Proof of Stake Consensus Mechanism and Staking—101 Guide
The article will educate about proof of stake and staking crypto assets in general.
Proof of stake Consensus and its relevance in the crypto industry?
Consensus means a mutual agreement between different parties/persons involved in a decision of some sort. In the blockchain world, without a consensus mechanism of some type, it is almost impossible to ensure secure and non-fraudulent transactions. Generally, more than 50% of the people participating in the blockchain should agree about the legitimacy of the ongoing transaction before approval. For participating in network security, the project gives their coins or tokens as a reward. There are many consensus mechanisms, but it is out of scope for this article.
Let’s look into two basic consensus mechanisms.
- Proof of work.
- Proof of stake.
Proof of Work (PoW)
PoW is the consensus mechanism for many blockchains, such as bitcoin($BTC). It functions by solving a complex cryptographic problem only possible by high-speed computing power known as mining. PoW requires huge amounts of energy to run the computing equipment. The amount of computing power used for mining $BTC for example is described by hash rate. The higher the hash rate, the more likelihood of receiving the rewards in the form of $BTC.
Proof of Work can be more centralized because as $BTC Network ages, $BTC becomes more difficult to mine, it begins a race to acquire the highest computing power. It becomes difficult for a normal investor to mine because of high capital and operational cost requirements.
The Mining facility, which doesn’t have the highest hash rate, doesn’t receive the reward, and the energy used by it goes to waste.
Since the idea of the crypto as an asset is of inclusion of more people, PoW consequently falls behind the concept called proof of stake(PoS).
Proof of stake (PoS)
PoS makes participation in the network easier for investors with less capital, the Miner is replaced by a validator. To participate in a PoS system, validators need to lock some tokens upfront (depending on the blockchain) to create new blocks, for that they receive tokens. Validators locking a certain amount of tokens often refers to it as running a Node. For example, to run a node in the Ethereum network, 32 $ETH is required, which comes around $96000 at $3000 per ETH.
In the PoS system, validators ensure the network security and legitimacy of a transaction. If a validator decides to validate fraudulent transactions, the node will receive a penalty/slashing. A node will lose some of its locked tokens for that bad behavior.
There are many ways with which the blockchain decides to choose the validator, it can be with the highest number of tokens staked, the longest time the tokens are being staked, random selection, or all of the above.
Benefits of the PoS system are,
- Less energy requirement.
- Low participation requirements than PoW.
- High transactions per second (TPS).
Also, in the previous ethereum example, you still require $96000, which is still a lot of money for normal investors. An investor with less capital can delegate their tokens to their choice of validator and also receive a reward. For Example, Terra ($LUNA) runs on a DPoS (delegated proof of stake) consensus mechanism and delegators earn staking rewards by using their native terra station wallet.
Choosing a good validator/staking provider
So, how to select a good staking provider/validator? Let’s look into that aspect of staking.
Running a node as a validator is not as easy as delegating to a staking provider. Apart from a minimum number of tokens required to become a validator, there are other skills a person/entity should possess.
- Must know how to set up a node.
- How to interact with project communities in discord and telegram to seek support when something goes wrong.
- Have an uptime close to 100%.
Custodial and Non-custodial staking providers
In crypto, you might have heard “Not your keys, Not your crypto”. Well, that is the basic gist of this difference between custodial and non-custodial staking providers.
If you decide to go with a custodial staking provider, you must trust that provider with your coins, because custodial means keys of your coins are with them. Much like a bank, if tomorrow a bank defaults, you will lose your money. In this age of sanctions and freezing of bank accounts, whenever the government decides to sanction, the custodial providers must comply with them.
On the contrary, choosing a non-custodial/decentralized staking provider, you will have full ownership of your coins. Other notable benefits are,
- You are actually interacting with the blockchain, and earning rewards doing so. That makes people educated about their investment decisions.
- You might get airdropped of a new coin, staking another coin. For example, in the cosmos ecosystem, there are frequent airdrops for stakers of $ATOM, $JUNO, $OSMO, $SCRT, etc. Airdrops are only for those who stake with non-custodial staking providers. Binance and other custodial staking providers also have $ATOM staking, but for staking with them, you don’t get airdrops.
For choosing your own staking provider, you must look into some key parameters,
- Custodial or non-custodial staking providers.
- Total staked value in dollars.
- The number of unique wallets/delegators contributing to the total staked value.
- For which coins the staking provider or validator is providing their services.
- Validator uptime.
The staking rewards website provides the overall rating on all of these factors so that you can decide your staking provider easily. You can check it here.
What are the locking period and liquid staking?
In staking, your funds might get locked in for a while. For example, ethereum is planning to shift to PoS from PoW system. So, the 32 $ETH that we talked about earlier is staked until ethereum runs on the PoS consensus system.
In $LUNA, the locking period is 21 days, during which you will not be able to withdraw your funds or receive the staking rewards. But, by using some innovative solution like liquid staking, you can then borrow some money for that locked tokens.
Liquid staking
Liquid staking is the way to use your staked tokens to borrow, lend or trade. Essentially, you will receive a derivative of a token that you already staked. Take that derivative token and then earn additional yield/profit on it by lending/borrowing/trading it.
One such example is Lido Finance. Lido basically lets you stake supported network tokens on their platform and gives you liquid tokens against that staked amount, while you earn the staking rewards. Currently, lido supports Ethereum, Luna, Solana, and Kusama.
Risks of staking
Well, staking is not only sunshine and roses, there are some risks.
- Lock-up Period — Your tokens are locked in many cases for months or even years, so you must know that during that time you will not be able to cash out or trade your staked tokens.
- Technical knowledge and choosing a validator/staking provider — If technical knowledge of a validator is lacking or the validator's intentions are bad, they will get slashed of their tokens, your tokens will also get slashed.
- Smart contract risks in crypto — Hacking is becoming more and more commonplace. Crypto is a very fast-paced industry, so sometimes critical things to secure the smart contract are left behind, making it vulnerable to hacking. Sadly, you can not do much about it if you don't understand the coding aspect of it. Sometimes, you receive a hacked amount from a network treasury.
There are several things that also need to be researched, such as
1. Reward time — How frequent is reward distribution because it directly affects the compounding of your staked assets.
2. Validator Commission — Validator takes a commission for you to delegate, so you must look into the percentage commission they are taking.
Why should you stake?
To summarize staking, it is a mind-blowing and easy strategy to earn passive income. You might be getting 0.4% in a developed economy to 4–6% in a developing economy annually on your dollars/fiat. In crypto staking, your rewards can be as high as 1000–2000% annually, with up to 20–60% on a stable dollar-pegged coin (depending on your risk appetite).
If you believe in some project’s fundamentals, and want to hold that coin for the mid to long term, you are essentially compounding your holdings by staking. Well, to search through many project websites and research on which wallets to create for staking, it can get cumbersome. I get your point, the idea is to earn income passively.
Glad that we have a staking rewards website, suppose you are long Luna, you can stake it and earn 6.8% as a delegator and 7.55% as a validator. You can also use their advance calculator with simple buttons to see how much passive income you will generate, with a single click you can check what will be your income if you compound it. For example, you can use this tool for Luna, here.
On that page, you can also see the percentage of participating, which means the percentage of the number of eligible tokens staked. This is just one example of the important metric that is provided by staking rewards.
But why do you care anon?
First, these are not just simple data, you can base your research on top of this data. For example, by using the participating percentage you can safely assume that if the percentage is higher, many people are willing to stake that coin and believe in it long term. Thus, making your research more well-rounded, apart from your fundamental and technical research.
Staking rewards is an industry leader and provides an excellent way to see staking rewards of over 260 coins at the time of writing this article. I highly encourage you to check the staking rewards website, here.
On Twitter, staking rewards also provides easy one look charts, that you can quickly process. You can check staking rewards twitter, here.
