Original title: The Risks and Rewards of Staking
By Christine Kim, Galaxy Research
Vice President of Translator: Chris, Techub News
This report details the basic concepts of staking, how Ethereum staking works, and what to look out for when participating in staking. The first part of the staking report (of three parts) aims to delve into the risks and rewards of various staking activities, including re-staking and liquidity re-staking. The second part of the report will focus on an overview of re-staking, including how it works on Ethereum and Cosmos and the main risks involved in re-staking.
introduce
Ethereum is currently the PoS blockchain with the largest total staked value. As of July 15, 2024, Ethereum holders have staked more than $111 billion in Ethereum, accounting for 28% of the total Ethereum supply. The amount of staked Ethereum is a moat for Ethereum's security. If stakers conduct double-spending attacks or violate protocol rules, their staked assets may be punished by the network. Stakers can receive rewards for maintaining Ethereum's security through protocol issuance, priority fees, and MEV rewards.
The ability for users to easily stake Ethereum through liquid staking pools without sacrificing the liquidity of the asset has led to a demand for staking that has exceeded the expectations of Ethereum developers. Based on the current staking situation, developers expect Ethereum's staking rate to grow further in the coming years. To mitigate this trend, developers are considering changing the protocol's issuance policy.
Staker Type
There are six main types of Ethereum users who can earn rewards through staking. The following table details their profiles:
Among all types of stakers, the largest number are custodial stakers, which are users who entrust their Ethereum to professional stake node operators to stake. Although the number of these professional operators is not large, they manage the largest amount of Ethereum among all types of staked entities.
Because the entities behind the liquidity staking, re-staking, and liquidity re-staking pool protocols do not directly run the staking infrastructure or fund their stakes, they are not considered in the analysis. While these entities (liquidity staking, re-staking, and liquidity re-staking pool protocols) do not directly run the staking infrastructure or fund their stakes, they receive a percentage of the rewards from stakers using their platforms. They play an important role in the Ethereum staking ecosystem as intermediaries between custodial stakers and professional (or amateur) stakers.
Lido is a liquidity staking protocol and is currently the largest staking pool operator on Ethereum, accounting for 29% of Ethereumâs staking. Due to the important role of liquidity staking pools on the Ethereum network, it is very important to understand the risks of liquidity staking.
The next section of this report will delve deeper into the risks of staking.
Pledge Risk
The risks associated with staking depend largely on the method and technology of staking. Here are three staking methods and their associated risks:
1. Direct staking: users or entities participate in staking themselves. The risks of directly staking Ethereum include staking penalties and confiscation risks.
Staking Penalty: If a userâs machine is down for a long period of time and cannot participate in verification work, it may result in the loss of staking rewards.
Slashing risk: If the validatorâs software is misconfigured, resulting in a violation of the rules of the Ethereum network, the user may lose part of the staked Ethereum, up to 1 Ethereum.
2. Delegated staking: Delegated staking means that users give their Ethereum to a third party (such as a professional staker or staking service provider) for staking. There are several risks in this method:
Risks of direct staking: Delegated stakers also face the same risks as direct staking, such as staking penalties and confiscation risks.
Counterparty risk: Because users entrust their assets to a third party for management, if these third parties fail to fulfill their responsibilities or obligations, the userâs assets may be at risk.
Technical risks: If users choose to pledge through smart contracts, although it can reduce the reliance on third parties, the smart contracts themselves may have loopholes or be at risk of being hacked, resulting in asset losses.
3. Liquidity staking: Liquidity staking means that users entrust their Ethereum to a staker for staking in exchange for a liquidity token that represents the user's staked rights. The risks of liquidity staking include:
All risks of direct staking and delegated staking: Liquidity stakers are also subject to staking penalties, slashing risk, and counterparty risk.
Liquidity risk: Due to market volatility and delayed price impacts when validators join or exit staking, the value of liquidity tokens may deviate from the actual value of the underlying staked assets they represent. This value deviation (decoupling event) exposes users to additional risks.
Total amount of Ethereum staked using three different methods
Another risk that needs to be noted in these three staking methods (direct staking, delegated staking, and liquid staking) is regulatory risk. The more intermediaries a user involves with their pledged assets, the greater the regulatory risk they face. Regulators may require these intermediaries to comply with specific regulations and standards.
Direct staking: Users manage and control their own staking, with relatively less regulatory risk.
Delegated staking: Users entrust Ethereum to third parties who may be subject to relevant regulations and regulatory requirements.
Liquid staking: Users obtain liquidity tokens through intermediaries, and these intermediaries may face more regulatory requirements.
In addition to regulatory risk, it is also necessary to elaborate on the protocol risk associated with these three types of staking activities. Protocol risk refers to the penalties that the blockchain network imposes on users who fail to meet the standards and rules of the Ethereum consensus protocol. There are three main types of penalties, ranked from least severe to most severe as follows:
Offline Penalty: A penalty incurred when a node is offline and fails to perform its duties (such as proposing blocks or signing block proofs). Generally, validators are only penalized a few dollars per day.
Initial slashing penalty: A penalty imposed on a validator when its violation of the network rules is detected by other validators. The most common example is if a validator proposes two blocks for a slot or signs two attestations for the same block. The penalty ranges from 0.5 ETH to 1 ETH, depending on the validator's effective balance, which currently goes up to 32 ETH. Protocol developers are currently considering increasing the maximum effective balance of validators to 2048 ETH and reducing the initial slashing penalty in the next network-wide upgrade, Pectra.
Correlated Slashing Penalty: After the initial slashing penalty, validators may be subject to a second penalty based on the total amount of stake slashed in the 18 days before and after the slashing event. The motivation for correlated slashing penalties is to measure the penalty based on the amount of stake managed by the validator who violated the network rules. The correlated penalty is calculated based on the malicious validator's effective balance, total balance, and proportional slashing multiplier.
In addition to the three penalties mentioned above, special penalties can be imposed on validators if the network fails to confirm and lock transactions in a certain amount of time so that they can no longer be changed or reversed. (For more information on Ethereum finality, see the Galaxy Research report). If the Ethereum network is unable to achieve finality (i.e. confirm and lock transactions so that they cannot be changed) for a period of time, it gradually imposes penalties on validators who have not contributed to the network consensus by destroying their staked shares to rebalance the validator set to achieve finality. This process means that validators who are offline or not fulfilling their duties face increasingly severe penalties over time to incentivize them to resume normal operations. The severity of the penalty is proportional to the time the network cannot achieve finality, and the longer the time, the heavier the penalty.
Staking Rewards
Of course, while taking on the risk, stakers also receive an annualized return of about 4% from the staked Ethereum. These rewards come from the issuance of additional Ethereum, priority fees attached by Ethereum users to their transactions, and MEV.
Ethereum Staking Yield
It is worth noting that staker rewards have been declining over the past 2 years for two main reasons. First, the total amount of staked Ethereum has increased, as well as the number of validators. When the value of the stake increases, the issuance rewards for validators are diluted, as shown in the following figure:
Only the staking yield paid by issuing additional Ethereum
While issuance rewards can be calculated based on the total number of active validators and the amount of ETH staked, the other two sources of income for validators (priority fees and MEV) are difficult to predict as they rely on the level of network transaction activity.
Over the past two years, due to the decrease in transaction activity, the base fee, priority fee, and MEV income of validators have also decreased. Generally speaking, the higher the value of assets transferred on the chain, the more users are willing to pay gas fees to prioritize their transactions in the next block, and the higher the MEV that Searchers profit by reordering transactions within the block. As shown in the figure below, there is a correlation between the dollar value of Ethereum transferred daily and transaction priority fees:
According to Galaxy's calculations, MEV increases validator returns by about 1.2%. Compared to other types of validator income, including additional ETH and priority fees, validator rewards from MEV account for about 20%. Some attribute MEV to additional value given to block proposers that does not come from priority fees or additional ETH. However, others argue that if priority fees are additional fees that users attach when submitting transactions to ensure that their transactions are processed by miners more quickly. , then it itself can represent MEV profits. To account for the fact that priority fees themselves may contain MEV, other methods compare the value of blocks built with MEV-Boost software to blocks built without MEV-Boost software.
The above chart shows that the size of MEV could be much larger than 20% of validator rewards. According to an analysis by Ethereum Foundation researcher Toni WahrstÀtter in October 2023, if validators receive blocks via MEV-Boost instead of building blocks locally, the median block reward will increase by 400%.
Staking Rate Prediction
Assuming that staking demand on Ethereum grows linearly as it has over the past two years, the staking rate is expected to exceed 30% by the end of 2024. As mentioned earlier in this report, higher staking rates reduce the returns obtained through the issuance of additional Ethereum. Liquid staking services on Ethereum (such as Lido's stETH) allow users to stake easily and bypass staking restrictions such as entry queues. Users can get staking rewards by simply purchasing stETH.
Large purchases of stETH will cause the value of stETH on the open market to be out of balance with the value of its corresponding underlying staked asset (i.e. Ethereum), which will in turn cause stETH to be at a premium until more Ethereum is staked. Unlike directly purchasing stETH, staking directly on Ethereum has a delay. Only 8 new validators or a maximum of 256 Ethereum valid balances can be added to Ethereum per epoch (6.4 minutes).
Therefore, assuming the maximum number of validators added per epoch between now and the end of 2025, it will take Ethereum more than a year (466 days to be exact) to reach a staking rate of 50%.
Historically, demand to enter the Ethereum staking queue has been higher than demand to exit. Although validator entry activity has slowed in recent days, staking demand is expected to surge again for a variety of reasons, including but not limited to additional yield from re-staking, increased MEV from a resurgence in DeFi activity, and regulatory changes in traditional financial products such as ETFs to support staking activity.
Entry and exit queue validators
Developers know itâs only a matter of time before staking rates go higher again and staker returns fall, so they are considering several options for changing network issuance to curb demand for staking.
Discussion on changes to additional Ethereum issuance
Ethereum holders should know that the staking yield will change dramatically in the future. Ethereum developers are weighing multiple options to ensure that Ethereum's staking rate tends to target thresholds, such as 25% or 12.5%. Caspar Schwarz Schilling, a researcher at the Ethereum Foundation, explained that the main reasons for maintaining a low staking rate include:
Liquid Staking Token (LST) Dominance: If the staking rate of Ethereum increases, more ETH may be concentrated in a staking pool (such as Lido). This poses two main risks:
Centralization Risk: When a large amount of Ethereum is concentrated in one entity or smart contract application, the network becomes less decentralized. This means that a few staking pools or smart contracts may have too much control over the network.
Security Risk: When a large amount of Ethereum is controlled by a single entity, once that entity or smart contract application is attacked or fails, it may have a serious impact on the overall security of the Ethereum network.
Credibility of Slashing: Related to concerns about LST dominance, a large amount of issuance going to a single entity or smart contract application could undermine the credibility of a large-scale slashing event on Ethereum. For example, in the event of a slashing event that affects a majority of stakers, the protocol could face pressure from Ethereum holders who may want to make a state change to restore the penalized staked ETH balance. Ethereum has only had one unscheduled state change in its history, which was after the infamous The DAO hack in 2016. While the likelihood of this happening is unlikely, it is not impossible that an unscheduled state change could be made in response to a large-scale slashing event. In fact, some Ethereum researchers believe that this outcome is more likely in the case of high issuance.
Ethereum is a trustless base currency: When the staking rate of Ethereum is high, it may lead to insufficient native Ethereum circulating in the market. At the same time, the issuance of liquid staking tokens (LST) by third-party entities may increase significantly. Some Ethereum researchers have stated that they prefer to promote the use of native Ethereum for activities other than staking, rather than using less decentralized liquid staking tokens.
Minimum Viable Issuance (MVI): Although the cost of staking is negligible compared to the cost of mining, it is not negligible. Professional staking providers require the hardware and software required to run validators, and therefore have operational costs. To stake through these providers, users must pay fees to these providers. In addition, even if users obtain liquid staked tokens by staking native Ethereum, they also take on additional risks by staking through a third party if the staking operation fails. Therefore, in order to maintain the stability and health of the Ethereum network, it is necessary to keep the cost of staking at a minimum. The additional cost of staking activities will lead to an increase in the issuance of Ethereum, causing supply inflation.
Ethereum developers and researchers are weighing various proposals to reduce the Ethereum staking rate. These proposals include, but are not limited to:
Short-term strategy: staking rewards cut
In February 2024, Ethereum Foundation researchers Ansgar Dietrichs and Caspar Schwarz-Schilling again proposed a staking yield cut. The idea was originally proposed by researcher Anders Elowsson. Dietrichs and Schilling suggested a 30% cut in staking yields, but the exact number depends on the staking rate at the time. Since the staking rate has been rising since February, the proposed yield cut should theoretically be higher. This proposal requires only a simple code change and dampens the economic incentive for staking by reducing issuance rewards in the short term. The proposal is a temporary measure intended to pave the way for long-term solutions such as the Target Policy.
Long-term strategy: collateral ratio target
In the long term, there are plans to implement a new Ethereum issuance curve. Specifically, when the staking ratio exceeds a target ratio (e.g. 25% of the total Ethereum supply staked), the cost for validators to stake and receive rewards will increase. This idea is based on the research of Elowsson, Dietrichs, and Schwarz-Schilling. There are several mechanisms to achieve this target ratio, each of which differs in the issuance schedule and the degree to which issuance decreases. For more information, please refer to the Ethereum research article.
All current proposals for changes to Ethereum issuance will not be included in the upcoming Ethereum hard fork Pectra. However, Ethereum developers are likely to push these change proposals in subsequent upgrades.
So far, discussions within the Ethereum community about issuance changes have been highly controversial and have not reached broad consensus. The main reasons for opposing the change include:
1. Concerns about reduced staking income: There are concerns that reducing staking yields will hurt profitability for both large staking providers and individual stakers.
2. Lack of adequate research and data support: The current proposals that affect issuance lack sufficient research and data-driven analysis.
3. Unclear staking ratio target: It is unclear what the exact target staking ratio should be to achieve MVI, and whether achieving this target through issuance changes can effectively reduce concerns about the centralization of staking distribution.
4. Profitability of independent stakers: There are concerns that the profitability of independent stakers will be affected, which may lead to the loss of these stakers, thereby exacerbating the centralization problem of staking.
In response to these concerns, Ethereum co-founder Vitalik Buterin shared preliminary research on adding new anti-correlation rewards and penalties in March 2024. These measures are intended to encourage more independent validators and reduce over-reliance on a small number of validators.
Furthermore, the monetary policy of the proof-of-stake blockchain Beacon Chain has not changed since its inception in December 2020. However, before merging with the Beacon Chain, Ethereumâs monetary policy had undergone several revisions in its roughly seven-year history.
Initial block reward: In the initial stages of Ethereum, the reward for each block was set at 5 Ethereum.
First reduction: In the Metropolis upgrade in September 2017, the block reward was reduced from 5 ETH to 3 ETH.
Second reduction: In the Constantinople upgrade in February 2019, the block reward was further reduced to 2 ETH.
Transaction fee burning: In August 2021, Ethereum underwent the London upgrade and introduced the EIP-1559 proposal, which began burning a portion of the rewards miners received from transaction fees.
Merged Upgrade: In September 2022, mining rewards were completely abolished on the network with Ethereumâs merged upgrade from Proof of Work (PoW) to Proof of Stake (PoS).
Under the Proof of Stake (PoS) consensus mechanism, monetary policy changes in Ethereum may be more controversial than before under Proof of Work (PoW). The reason is that a wider range of users are affected. Unlike changes that only affect miners, the current changes will affect more Ethereum holders, staking service providers, Liquidity Staking Token (LST) issuers, and re-staking token issuers.
As more stakeholders participate in the Ethereum network, developers are less likely to change Ethereumâs monetary policy as frequently as in the past. The controversial nature of this policy and rewards may cause staking-related policies and rewards to become more fixed and rigid in the future.
Therefore, as the Ethereum staking industry grows and matures, the window of opportunity to change the Ethereum codebase is shrinking, and this window is unlikely to last for long.
in conclusion
The staking economy built on Ethereum is still in its infancy. When the Beacon Chain first launched in 2020, users who staked Ethereum had no guarantee of being able to withdraw Ethereum or transfer funds back to the mainnet. When the Beacon Chain merged with Ethereum in 2022, users received additional rewards for staking through transaction priority fees and MEV. When the staked Ethereum withdrawal function was enabled in 2023, users could finally exit validators and profit from their staking operations. There are also a series of other changes coming on the Ethereum development roadmap that will affect the staking business and individual stakers. While most of these changes will not affect the economic incentives for staking, such as the increase in the maximum effective balance of validators in the Pectra upgrade, some of them will.
Therefore, it is important to carefully evaluate the risks and rewards of staking on Ethereum as the Ethereum roadmap continues to evolve and is implemented via hard forks. Because Ethereumâs staking economics encompasses many more stakeholders than in the Ethereum PoW era, changes that affect staking dynamics may be more difficult to execute over time. However, Ethereum is still a relatively new proof-of-stake blockchain, and significant changes are expected in the coming months and years, and people need to carefully consider the impact of changing staking dynamics on all relevant stakeholders.
