The ability to function without a central government is one of the distinguishing features of public blockchains. consensus mechanisms, a collection of algorithms, and economic incentives, are used to achieve this and to control how their networks work.
Miners protect the Bitcoin network with a Proof of Work (PoW) consensus mechanism, while stakers protect Ethereum with a Proof of Stake (PoS) consensus mechanism. PoS requires stakers to put their token capital at risk, whereas PoW requires miners to secure the network through computational power this describes how staking secures the ethereum blockchain
As compensation for their work preserving the blockchain, stakeholders receive rewards. As a result, token owners who stake their assets and approve transactions can make money. Staking returns, however, are usually small in comparison to the volatility of token prices, and for the majority of crypto asset investments, price volatility should be viewed as the main source of risk and potential return.
A new approach to digital commerce organisation based on open-architecture platforms devoid of central authorities is provided by public blockchains. Public blockchains, which are worldwide decentralised computer networks protected by cryptography and financial incentives, are distinct from companies, which are managed by boards of directors and subject to national laws. Arguably, the main innovation of this new technology resides in the techniques that are employed to maintain network stability and align economic incentives.
Proof of Work vs Proof of Stake
Blockchains maintain identical data on all nodes inside their networks. Without assistance from a central authority, the nodes must reach a consensus over what data should be stored on the network. Every public blockchain has a "consensus mechanism"—a prescriptive algorithm based on financial incentives that brings the nodes to consensus—to regulate this process.
Proof of Work is the name of Bitcoin's consensus algorithm (PoW). A computational issue is presented to specialised service providers known as miners under Proof of Work (PoW) systems. The winner of the competition gets to update the blockchain and receive token incentives. Since these puzzles are solved by brute force, or by making numerous guesses, they need a large amount of resources, such as initial capital investment and continuous electrical expenditures.
Because of this, resolving the puzzle demonstrates to other network users that the successful miner has a financial stake in the outcome and can be relied upon to update the chain. Miners receive token incentives in exchange for their labour.
Ethereum switched to a new consensus mechanism, Proof of Stake (PoS), in 2022 from the same PoW algorithm at first. In this strategy, network users exhibit their vested economic interest by "staking" their Ether, the native token of the Ethereum blockchain, rather than resolving an energy-intensive computing problem. The task of staking involves verifying transactions and maintaining the network.
Correct completion of these tasks results in the awarding of extra tokens to participants, whereas actions taken against the chain's best interests may result in a "slashed" (i.e., penalised and decreased) stake. Stakeholders are trusted to confirm transactions and update the network because their financial interests coincide with the chain's smooth operation – they have "skin in the game." Staking, which uses less electricity than mining, is viewed by some as a more ecologically responsible method of achieving blockchain consensus.
PoS networks are becoming more and more common, even if Bitcoin is still the largest public blockchain in terms of market capitalisation. For instance, a PoS consensus mechanism is used by more than half of the protocols in our Crypto Sectors for Smart Contract Platforms and Currencies. PoS-based chains make up roughly 30% of the market capitalisation of these Crypto Sectors overall and 90% of the market capitalisation when Bitcoin is excluded (Figure 1).
Ethereum Transactions and the Role of Stakers
Stakeholders on a proof-of-work blockchain, such as Ethereum, are in charge of confirming that each transaction complies with the rules of the network. This service is essential to the blockchain's operation.
It can assist to think about the Ethereum transaction mechanisms in order to gain a better understanding of the role of stakers. Figure 2's stylised explanation illustrates the approximately eight steps involved in an Ethereum transaction. Although users start the process and certain steps may involve other specialised service providers, validator nodes must actively participate in the majority of the steps. Since validator nodes work in unison to execute all Ethereum transactions and other state changes, stakers are essentially in charge of maintaining the blockchain.
The network automatically burns the Ether paid as base fees, designed to benefit all users through a reduction in token supply. Stakers earn priority fees as well as newly issued Ether (Figure 3). By providing these services, stakers are rewarded with additional tokens, which come from fees paid by users and from new issuance. On Ethereum, fees are divided into base fees and priority fees ("tips").
Staking Rewards and Income
Because of the token rewards, stakers can potentially generate income from their assets. In traditional markets, the best analogy might be to agricultural land. The land itself has a market value that may rise or fall in price over time, but it can also be put to productive use by planting crops. In the same way that staking rewards are a payment for the service of validating a blockchain, crops can be considered a payment for the service of farming agricultural land. In both cases, an asset owner is offering a useful service and generating service income.
Ethereum stakers currently earn an average reward rate of 3.1% (Figure 4). According to calculations from data provider Allium, Ethereum’s staking reward rate has trended lower over time as the share of Ethereum supply has increased (when staked supply declines, the protocol offers a higher reward rate to incentivize staking activity). The day-to-day variability in the staking rewards also reflects changes in network congestion and priority fees: when network traffic increases, users typically pay higher fees to confirm their transactions.
For an Ethereum holder staking their tokens and providing validation services, staking rewards can be considered a source of income. For example, since the start of 2023, the spot price of Ethereum’s Ether token has increased by 173%. Over this period, we estimate that staking rewards have averaged about 4.5% annualized.
Therefore, the hypothetical return for an Ethereum staker — including both price returns and staking income — would have been 192%. The calculation assumes that stakers correctly performed their responsibilities (i.e., earned all rewards and did not experience slashing) and did not pay any third-party fees. In practice, the income earned by an Ethereum staker will depend on these assumptions.
Although staking rewards can contribute incrementally to a token holder’s returns, compared to other assets, Ethereum’s staking reward rate is relatively low in the context of its volatility. In other words, investors should consider the token price itself, rather than the staking reward, to be the primary source of risk and potential return.
Investments held primarily for their income typically have a high yield relative to their price volatility (otherwise gains/losses from prices changes will overwhelm the income returns). Ethereum has a relatively low staking reward rate relative to its price volatility — comparable to the dividend yield on U.S. equity indexes. These types of investments are typically held primarily for potential capital gains from price appreciation, rather than income returns.
What’s at Stake
Consensus mechanisms are to blockchains what laws and property rights are to traditional business enterprises: one cannot exist without the other. As the crypto industry evolves, Grayscale Research expects that PoS consensus and staking will become an increasingly important part of the ecosystem. Although staking reward rates are typically low compared to crypto asset price volatility, they can be a source of additional income over time, so many token holders will be willing to serve as validators to earn these rewards.
While conceptually straightforward, in practice staking involves additional complexities, several of which are discussed below.
Four Ways to Stake
There are four ways to stake Ethereum: Solo Home Staking, Staking as a Service, Pooled Staking, and Centralized Exchanges. Solo Home Staking is the most impactful and trustless method, offering full control and rewards, but requires at least 32 Ether, a dedicated computer, and some technical know-how, enhancing network decentralization. The discussion above takes a Solo Staking perspective.
Staking as a Service allows users to delegate hardware management while earning native block rewards, requiring 32 Ether and with withdrawal keys usually remaining with the user. Pooled Staking enables users to stake any amount of Ether, earning rewards through simplified processes involving third-party solutions and liquidity tokens, allowing easy exit but carrying third-party risks.
Centralized Exchanges offer minimal oversight and effort, suitable for those uncomfortable with self-custody, but involve higher trust assumptions and centralization risks, consolidating large pools of Ether and providing a fallback option for earning yield.
Bonding/Unbonding Queues
The bonding/unbonding queues in Ethereum involve validators waiting to begin staking or to unstake due to the network's processing rate limit per epoch, known as churn (Exhibit 8). These queues protect the stability of Ethereum's PoS consensus. Queue durations increase if validators join faster than they are processed and decrease if fewer validators join. Churn is the rate limit on validators entering or exiting per epoch, adjusted based on the number of active validators to maintain consensus stability. An epoch is a period of 32 slots, each 12 seconds long, totaling 6.4 minutes, during which validators propose and attest blocks. Sweep refers to the time taken for funds to be withdrawn to a specified address after exiting the validator queue and becoming withdrawable; the more validators there are, the longer the sweep delay.
Liquid Staking Derivatives
Liquid staking derivatives (LSDs) were created to address the lockup nature of staked Ether, providing liquidity to staked assets that would otherwise be inaccessible. When users stake Ether with a liquid staking provider, they receive an LSD token representing the staked Ether. This token is fungible, transferable, and can be used in various decentralized finance (DeFi) activities. LSDs unlock the liquidity of staked Ether, allowing users to earn additional yield through DeFi activities such as lending, providing liquidity, and using it as collateral, while still earning staking rewards.
Restaking
Restaking involves using already-staked Ether to simultaneously secure the Ethereum network and other decentralized protocols, earning additional rewards. The purpose of restaking is to help less developed protocols leverage Ethereum's robust validator community without incurring high costs and resources. Restaking was introduced by the third-party protocol EigenLayer, not through an Ethereum Improvement Proposal (EIP) or the Ethereum Roadmap.
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