perhaps the insurance against DeFi lending that such a product would require.
But does that make Kiln a bank? After all, there’s reason why the leading stablecoin operators such as Bitfinex and Circle don’t do this themselves: they’d look a lot like a bank paying interest on a deposit.
“We’re non-custodial,” Szabo said. “We can market the integration of money markets with stablecoins, but we’re not a bank because we don’t have customer funds.”
How strong an argument is that – strong enough to persuade the Fed?
“We’re like a decentralized bank,” he said.