Introduction to Crypto Staking

Explaining how a crypto holder can earn rewards on their assets

Rishi Sidhu
May 28 · 11 min read
Overview

What is Staking?

Your crypto-assets earn while you sleep!

The higher the amount of crypto-assets you pledge, the higher the rewards you receive. The rewards are distributed on-chain, which means the process of earning these rewards is completely automatic. All you have to do is to stake them. This means your crypto-assets earn while you sleep!

Simplified Staking

Where do these rewards come from?

Every time a block is validated new tokens of that currency are minted and distributed as staking rewards

  1. Staking rewards/inflationary rewards
  2. Transaction fees

Note: I use the terms protocol, network, and cryptocurrency interchangeably. They mean slightly different things but convey the same logical concept

Staking rewards — You stake your crypto-assets with a PoS node (a server running the protocol stack) to validate a block of transactions. If the node you have delegated to successfully signs or attests to blocks, you receive staking rewards — thereby increasing your net crypto-assets. In case your node is unresponsive or malign (double-signing), a portion of the node’s assets, and hence your assets, can get slashed or destroyed.

The staking rewards are, thus, an incentive for these nodes to perform the process of ordering the transactions, verifying them, collecting them in a block, and subsequently validating the block. When these rewards are freshly minted they get the name inflationary rewards.

Every time a block is validated new tokens of that currency are minted and distributed as staking rewards!

Transaction Fee — In addition to the staking rewards, each transaction carries with itself a small fee making it easier for the node to prioritize the selection of transactions to be entered into the block. The accumulated fees from the underlying transactions also go to the node.

Transactions are what make up a cryptocurrency. For different protocols, these transactions could mean different things. They vary from token transfers to smart contract executions. Despite the dissimilarity in transaction types, the common thread is that these transactions always get ordered and clubbed into a new block so that all nodes in a network can agree on the state of the network.

Transactions →Block

In a centralized institution like a bank, every transaction can be verified by the central authority (bank’s central server). However, the lack of centralized authority in the crypto world requires the verification and subsequent validating of these blocks by the decentralized nodes of the network. These nodes are known by a variety of names — validators, bakers, etc. Their counterparts in the proof-of-work networks are called miners!

How can I participate in staking?

If PoS were a democracy, your stake would be your vote!

  1. Validation — Appropriate for companies or technical enthusiasts
  2. Delegation — Appropriate for most individual crypto-asset holders

Delegation is the method by which an individual can reap the rewards of staking. However, to understand delegation we will have to get into the details of how proof of stake (PoS) works!

If you already know how PoS works you can skip over to the delegation section.

Proof of stake

Proof of stake, just like Bitcoin’s proof of work, is a type of Sybil resistance mechanism used to ascertain participation in blockchain consensus by utilizing assets as collateral. In simpler terms, to become a validator node in such a network crypto-asset holders are required to stake their tokens as collateral, instead of spending electricity as is the case with Bitcoin nodes.

Additionally, validators are selected randomly to create the block. The probability of a validator’s selection is directly proportional to the volume of crypto-assets staked.

This means that PoS is a system where the value at stake is the main determinant of which blocks are added to the blockchain. If PoS were a democracy, your stake is your vote! Participants in a Proof-of-Stake network essentially vote with their assets on blocks of transactions that they deem valid. They get rewarded if the majority of the network agrees and risks losing their stake (deposited tokens) if they try to cheat, e.g. by voting on two different blocks of transactions at the same time. The former encourages a rise in the number of nodes and the latter discourages malicious behavior.

Does this mean that anybody who holds even 1 token can become a validator? The answer is an obvious NO! Generally, the requirements to become a validator are much more stringent and difficult to achieve practically. Let’s take a look at a few of them.

To become a validator some of the hurdles one can possibly face.

  • Stake a minimum amount of tokens — For example in Ethereum 2.0 one would need to stake 32 ETH
  • Set up secure and performant infrastructure that should ideally be online 24x7
  • Build a team of skilled engineers to run and continuously upgrade the infrastructure in accordance with the protocol.

These are just a few of the hurdles to become a validator. Not all of them apply to every network but most networks demand steep requirements that an individual may find difficult to fulfill.

Delegation

Owning a huge number of tokens of a single currency or operating validation infrastructure may not seem worthwhile to a lot of people. Fortunately, most PoS protocols foresee this problem and incorporate ways to enable asset holders to stake their tokens with a validator that they do not run themselves.

The process of staking your assets with a validator without actually sending them your tokens is commonly called delegation.

Delegating your assets means letting them count towards the stake of a validator in return for a share of the reward received. In practice, a delegator deposits tokens in a smart contract specifying the validator whose influence in the network she wants to increase. As a result, the rewards earned in the validation process increase, but instead of only the validator receiving compensation, the rewards are automatically split between the validator and the delegator, usually by applying a simple commission rate as pictured below.

Choosing a validator

When delegating your assets it is extremely important to put special emphasis on choosing the validator. A more reliable validator will keep your funds secure as well as grow them reliably. Some of the factors for deciding your validator are as follows.

  1. Uptime — Percentage of time a validator is available online. This indicates a validator’s reliability.
  2. History of slashing — Slashing is the process of punishing a validator for being unavailable or making mistakes while signing blocks.
  3. Years of operation and supported networks — it is likely that validators that support multiple networks and are operating for a long time are more experienced and reliable.
  4. Financial health — There are costs associated with building and maintaining secure validator infrastructure which include hardware costs, employment costs, etc.
  5. Governance support — How actively do they participate in protocol governance and similar discussions indicate their intent to further the cause of decentralization.
  6. Community — Anyone who makes an effort to put out blogs of high quality, podcasts, Telegram responsiveness, and other ecosystem support is bound to be there for the delegators always.
  7. Team — Always check out the validator’s team page, Twitter accounts of founders, and Github repos. A validator with respected founders, excellent engineers, and helpful Telegram channels is assured to keep your money safe.

Staking v/s other investment strategies

Keeping crypto-assets liquid is a good strategy for the short-term investor but is not wise for those who are in it for the long haul.

The end of Hodling

The traditional method of crypto-investing was a rather straightforward experience — you obtain the desired crypto asset, store it (or leave it on an exchange), and wait.

Simply holding a PoS token is no longer an optimal strategy now! Many networks reward participation by inflating tokens and handing them out to participants resulting in a dilution of the assets of non-participating token hodlers.

But is staking the best alternative out there for the Hodlers? Let’s take a look at some of the investment strategies.

Continue Hodling

Keeping tokens liquid is a good strategy for the short-term investor but is not wise or recommended for those who are in it for the long haul.

Stake

When staking, an investor has one of the 2 options

  1. Delegate to other validators — Easy but fewer rewards
  2. Validate yourself — Difficult and average rewards

Other strategies

  1. Loan tokens (e.g. using lending protocols like Aave or Compound)
  2. Use tokens as collateral (e.g. issuing DAI with a Maker vault, or using tokens in other decentralized finance protocols)
  3. Liquid staking — Liquid staking combines the benefits of staking with the liquidity of the above-mentioned strategies. The staked positions are tokenized and by doing that one is able to achieve liquidity. The liquid tokens provide further leverage through collateralization and investment in DeFi.

Assessment

Staking is the more reasonable investment for the long-term investor but liquid staking is emerging to be a clear winner among all the strategies. It provides the benefits of reward accrual through staking while hedging the liquidity risk. Liquidity risk mitigation is a huge need that gets addressed through liquid staking and might become the reason for its success.

Chorus One published a comprehensive report last year that turned out to be foreshadowing in many ways. It is worth a read and goes into great detail about what this strategy entails.

Ethereum is moving towards fully migrating to Proof-of-Stake and Lido Finance is providing a liquid staking solution for it. This article by Paradigm covers how a decentralized eth2 stake pool provides liquidity to staked assets:.

Chorus One is also building a liquid staking solution for Solana on behalf of Lido:

The benefits of staking come bundled with some risks as well. Let’s take a quick look at that.

Risks of staking

From an economic perspective, a rational investor should choose the option with the highest risk-adjusted return. In practice, this means that a token holder should figure out

  • The kind of risks involved (ideally quantify them)
  • The expected returns (after subtracting costs and considering other limitations) of the various options
  • Compare the various alternatives to each other to make the optimal decision based on her risk profile

Let’s analyze risks associated with staking.

  1. Liquidity risk associated with having to lock up staking tokens — There is often a lockup period associated with staking to be able to penalize potential malicious nodes and to prevent long-range attacks. Without this period a malicious party could attack the network and withdraw their stake immediately leaving no chance for the protocol to punish his offense. However, liquid staking alleviates this risk neatly by making staking a more capital-efficient process.
  2. The risk of losing deposited crypto-assets due to slashingStaked crypto-assets in a PoS network are often subject to being slashed (destroyed) should a malicious action be detected by other network participants. A common slashable offense is the signing of two blocks at the same height, also referred to as double-signing.
  3. Low returns due to bad validator performance — Operating validation infrastructure is an extremely challenging responsibility. Failing to propose or verify blocks of transactions means missing out on rewards and being offline for some extended periods of time can even result in liveness-slashing. Continuously signing and sending messages on behalf of staked crypto-assets as part of the consensus process requires technical and operational excellence. There are additional functions that validators may need to perform like providing prices as oracles. All of this requires technical expertise. The lack of it is a risk to the delegator.
  4. The opportunity cost — There is an opportunity cost of using the token differently, e.g. loaning it. Additionally, there is an opportunity cost to stake with a different validator. The liquidity risk makes it difficult to move the staked money quickly. This risk too is largely mitigated by liquid staking making it easy for the asset holder to reap rewards on the liquid tokens.
  5. Minimum staking balance — Sometimes protocols impose a minimum staking balance. This becomes a hindrance for small ticket investors. However, again liquid staking can help here by enabling smaller delegation limits as is done by Lido on Ethereum 2.0.

The following table compares the risk-reward scenarios for the various strategies available to a crypto investor. Clearly, liquid staking wins across the board.

Comparison of Strategies on 4 metrics — Dilution safety, Liquidity, UX, and Additional Yield

Why Chorus One?

We are growing quickly and have been entrusted with $1.4 Billion worth of assets!

We support close to 20 networks and one of the top validators on networks like Solana, Cosmos, SKALE, and many others.

We have been reliably operating for the last 3 years and have been around for longer than most of our competitors. We are growing quickly and have been entrusted with $1.4 Billion worth of assets! We are also venturing into the space of liquid staking with the proposal for Lido for Solana already approved by the Lido DAO.

For more information follow our social media channels.

Website: https://chorus.one

Twitter: https://twitter.com/chorusone

Telegram: https://t.me/chorusone

Newsletter: https://substack.chorusone.com

Thanks to the editors Felix Lutsch and Xavier Meegan for resources, contribution to the text, images, and feedback.

Chorus One

We offer staking solutions and build interoperability protocols for decentralized networks.

Rishi Sidhu

Written by

Blockchain | Machine Learning | Product Management

Chorus One

Chorus One is a leading staking provider securing over $1bn of assets and facilitating interoperability between decentralized networks.

Rishi Sidhu

Written by

Blockchain | Machine Learning | Product Management

Chorus One

Chorus One is a leading staking provider securing over $1bn of assets and facilitating interoperability between decentralized networks.

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