What is Staking? Everything you need to know

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Dear Crypto Enthusiasts,

in the next series of articles, we will cover the most important trends of the crypto industry in the upcoming months. The first topic we will cover is staking.

Staking fundamentals

Staking is one of the most attractive and lower-risk ways to generate a passive income on your cryptoassets. But more than that, staking is a way of actively participating and providing value to a decentralized network. It is our gateway to the decentralized economy. What does this mean exactly?

At a very basic level, staking is the act of depositing an asset and “locking” it as collateral in a protocol. By “locking it” one can provide a service needed for the long-term sustainability of the platform. This could be the provision of security, liquidity, governance resiliency, or many others (more in this later). Additionally, staked assets have value accrual mechanisms and give their holders a claim on the value generated by the protocol.

Staking can take a variety of forms. The first one is to stake at the platform layer (known as Blockchain Layer 1). This is possible in blockchains that have a Proof -of- Stake consensus mechanism, such as Polkadot, Cosmos, Cardano, and importantly Ethereum 2.

Top 10 assets staked at a platform layer. with their respective rewards. Source: Staking rewards

By staking assets in a Proof-Of-Stake (PoS) blockchain, one can serve as a validator to this blockchain. Validators are crucial for any distributed ledger as they have the power to organize transactions in blocks and write them into the “official” or canonical ledger. They play a similar role as miners in traditional Proof-Of-Work blockchains, with the difference that instead of executing energy-intensive computing calculations, validators leave collateral (a stake) to guarantee that all entries into the ledger are done according to the predefined rules. By doing this, they help achieve consensus and simultaneously secure the network. For executing this important work, validators are rewarded with native protocol tokens, which are provided by transaction fees paid by users or issuance of new coins (inflationary mechanisms).

One of the most interesting aspects of staking is that it provides the right to provide work to the network. Staking acquires an additional meaning: a digital work agreement.

Ethereum 2 staking

One of the most interesting staking opportunities will arrive from Ethereum 2, which recently launched its Phase 0. Why?

The Ethereum blockchain is the second-largest blockchain with a market cap of USD 200b, currently hosts tens of thousands of applications, assets worth >100b USD, and settles > 1 tr USD in value. It will completely overhaul its consensus mechanisms while keeping the application layer intact. Ethereum 2 upgrade will increase considerably Ethereum’s scalability, security, energy efficiency to tackle centralization risks. This upgrade is a result of several years of research and arguably the most important event in the crypto industry in the last years.

The “Blockchain trilemma” says that Blockchain can fulfill 2 but not three of the following characteristics: Decentralization, security, and scalability. It is argued that Ethereum 2 will solve this, Source: Messari

Although Ethereum 2 is still not fully functional (that will come after phase 1.5), it is already possible to stake Ether in the network. This transition will transform Ether, the asset as well. Ether will become a productive asset, a yield generating asset, or in other words, a capital asset.

Source: What is an asset class, Anyway?, Robert Greer, 1997 popularized in the crypto Ecosystem by PlaceHolder Ventures (C. Burniske)

The returns on this new capital asset will depend on the total number of ETH locked in the system. Currently, with ~3.6m ETH locked, the annualized returns are around~8.2%. As more ETH is staked, the expected returns will decrease. In the long term, yields are expected to gravitate on the 4% –6% range. Returns are denominated in ETH!

Yields on staked ETH are variable and depend on the amount of ETH staked in the system. Source eth2 launchpad

This gives Ether, the asset, the qualities of stock but also qualities of a bond. Some name it the birth of the Internet bond. Unlike traditional bonds, it has no counterparty risk. Staked ETH gives yield at a protocol level, not via a counterparty, and has no default risk. The Ethereum blockchain is solvent by design and programmed to issue new coins to validators who staked their ETH. In this aspect, it has some similarities to Treasury Bonds of large economies like the US or Germany. They are considered “risk-free” because the debtor (the State) can “print money” to pay out their debt. For this reason, some consider that the ETH 2 staking rate can develop into the risk-free rate of the Ethereum economy.

This is not the only way ETH Stakers is paid. Stakers also have a claim on a percentage of the fees generated by the network. Fees are collected on top of the new issuance describe above. Some of the fees will be burned when EIP- 1559 (a fundamental reform on how transaction fees work) but the economics of the platforms are very healthy. Ethereum is by far the crypto platform that generates more fees, more than 26 m USD daily!

Blockchain protocols generate revenues by charging fees to their users. Ethereum is the platform that generates the most fees. Source

In the next articles, we are going to go deeper into Ethereum2 and DeFi staking. Stay tuned!

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What is Staking? Everything you need to know was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.