This article was kindly contributed by Guest Author, Jonathan Wai.
Staking of Crypto Assets
Earlier in our series on yield farming, we introduced crypto-lending as one method of yield farming and discussed its risks.
While the lending of crypto assets is relatively easy to understand because it is modeled after lending and borrowing in traditional finance, crypto-staking is a concept unique to the crypto-verse and a deep dive into blockchain technology is needed to understand its mechanics.
Distributed Ledger Technology
Key to understanding the mechanism behind staking is knowing how blockchain technology works. Put simply, a blockchain is intended to be a “ledger”, or a database that records transactions, much like a piece of paper on which you might write down your expenses. However, what makes blockchains different from other types of ledgers is that it is decentralised: the “piece of paper” that records ledger transactions is not held by a single person or entity, but is distributed to hundreds and even thousands of different entities. This makes blockchains a type of Distributed Ledger Technology (“DLT”).
The value proposition of DLT is that it is thought to be more secure than centralised ledgers. To understand why, imagine if someone snuck into your house and stole your piece of paper, or if a hacker hacked into a bank and modified its transaction database: with centralised ledgers, transaction information can easily be lost or manipulated as there is only one copy of the ledger stored at a centralised location.
By contrast, distributed ledgers are more secure because even if one copy is lost or modified, there exists other copies of the transaction data that can be used to verify the existence and authenticity of records. This way, transactions are publicly accessible and fraud or improper activity can be easily identified.
Understanding Proof-of-Stake
However, DLT has to address one important issue: how do we ensure that all the distributed copies of the ledger are correct and that none are maliciously modified? This is where a “consensus mechanism” is required to decide what the correct transactions are. The two most common types of consensus mechanisms are proof-of-work (“POW”) and proof-of-stake (“POS”). Early blockchains and cryptocurrencies like Bitcoin rely on a POW consensus mechanism, but preference in more recent projects has shifted to POS. Ethereum, for example, is undergoing a transition from POW to POS, expected to be completed in 2022.
The POS mechanism involves different parties, known as validators, acting independently to verify transactions. When transactions are ready to be added to the blockchain, the blockchain’s POS protocol will randomly select validators to review these transactions as a “block”.
These validators have the responsibility of ensuring that only legitimate transactions are approved and recorded on the blockchain: if a majority of validators verify a block, it is added to the ledger on the blockchain. This is similar to asking some friends to help you double-check a piece of work; if all of them confirm that there are no errors, you can be certain that your work is error-free.
To make POS even more secure, there are requirements for becoming a validator and there are penalties for incorrect validation. In order to become a validator, an amount of that blockchain’s token must be deposited, or “staked”.
In the Ethereum network, each validator must stake a minimum of 32ETH, which is worth more than US$100,000 at time of writing. Where a validator successfully validates a legitimate transaction, it is rewarded with more tokens for its contribution. However, if a validator tries to validate an illegitimate transaction, a portion of the staked tokens will be deducted by the protocol as a penalty. The staking requirement and penalty for validating illegitimate transactions provide a financial incentive for only validating legitimate transactions, adding to the integrity of the POS blockchain.
Staking Rewards
When you stake your crypto assets (tokens such as ETH), you are usually depositing these tokens with an established validator to be staked by the validator, known “delegating” your tokens. Of course, if you have the technical expertise and enough of the blockchain’s token, you can also start your own validator node and become a validator yourself, potentially accepting delegations from others as well. In exchange for staking your tokens to be a part of the validation process, you will be rewarded with more tokens – provided validation is done correctly. When delegating tokens, note that your chosen validator may keep a portion of rewards as staking fees.
Because the security and integrity of a POS blockchain hinges on the work done by its validators, staking often provides substantial rewards. At time of writing, staking ETH (on the Ethereum network) and ADA (on the Cardano network) offers about a 5% annual return, while staking DOT (on the Polkadot network) and BNB (on the Binance Smart Chain) offers about a 13% annual return. Often, tokens given as rewards are newly minted and contributes to inflation, but tokenomics can vary between projects.
Investors should also be aware that rewards decrease as the total amount of staked tokens increases, so mature blockchains usually have a stable staking return while newer ones may offer higher rewards to encourage staking.
Closing Thoughts
Staking plays a very important role in the crypto-verse, especially as newer projects prefer the POS mechanism to POW. Aside from being the backbone of POS blockchains by ensuring the integrity of network transactions, staking also offers the opportunity to earn yield on crypto assets in addition to price appreciation and is the cherry on top for long term investors.
As mentioned in our earlier article on crypto-lending, staking also plays a huge role in helping to supercharge returns for lenders and is a key mechanism that sets decentralised finance apart from its traditional counterpart. As interest in crypto investing grows, the role of staking in an investor’s portfolio cannot be understated.
Read Part II: Risks of Crypto Staking.
This article was kindly contributed by Guest Author, Jonathan Wai.
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