29 Nov, 2022
5 min read
Before we delve into the Ethereum staking ecosystem, it’s important to understand what staking is and how it secures blockchain protocols. Every blockchain is a distributed network of nodes that work together to maintain a constant truth state. In other words, validators must verify every transaction the network processes before it’s recorded to the underlying blockchain.
However, there are several different ways this validation process can occur, which is dictated by the consensus mechanism in use. For example, before “The Merge” on September 15, 2022, the Ethereum network was a Proof of Work (PoW) blockchain. Under this model, miners must “mine” blocks using their computers (nodes) to solve complex mathematical formulas, proving they are a legitimate part of the network; transaction validators.
But since the successful completion of “The Merge,” the Ethereum network has moved to a Proof of Stake (PoS) consensus mechanism. PoS allows the Ethereum blockchain to run with significantly lower transaction fees, higher throughput, and less energy consumption—let’s take a closer look at how this works.
The Ethereum network seamlessly transitioned to PoS by merging the main chain with the Beacon chain. The Beacon chain has been running the PoS consensus mechanism parallel to the main chain since 2020. The original Ethereum main chain (Ethereum 1.0) is now referred to as the “Execution Layer,” while the fully merged chain (Ethereum 2.0) is known as the “Consensus Layer.”
Instead of utilizing complex mathematical formulas to validate transitions, the PoS consensus mechanism requires that validators lock up 32 ether (ETH). This practice, known as staking, allows validators to vote on the legitimacy of transactions. In addition, because validators have a vested interest or stake in the network, it discourages them from acting in bad faith. For example, if a validator approves a fraudulent transaction, their stake can be “slashed,” costing them a significant amount of ETH.
But why would validators want to stake ETH in the first place? Below, we’ll discuss the benefits of staking and how anyone can do it.
In exchange for securing the Ethereum network, stakers earn a portion of the network fees as rewards. These rewards represent an annual percentage yield (APY) applied to staked funds. For example, at the time of writing, 15,269,536 ETH was staked across 477,173 validators earning an average of 4.9% APY. This process is similar to depositing money into a yield-bearing savings account with a traditional bank and accruing interest.
In addition to generating rewards, stakers make Ethereum more resilient, protecting the network against attacks as more ETH is staked. The more staked ETH, the harder it is for one entity to control most of the network. Specifically, for one individual to become a threat, they would need to hold the majority of validators, which means controlling the majority of ETH in circulation. Finally, because stakers don’t need energy-intensive computers to complete complex mathematical “mining,” the protocol is infinitely better for the environment.
As mentioned, stakers need 32 ETH to set up a validator node. At the time of writing, this would require an investment of over $38,000. Given this barrier to entry, several centralized exchanges, non-liquid staking pools, and liquid staking protocols have been established in recent years. These staking services allow investors to earn yield without requiring the entire 32 ETH. These platforms can deliver this functionality by pooling ETH deposits—setting up and maintaining validator nodes on behalf of investors. Although staking services take a portion of fees earned, they also encourage participation and staker distribution.
Centralized crypto exchanges like Coinbase and Kraken offer some of the most popular staking services. Although rewards vary, most centralized exchanges provide returns in the 3% to 7% range. Despite the ease of using these centralized exchanges, it’s important to remember that they retain control of your wallet keys. As a result, you could lose access to your ETH if anything happens to the exchange. Investors should also consider that many exchanges will not allow you to unstake your ETH until future Ethereum protocol upgrades are complete.
Unlike centralized exchanges, liquid staking protocols are non-custodial, meaning investors retain control of their funds. These decentralized, on-chain protocols were initially developed to counter the risk of centralized exchanges accumulating the majority of stoked ETH, mainly because these platforms must comply with local regulations.
These liquid staking platforms pool staked ETH and issue derivative tokens to stakers that can be actively traded and used on decentralized finance (DeFi) protocols. This option allows stakers to earn yield while maintaining the liquidity of their assets. In general, liquid staking pools provide the highest earning potential when staking ETH.
For example, an investor might stake ETH on the Lido protocol earning 5% APY. In exchange for staking their ETH, they receive stETH derivative tokens from the Lido protocol. They can then stake this stETH in a liquidity pool on the Curve protocol earning an additional 4.5% APY, generating a total of 9.5% APY.
However, despite the benefits of liquid staking protocols like Lido, RocketPool, Ankr, and Stakewise, it’s essential to consider the tax implications. Specifically, because derivative tokens represent staked ETH, liquid staking triggers a taxable event when swapping one token for another (i.e., ETH for stETH).
Unlike liquid staking protocols, non-liquid staking pools like Everstake, Chorus One, and Bitcoin Suisse do not issue derivative tokens. And while that means there is no opportunity to amplify yields, it also avoids triggering a taxable event as no tokens are being swapped in the process. However, it’s important to note that actual staking rewards earned as APYs are still considered taxable on both liquid and non-liquid staking platforms.
Like centralized exchanges and liquid staking protocols, traditional non-liquid pools allow investors to generate yield without the 32 ETH required to self-stake. In general, staking rewards for non-liquid pools average around 4% to 6%. While not as high as liquid staking platforms, they remain an attractive option for utilizing idle ETH. That said, as custodial platforms that lock in ETH, investors must treat them similarly to centralized crypto exchanges in terms of risk.
Although less common, users can also engage in staking by setting up a solo validator node, which requires dedicated equipment and at least 32 ETH. Specifically, these individuals will need a physical computer with a 24/7 internet connection and specialized software. This software includes an “Execution Layer” client and a “Consensus Layer” client, in addition to validator-specific Ethereum keys.
In addition to understanding the intricacies of the Ethereum blockchain, anyone undertaking this approach must be prepared to deal with any issues that arise to avoid “slashing” their stake. For example, if a node goes offline, it may be subject to slashing as a penalty for failing to secure the network. As a result, many stakers utilize off-site cloud service providers to run their nodes to avoid this outcome. At the time of writing, Allnodes, Blox, and Blockdaemon are some of the most popular platforms used for this purpose.
Over the coming months and years, Ethereum will undergo several more protocol upgrades. The next, known as the Shanghai upgrade, will allow investors to unstake their ETH deposits, making the staking ecosystem much more liquid. After this, the tentative upgrade schedule is as follows:
While changes are likely to emerge as this roadmap unfolds, The Merge has proven that major protocol upgrades are possible, reinforcing Ethereum’s position as the leading blockchain for application development.