An overview of Staking pt. 1

Proof of Stake (PoS) first made its debut in 2012, thanks to a paper by Sunny King and Scott Nadal. They aimed to tackle Bitcoin mining's massive energy consumption, which back then, was about $150,000 daily to keep the Bitcoin network running. Fast forward to today, and that cost has skyrocketed to a whopping $40 million per day, assuming a $0.15/KWh cost and taking into account the 0,42 TWh of electricity the Bitcoin network used daily in May 2024.

Instead of leaning on energy-hungry mining to add new blocks, Sunny and Scott proposed a new approach called "staking." This method uses a deterministic algorithm to select nodes based on how many coins a person holds. They hoped this would create a system requiring less energy consumption. However we had to wait until recently and the Ethereum 2.0 update for the PoS model to gain in popularity.

At its core, staking plays a vital role in maintaining and securing blockchain networks, while also offering participants the opportunity to earn rewards. For those new to the crypto space, staking can be likened to earning interest on a savings account, but with some unique twists and added complexities. In this article, we'll explore what staking is, how it works, its benefits and risks, and some of the innovations that are shaping its future.

Staking 101: Back to basics

Staking is a process by which cryptocurrency holders can participate in the operation and security of a blockchain network. In return for their participation, they can earn rewards in the form of additional cryptocurrency. The concept of staking is closely tied to the Proof of Stake (PoS) consensus mechanism, which is an alternative to the more widely known Proof of Work (PoW) mechanism used by Bitcoin.

In simpler terms, staking involves locking up a certain amount of cryptocurrency in a wallet to support the network's operations, such as validating transactions and securing the network. In exchange for this commitment, participants are rewarded with new cryptocurrency tokens. This process not only incentivizes participation but also ensures the network remains secure.

Unlike Proof of Work, which requires miners to solve complex mathematical problems to validate transactions and create new blocks, PoS selects validators based on the number of coins they hold and are willing to "stake" as collateral.

Validators are chosen to create new blocks and validate transactions based on the number of coins they have staked. The more coins a participant stakes, the higher their chances of being selected as a validator. This process not only secures the network but also eliminates the need for energy-intensive mining operations, making PoS a more environmentally friendly alternative to PoW.

Validators and Nodes

In a PoS network, validators (also known as stakers) are responsible for validating transactions and creating new blocks (👋 Validation Cloud, one of our portfolio company at Blockwall operating validator network for several chains). To become a validator, a participant must lock up a certain amount of cryptocurrency in a specific wallet as collateral. This collateral is known as the "stake."

Validators are chosen to validate transactions and create new blocks based on a variety of factors, including the size of their stake and the length of time they have been staking. Once chosen, validators are responsible for ensuring the accuracy and validity of transactions within a block. If a validator successfully validates a block, they are rewarded with additional cryptocurrency tokens.

Nodes, on the other hand, are individual computers that store a copy of the blockchain and participate in the network's operations. While all validators are nodes, not all nodes are validators.

Supporting the Network

By locking up their tokens and participating in the validation process, stakers help maintain the network's integrity and security. This decentralised approach ensures that no single entity has control over the network, making it more resilient to attacks and manipulation.

Staking encourages long-term participation and commitment to the network. When participants stake their tokens, they are more likely to act in the best interest of the network, as their staked assets are at risk if they engage in malicious behavior as most PoS networks have way to incentive but also punish participants in the case of bad behaviors.

How Big is Staking in 2024?

At the time of writing this article, the overall staking ecosystem is thought to amount for $239Bn across all monitored PoS networks and chains (source).

As seen above Ethereum largely dominates the staking landscape currently with a substantial portion of the overall staked TVL (Total Value Locked) in the crypto ecosystem roughly amounting for $100+Bn of staked asset on chain since it’s transition to a PoS model after completion of “The Merge” on Sept. 15, 2022.

Staking - The New Gold Rush?

One of the primary benefits of staking is the opportunity to earn rewards. When participants stake their cryptocurrency, they receive rewards in the form of additional tokens. These rewards are typically distributed on a regular basis, such as daily, weekly, or monthly, depending on the network's protocol.

The rewards earned through staking can be quite attractive, especially when compared to traditional financial instruments like savings accounts or bonds. The potential for higher returns makes staking an appealing option for investors looking to grow their crypto holdings.

Staking is representing a new generation of fixed income product offering within the crypto space, challenging the common wisdom about traditional financial products.

How Does Staking Generate Yield

Staking generates yield through several mechanisms, which vary slightly depending on the specific blockchain network:

1. Block Rewards
2. Block rewards are a primary yield mechanism in staking. When a new block is added to the blockchain, validators receive rewards in the form of newly minted cryptocurrency. The probability of earning these rewards is proportional to the amount of cryptocurrency staked.
3. 
   For example, in the Ethereum 2.0 network, validators are selected to propose and validate new blocks based on the amount of ETH they have staked. The more ETH you stake, the higher your chances of being selected and earning block rewards.
4. Transaction Fees
5. In addition to block rewards, validators earn a portion of the transaction fees generated by the network. Each transaction processed by the blockchain incurs a small fee, which is distributed among validators. As network activity increases, so do the transaction fees, leading to higher yields for stakers.
6. On NEAR, for instance, transaction fees are collected and distributed to stakers as part of their rewards. This creates an additional stream of income for those participating in the staking process.
7. Inflationary Rewards
8. Some blockchain networks use an inflationary model to reward stakers (as opposed to deflationary model like Bitcoin). In these networks, new tokens are continuously minted and distributed to validators as rewards for their participation. This controlled inflation incentivizes staking and ensures network security.
9. Solana is a prime example of a network that uses inflationary rewards. By staking $SOL, participants earn additional tokens over time, which helps counterbalance the inflationary effects and encourages long-term holding and participation.
10. Compounding
11. One of the most powerful aspects of staking is the ability to compound your rewards. By regularly staking the rewards you earn, you can increase your staked amount, leading to exponential growth in your yield over time. This reinvestment strategy allows your initial investment to grow at an accelerated rate.
12. Exchanges like Binance and Kraken offer easy-to-use staking services where rewards are automatically restaked, maximizing your compounding potential without additional effort on your part but they’re definitely not the only one as this usually comes in handy when staking your assets.

Staking Delegation: Making Staking Accessible to Everyone

One of the key features that make staking accessible and attractive, especially for those who may not have the technical expertise or significant capital to become validators, is staking delegation. Delegation allows token holders to participate in the staking process without directly managing the complexities of being a validator.

Staking delegation enables token holders to delegate their tokens to a validator, who then stakes the tokens on their behalf. In return, the delegator receives a portion of the rewards earned by the validator. This system benefits both parties: validators gain more staking power, increasing their chances of earning rewards, and delegators earn passive income without needing to run a validator node.

Nowadays it’s become fairly easy for anyone to delegate staking to a staking provider with big names such as Lido, Kiln, Rocket Pool, Nexo…

While delegation may appear like the perfect way to stake your tokens (I see you lazy stakers 👀) it’s also critical that the market doesn’t fall into the trap of centralization as staking pools grow bigger.

As one of the downside of the PoS implementation Etherum co-founder Vitalik Buterin has recently highlighted that a few large entities control a significant portion of the staked Ether, which in turn could wield disproportionate influence over the network. This centralization contradicts the fundamental ethos of blockchain technology, which aims for decentralization and distributed control. A centralized staking setup could lead to these entities having undue influence over governance decisions and network upgrades​.

For instance, the staking protocol Lido alone has a TVL of around $30.56 billion, controlling about 32% of all staked Ether on the network​.

Associated risks of Staking - Protection mechanisms

While staking offers numerous benefits, it is not without risks for its underlying staked assets as protocols and networks usually have embedded protection mechanisms to ensure safe and ethical staking/validation operations.

Slashing

One of the primary risks of staking is the potential for slashing. Slashing is a penalty imposed on validators who engage in malicious behaviour or fail to perform their duties correctly. This can include actions such as double-signing transactions, producing invalid blocks, or being offline for extended periods.

When slashing occurs, a portion of the validator's staked tokens is permanently taken away. This serves as a deterrent against malicious behavior and ensures that validators act in the best interest of the network. However, it also means that validators must be vigilant and diligent in their responsibilities to avoid losing their staked assets.

Lock-up

Another risk associated with staking is the lock-up period. When participants stake their tokens, they are often required to lock them up for a certain period. During this time, the staked tokens cannot be withdrawn or traded, reducing their liquidity.

The length of the lock-up period can vary depending on the network's protocol, ranging from a few days to several months. This lack of liquidity can be a significant drawback for investors who may need access to their funds on short notice. It's important for participants to carefully consider the lock-up period before deciding to stake their tokens.

Innovations in Staking

As we only scratched the surface on staking the ecosystem has continually evolved, with new innovations aimed at enhancing the staking experience and addressing some of its limitations. Two notable innovations in this space are liquid staking and restaking:

Liquid Staking

Liquid staking is an innovative approach that aims to address the liquidity issue associated with traditional staking. In liquid staking, participants receive tokens that represent their staked assets. These tokens can be freely traded or used in other decentralized finance (DeFi) applications, providing stakers with liquidity while still earning staking rewards.

For example, when a participant stakes their tokens in a liquid staking protocol, they receive a derivative token that represents their staked assets. This derivative token can be used in various DeFi applications, such as lending, borrowing, or trading, allowing participants to maximize the utility of their staked assets without waiting for the lock-up period to end.

Restaking

Restaking is another innovative concept that allows participants to maximize their returns by staking their assets across multiple protocols. In traditional staking, participants can only stake their tokens in a single network. However, restaking enables them to "double-dip" by staking their tokens in multiple networks simultaneously.

For example, a participant can stake their tokens in one network and use the rewards earned to stake in another network. This approach not only increases their overall returns but also diversifies their staking portfolio, reducing the risk associated with staking in a single network.

In conclusion, staking has evolved into a crucial element of the blockchain ecosystem, offering participants the dual benefits of supporting network security and earning rewards. But the story doesn’t end here: Innovations such as liquid staking and restaking are pushing the boundaries of what’s possible in the staking world. Liquid staking addresses liquidity issues, meanwhile, restaking offers the opportunity to maximize returns by staking assets across multiple protocols simultaneously.

Meanwhile staking is equally shaking the traditional financial world by bringing a new range of fixed income products to the table with unique mechanisms, effectively turning blockchains into productive assets with cash flows that traditional investors understand and like. This alone is leading many more traditional players to start engaging with the crypto space.

We’ll be diving deeper into the technical details and implication of these innovations in a following article so stay tuned and happy staking!