- Blockchain Consensus
- What Is Consensus?
- Proof of Work (POW) Consensus
- Proof of Stake (POS) Consensus
- Issuance & Rewards
- Proof of Work Rewards
- Proof of Stake Rewards
- Downside of Staking
- Liquid Staking
- Liquid Staking Example
- Lido (stETH)
- Coinbase ETH (cbETH)
- Rocket Pool (rETH)
- Swell (SWETH)
- Diversifying Your Staked ETH
- The Future of ETH Staking
- The Great “Unlock”
- De-Risking Staking
- Post-Unlock Staking Rewards
- Ethereum’s “Risk-Free” Rate
- Betting On Predictions
Today, we're going down a rabbit hole I've wanted to go down with you for a long time. Which is staking your ETH and Ethereum's new Proof of Stake (POS) network. And in particular, how to earn yield staking your ETH the right way. It's a monster topic. So I collaborated with my buddy Pete to help me out.
What Is Consensus?
Proof of Stake is what we call a consensus mechanism, or rather, away for nodes on a distributed network to agree with one another. It's just one of the ways. And understanding consensus is foundational to understanding all blockchains.
Blockchain is really just a distributed ledger. We've used ledgers for keeping track of financial transactions for thousands of years. And you have this problem...
- Let's say you have account A and account A has 100 units in it
- Account A sends 50 units to Account B and 70 units to account C
- We have a problem because account A only has 100 units and now we've spent 120
So the way we've always addressed that is whichever of those transactions happen first is valid and whichever happens second is not valid.
So in the example, if the transaction to account B is valid now account A has 50 left. Now the transaction for 70 to account C is invalid. We don't recognize it. So prior to what we're now calling Proof of Work (POW), you always had to have a centralized authority to determine that sequence, which of these transactions happened first.
Proof of Work (POW) Consensus
In the Bitcoin white paper. Satoshi solved the need for a centralized authority using Proof of Work (POW). POW is a consensus mechanism, a way for all nodes on a network to agree with one another. Away for them to agree on which transaction came first. And it does this with a lottery.
Bitcoin miners burn electricity by taking all the transactions, which have occurred on the Bitcoin network since the last block and hashing it millions of times per second, using SHA256. They're trying to guess that winning lottery number. The second they have the winning number that match the current difficulty of the network, they broadcast it to all the other miners as proof. Once verified, they instantly agree because the only way to have discovered that magic winning lottery number was by putting in the work - by burning energy.
It's proof that they had skin in the game and that they're playing by the rules. This is consensus. And this is how nodes on a distributed network come to agree with one another.
Proof of Work is how consensus on Ethereum has worked since day one. That is, until The Merge which happened in September of 2022 when Ethereum swapped out Proof of Work for Proof of Stake. A very different way of reaching consensus.
Proof of Stake (POS) Consensus
With Proof of Stake, we still need to maintain consensus across the network and incentivize the people participating in a distributed network to participate honestly. But instead of miners, we have validators.
Rather than having this big race to see who can guess the lottery numbers the quickest validators are incentivized for honest behavior and disincentivizes dishonest behavior.
To participate in Proof of Stake, you have to put forth a stake, which is some amount ETH, it's something that's valuable. The stake is a bond that you will act honestly, and the definition of honest is well defined by the code.
By “solo staking” you personally run any of the Ethereum validator clients, it follows the rules automatically. It's actually pretty simple to be a validator.
As a validator, you're pledging that you won't do things like propose two different blocks in the same slot. That would be a malicious act, it’s the type of thing that we wanna discourage. So you could lose some of your stake in the form of slashing if you're caught doing this.
Slashing exists because there are people technical enough to re-write the code and adjust the rules. If they're caught doing so, they'll be slashed, and some of their Ethereum will be taken from their stake.
But why would anybody ever want to do that? Because you get rewards if you do honest things!
Issuance & Rewards
Proof of Work Rewards
This is why we're here. In Bitcoin, rewards are only issued to miners and to be a miner, you have to buy specialized hardware and burn electricity. Which some might argue is a waste of energy. But more importantly, is that it costs a lot of money.
Let's say you become a miner anyway, and you're lucky enough to stumble on a winning lottery number and propose a Bitcoin block. You'd receive two types of rewards:
- A block reward
- Transaction fees
A block reward is issued every block to the miner who proposes the winning block. The block reward is currently 6.25 Bitcoin. And every 210,000 blocks (about every four years) this block reward gets cut in half in an event known as the having.
The second reward given to miners is all the transaction fees included in their block. You know that tiny sliver of BTC you tack on to every transaction you make? That goes to the miner who proposes the block your transaction gets included in. Someday when block rewards run out. Transaction fees will be the only reward left for Bitcoin miners.
Proof of Stake Rewards
And this is how Ethereum used to work. You had to mine, Ethereum using proof of work to earn rewards. But the Ethereum Merge swapped out POW for POS and now you can earn rewards for just staking. Which doesn't require specialized hardware or a ton of electricity.
As a solo staker, you’ll receive a few different types of rewards:
- Attestation rewards
- Proposer rewards
- Priority fees
- MEV payments
- Sync committee rewards
Attestation rewards, currently around 10,000 gwei are earned roughly every 6 minutes. This is awarded for helping the network agree on the current head of the chain - the latest block.
Proposer rewards are similar to block rewards in POW. They’re given to the validator who proposes a block, which occurs every 12 seconds in Ethereum vs every 10 minutes in Bitcoin.
EIP-1559 changed the way fees are awarded to validators. Instead of all the transaction fees in the block, validators are rewarded with the priority fees. Priority fees are fees some transactions include to ensure their transaction is included sooner than other transactions who are simply paying the recommended fee.
Miner Extracted Value (MEV) is an off chain payment to validators from bots looking to include transactions in their block.
About once every three years your validator will be chosen to be on the sync committee. The sync committee helps support lightweight clients by pointing them to the head of the chain. The reward is big, but it doesn’t happen that often.
As you can see, there's a lot of different ways validators are rewarded. This is why it becomes difficult to compute the Annual Percentage Rate (APR) or yield for being a validator. Some rewards come often, some take years to happen.
The current APR for staking ETH falls somewhere between 3-5% paid in ETH.
Downside of Staking
While the benefits of staking ETH are obvious, there are also some important downsides to consider.
- You must stake a minimum of 32 ETH to be a validator
- You can’t use your ETH in DeFi while solo staked in a validator
- Solo staking is still a bit technical
- There is currently no way to withdraw your stake
That’s right. At $1,600 per ETH, you need a minimum of ~$50,000 worth of ETH to be a validator! And you can’t withdraw it! Yet…
At the time of writing this, theres currently no way to withdraw your staked ETH! It was designed this way intentionally. Apparently enabling withdrawals added more complexity to The Merge so withdrawals will be enabled in a future Ethereum update called the Shanghai Upgrade. The Shanghai Upgrade is expected to go live Q2 of 2023 at which point withdrawals will be enabled.
Because of these drawbacks only ~14% of all the ETH is currently staked. Thats 16 million ETH locked up until the Shanghai Upgrade. And of that 16 million staked ETH, only 30% is staked directly or solo staked. The remaining 70% of ETH is staked via Liquid Staking providers.
Liquid Staking Derivatives (LSDs) are token projects that popped up to make staking easier. You give them your ETH and they stake it for you for a small fee. They also give you a tokenized representation of your ETH known as an LSD.
LSDs are pegged to the price of ETH and allow you to maintain your liquidity while you earn your staking rewards. This all sounds great. But there are some things to watch out for and all these LSDs work differently.
Liquid Staking Example
Take Coinbase for example, which is a centralized liquid staking provider. If you go on Coinbase and buy some ETH, a dialogue box will pop up and ask if you want to stake it. Although this is as simple as clicking a button, the problem is that you are giving Coinbase custody of the ETH you just bought. It is now Coinbase's ETH they're going to stake, and they're going to get some staking rewards. In return, you will receive a liquid staking token - (in Coinbase’s case, this is called called cbETH).
As far as cbETH goes, you can really think of it as a future deliverable of the staked ETH plus the reward that that staked ETH is going to earn over time. So if you have a cbETH, a year into the future when withdrawals are enabled you can take your cbETH and withdraw one of Coinbase's ETH that they have staked. But in the meantime, you can take your cbETH and exchange it (there’s always some market price).
The important thing to remember is that even if you sell your cbETH, the underlying ETH stays staked and stays owned by Coinbase. But you have the option to go to Coinbase and ask for the ETH plus the reward.
In general, we can classify liquid staking into three categories: centralized, permissioned, and permissionless.
There are several liquid staking providers, let’s go over the biggest ones from each category.
Lido offers stETH, which stands for Staked ETH. stETH (currently) represents a whopping 75% of liquid staked ETH. Lido is what we call permissioned, meaning they don't control all the validators themselves. But they vet the validator partners to ensure that they know what they're doing.
Lido’s website currently claims a 4.6% APR, after the 10% fee that they charge on all rewards earned.
The way rewards accrue with stETH is tricky. Every day at 12:00 PM UTC, Lido does what's called a rebasing. They take inventory of all the rewards earned in the last 24 hours, and how much new ETH has been staked with them. As a result, the amount of stETH in your wallet appears to “automagically” increase - as in the number just goes up without receiving a fresh transaction.
It's important to know that stETH currently trades at a slight discount. Instead of staking your ETH directly with Lido, we recommend swapping ETH for stETH on Curve, where one ETH currently gets you around 1.01 ETH (or a 1% discount).
Coinbase ETH (cbETH)
As mentioned, Coinbase ETH (cbETH) is fully centralized, meaning Coinbase runs all the validators themselves. cbETH currently represents 15% of the liquid staked ETH market and they're currently quoting 3.88% APR. Unfortunately, Coinbase charges a high 25% fee on all the rewards earned by staking your ETH with them.
cbETH rewards accrue a bit differently than stETH. Instead of a rebase, cbETH rewards accrue to the token itself. Meaning that if you stake one ETH with Coinbase, you won't get exactly one cbETH in return. This is because the value of cbETH is slowly increasing over time as Coinbase validators earn more and more rewards.
To simplify, just know that someday when withdraws are enabled Coinbase will give you more ETH than what you put in when you're ready to unstake.
Frax is a stable coin that recently released an ETH staking derivative as well called frxETH. For now, it's a bit centralized - but they've confirmed that they are planning to enable anyone to run a validator once the Ethereum Shanghai upgrade is released.
Frax currently pays over 8% APR, which is double its competitors. This is because they do things a bit differently. When you deposit your ETH with Frax, you get frxETH in return. frxETH doesn't regenerate any rewards on its own, but you can choose to swap your frxETH for staked Frax ETH (sfrxETH) which generates the rewards from their validators. Or, you can take stake your frxETH in DeFi (like Curve) so you can earn swap fees and DeFi fees from there.
Currently 50% of Frax ETH is earning fees in defi, and 50% is earning fees from the stakes, from the rewards, or from the validators. And because only half of the Frax ETH is earning 100% of the staking rewards, staked Frax ETH earns about twice as much as all the other providers. It's a pretty cool system!
Rocket Pool (rETH)
The last liquid staking derivative will cover is Rocket Pool, or rETH. rETH is permissionless. On their site, rocket pool currently quotes a 6.61% APR for note operators and a 4.15% APR if you want to stake without being a node operator. To buy rETH on Uniswap, you currently pay a 6% premium.
As Pete explains, Rocket Pool’s “problem” - despite there being many good things about RPL - is that they need node operators. As opposed to Lido or Coinbase, which can just spin up a new validator anytime they want to. In Lido’s case, they have trusted parties and they can say “here's another 32 ETH, please spin up another validator.”
But if somebody comes along and deposits 16 ETH worth in aggregate into Rocket Pool's pool, they need somebody to sign up and say, “Here's my 16 ETH and I'm gonna run a new mini pool.” The problem that Rocket Pool is having is that not enough people signing up to do that.
The problem is their deposit pool. There's actually a limit on how much they will allow to sit in their deposit pool, not actually being staked because they don't have enough node operators. They’ve reached that limit, and there was a time when you actually couldn't buy rETH from Rocket Pool because that deposit pool was full. in the case of Rocket Pool, if you want to run a node - instead of 32 ETH, currently you need 16 ETH and at least 1.6 ETH worth of the RPL token.
Your 16 ETH is instead of the 32 ETH that you're putting your own stake in your own node. Rocket Pool then matches that with 16 ETH from their pool. So as an end user, if you're not running a node and you just want to stake with Rocket Pool and get some RPL - say you take 0.1 ETH and deposit it, and you get 0.1 rETH - there would now there's 0.1 ETH sitting in a pool.
So that's gonna sit there in the pool until that accumulates to at least 16 ETH. Then, somebody who is willing to run a new (what Rocket Pool calls) “mini pool” (think node) - the pool is going to provide that 16 ETH to match the node operator’s 16 ETH, bringing us to the required 32 ETH needed to run a node.
Importantly, you don't need to apply to be a Rocket Pool node operator (hence the “permissionless” part). Anyone can do it.
The way they make that work is you have your own 16 ETH at stake, which if you suffer any penalties, it comes out of your 16 ETH. This is how the pool insures itself in addition to the RPL deposit (you have to have a deposit of at least 1.6 ETH worth of RPL, which essentially goes into an insurance pool.)
Swell is also a new player in the scene. They’re an interesting hybrid between permissioned and permissionless node operators.
Swell also has a unique value accrual method. They have swETH, which is a pegged token (it remains one to one pegged with Ethereum). But when you deposit to get swETH you receive an NFT, and the value that's in your staked ETH actually accrues to that NFT.
Diversifying Your Staked ETH
As with all sound investing principles, putting all your eggs in one basket introduces further risk. Some people choose to diversify their liquid staking assets. However, that involves having multiple baskets and greatly increases complexity. It requires keeping track of where everything is and what's going on with all these different ecosystems.
Whether or not you choose to diversify will come down to 1) your personal net worth you have invested and 2) and how much of your time you can afford to spend keeping track of it all. However, diversifying will indeed at least spread your risk, but none will protect if something goes catastrophically wrong with Ethereum itself - so you might want to diversify that, too!
The Future of ETH Staking
The Great “Unlock”
The big question is, “What will happen to the ETH when the unlock occurs?” Some speculate that people who have staked ETH are going to unlock it immediately and sell. However, others counter that people bullish enough sign away their ETH indefinitely with no guaranteed promise that they'd ever be able to unlock it, may not be quick to sell their stacks.
In addition, it’s also important to consider that there are Lido validators who have been accruing rewards this entire time, and now have more than 32 ETH. Node operators who have 35+ ETH are certainly going to want to do different things with that accrued value. There's a good chance liquid staking providers may sell accrued rewards to pay bills. This will likely put a downward market pressure on the price of ETH for a while.
On the other hand, Lido has also said that if they have a bunch of validators that each have, say 35 ETH, they wanna sweep all that up and start new validators - something they can't do currently. This could lead to higher APRs as more validators come online with the same number of ETH.
Right now there’s a significant risk to staking ETH because you’re essentially waiting on the hard fork to happen. However, once withdrawals have been enabled for a period of time and has been working successfully, the risk level goes way down.
We may see staking explode during this period and see a far higher percentage of the overall ETH getting staked in Proof of Stake networks (80-90%). A more conservative estimate would be around 60%. In contrast, currently only around 14% of ETH is staked - so this would be a huge deal.
But even with 14% of ETH becoming unlocked, would that flood the market and cause a price dump? Supporters of ETH will point to the merge and how speculation about possible glitches or problems was rampant. In the end, the process ended up going smoothly!
Post-Unlock Staking Rewards
So if 60-90% of all the ETH in existence were to get staked, then what happens to the staking rewards? What's the yield going to be on staking your ETH?
Pete thinks it’s very possible that it ends up being a 1%, maybe even 0.5%. But if it's easy enough, isn't 1% better than 0%? On the other hand, if Lido is indeed able to sweep up all the validators with extra ETH (which isn’t currently possible) and start new validators, they would actually be able to then pay higher APRs.
We may also see the discounts we've been seeing on LSDs disappear when the unlock happens - as long as the providers make good on their claims and withdrawals are easy to initiate. We’ll start seeing stETH and cbETH and all these LSDs go back to peg, and that risk premium will disappear.
So overall, the yield from staking ETH might shrink. But that doesn't mean ETH yield is going away! In fact, one theory heading into the next bull market is that ETH and LSDs will take center stage as some of the biggest sources of yield in all of DeFi.
Ethereum’s “Risk-Free” Rate
Ethereum now offers its own sort of risk-free rate with no upfront investment costs, sort of like how T-bills are the risk-free rate in fiat since it's paid by the government that issues the money. And while this risk-free rate might be low, any revenue generated is enough to build on top of. For example, in the lending markets Compound pays out 0.09% APY for supplying ETH but also incentivizes that by paying an additional 0.13% APY in COMP token.
With decentralized exchanges like Curve, the base APY comes from fees charged on swaps. Curve incentivizes it with CRV, and Convex incentivizes it with CVX. The frxETH pool only pays a base rate of 0.055% APY but incentivizes it with FXS, which brings the pool's APY up to over 8% from the base APY. And this is during the bear market where these tokens are down in the dumps! Imagine the APY once these tokens are doubling, tripling, 10x-ing…
In the last bull market, stable coin farming was all the rage because of the introduction of pegged pairs. When the price of all the tokens in a pool are pegged to one another, the volatility risk goes away. For example, Curve's 3pool is made up of USDC, Tether and DAI - they all equal $1. As a result, investors don't have to worry about their principal fluctuating when depositing stable coins into the 3pool.
The same thing is now happening with ETH and LSDs. Although the rate for solo staking ETH might go down to a couple percent, more and more swaps are happening between ETH and cbETH, ETH and frxETH, etc. And if you're holding ETH, you might as well drop it into one of these pools because the LSDs are technically pegged to the price of ETH!
Our prediction? Yields around 20% for pegged ETH pools. That's going to be the norm during the next bull market. Furthermore, it will drive demand for ETH which is in short supply right now - especially as most of it gets staked and issuance might go deflationary.
Another way to play the rise of staking and LSDs might be to invest in the tokens offered by the providers themselves, although it’s still difficult to assign value to these at the moment.
Betting On Predictions
So let’s say these crazy theories of 80-90% of ETH being staked are true, and that liquid staking becomes the foundation for all of DeFi. How does one place a bet on that being right?
The truth is, it’s harder than you might think. For example, just buying stETH doesn't actually place that bet. You're only getting the staking award, which is the supposed “risk-free” rate.
LIDO, RPL and FXS allow you to place that bet on your theory being correct. Lido token is only a governance token and doesn't benefit directly from the increase in TVL.
Rocket Pool incentivizes staking RPL because they need people to run mini pools, so the proceeds for the pool actually accrue to RPL holders.
Frax's ETH staking implementation doesn't currently charge any fees, but it's theorized they will someday, and that value will flow to FXS holders.
You could purchase Coinbase stock, but that's also very diluted with everything else that they have going on.
Staking is what the Ethereum network wants you to do with your ETH. It's helping to secure the network and is setting up ETH for a major supply shock going into the next bull market.
Written by: @gerbz Gerbz is the founder of BitLift and has been journeying down the crypto rabbit hole since 2013.