Introduction

After the transition from Proof-of-Work to Proof-of-Stake last September, another great milestone is approaching in the history of Ethereum. The Shanghai update announced to take place in March 2023 brings new opportunities to the early-bird and ever-growing staker community of Ethereum. Currently, anyone who decides to stake (essentially lock-up) their Ether on the blockchain cannot withdraw them and without any functionality update, they remain staked forever. The Shanghai update aims to address this deficiency by introducing the option of unstaking to the Ethereum blockchain. According to the data provider Staking Rewards around 14% of all Ethers are currently locked up on the blockchain as stakes[1]. Whether the new upgrade leads to a massive withdrawal or encourages even more staking remains to be seen.

On this occasion, we would like to provide an unbiased overview of existing staking opportunities, including Ethereum and outline a discussion of their underlying economics. What are the differences between the staking designs and the reward distribution mechanisms of existing POS blockchains and how should they be evaluated? In this and a series of upcoming posts, we strive to answer these questions.  First, we discuss the main characteristics that constitute POS consensus mechanisms. We introduce staking in general, outline the relevant dimensions of POS systems, and briefly discuss the economics of staking. In a second article, we provide information on the specific staking mechanisms of nine different POS blockchains: Algorand, Avalanche, Cosmos, Cardano, Ethereum, NEAR Protocol, Polkadot, Polygon, and Solana. We focus especially on how individual- and aggregated rewards are calculated and how rewards are financed. Finally, we synthesise our findings into a general discussion of the predominant staking design choices and their consequences for the different stakeholders in the blockchain ecosystem.

At this point, it may be important to mention that a range of terms has developed to describe the various possible modifications to the staking mechanism design (e.g., Delegated-Proof-of-Stake, Nominated-Proof-of-Stake, Hybrid-Proof-of-Stake, etc.). In the following, we use Proof-of-Stake as an umbrella term that encompasses these more specialized terminologies and then introduce the modifications.

Staking explained

Staking is the foundation of the Proof-of-Stake (POS) consensus mechanism, where individuals lock up their assets (native coins) on a blockchain to secure the protocol. The stake acts as a form of collateral to ensure that validators, who are responsible for verifying and appending the blockchain, act in a manner that is in line with the protocol's rules. In traditional POS-blockchains, only validators can stake, therefore they are comparable to miners in Proof-of-Work (POW) systems, such as Bitcoin. Both validators and miners compete to append the blockchain and receive a reward for their “work”. Unlike in POW, validators are not competing by solving cryptographic puzzles but are selected randomly by the consensus algorithm primarily based on the size of their stake. Therefore, validators mostly compete with their stakes, whereas miners compete with computing power. The investment focus moves from computational resources to native coins. For this reason, POS is considered to be far more energy-efficient than POW.

Despite not needing to solve puzzles, validators still must provide computing power when selected to append a block, to ensure proper validation. To incentivise this and to ensure that validators act truthfully, many POS-blockchains implemented so-called slashing algorithms. This means that failed or false block validation can lead to the forfeiture of the staking reward or the stake itself. Thus, the staking reward, consisting of newly created coins, not only compensates for the initial investment in the form of the stake but also covers the cost of providing the computational power required for proper transaction validation.

Variations of POS

In the classical POS system such as Ethereum, stakers provide the stake and the necessary computing power to verify and approve blocks of transactions. In these systems, only so-called validators can stake. In other words, the ownership of the invested capital and the executive function it grants are both retained by the same agent. Over time, permutations of the POS mechanism have been developed that allow for the separation of validation and staking, attributing separate roles to validators and stakers.

The simplest advancement of POS is the Delegated-Proof-of-Stake (DPOS). In DPOS blockchains, like the Avalanche Network, a delegator can commit their stake to the validator. The validator in turn operates a staking pool which collects the assets from the various delegators. As in the classical POS mechanism, the validators also have the task of appending new blocks to the blockchain. Staking rewards are distributed among both validators and delegators.

Another extension of POS is the Nominated-Proof-of-Stake (NPOS) mechanism that was first implemented by Polkadot. Similar to DPOS the roles of staking and validation are separated. Validators are elected by the so-called nominators to participate in the block-update process. In comparison to DPOS, a nominator’s stake, however, is allocated by a pre-defined algorithm among those validators who received the most votes. Once an active set of validators is established by the voting result, the staked assets are distributed among validators to ensure sufficient decentralization[2]. Importantly, this protocol introduces reputation as a defining attribute of validator success. Nominators will only commit their assets to validators whom they trust to act truthfully and in a manner that will maximize their staking returns.

Compared to DPOS, NPOS has introduced a new role for the delegators/nominators. Nominators get the additional role of nominating validators next to providing financial backing. Nominators’ stakes are then distributed among a set of active validators, unlike in DPOS, where stakes are delegated to a single validator of choice.

Different ways of staking

Participating in POS as a delegator or validator usually requires technical knowledge to mitigate the risk of slashing. Since most individuals do not have sufficient knowledge, third parties (such as Lido or Coinbase) started to offer staking as a service. These service providers allow anyone to participate in the staking process without any prerequisites. We broadly delineate the staking possibilities and describe their potential risks and benefits among two dimensions: 1) whether individual stakers stake directly on the blockchain itself or through a third-party platform (indirectly) and 2) if the third-party platform provides a custodial or a non-custodial service. Examples are provided in Figure 1.

Figure 1: Different Forms of Staking with Examples

Source: Center for Cryptoeconomics

Direct vs. indirect staking:

Various definitions of direct staking exist. We define it as the act of individuals directly staking their assets on a proof-of-stake (POS) blockchain, which consequently positions them as active participants within the POS ecosystem. In comparison, we define indirect staking as when users stake through a third party and are itself not a participant of the POS mechanism. Note, we consider delegators and nominators as direct stakers since they lock their assets on the POS blockchain by themselves and not through a third party and are a primary agent of the POS ecosystem.  

Direct staking can be conducted using an own validator or by delegating/nominating stakes. On most blockchains, running a validator node requires having access to hardware infrastructure, knowledge of a specific software environment, and active participation in the consensus mechanism of the blockchain. While computing power requirements are much less prohibitive than on POW protocols, successful validator nodes still need to have access to a stable internet connection and be able to run their node perpetually and without interruptions. A less resource-intensive form of direct staking is when individuals stake their own assets directly as part of the POS system on the blockchain as a delegator/nominator.

While being the most involved form of staking, one of the major benefits of direct staking is that one directly accrues potential staking rewards. Fees for direct staking are lower in the case of delegating/nominating or non-existent in the case of running an own validator in comparison to staking through a third party. Direct staking requires individuals to have some knowledge of blockchain technology whilst indirect does not. Overall, the trade-off between direct and indirect staking tends to be determined by the risk associated with the transfer of ownership and the search and transaction costs associated with staking through a third party.

Custodial vs. non-custodial staking:

Indirect staking can be custodial or non-custodial, depending on whether the staker remains the owner of their assets (non-custodial) or transfers the ownership to a third-party platform (custodial). In custodial staking, the fact that ownership of the staked assets shifts from the staker to the custodian represents a risk that is not present when a staker stakes through a non-custodial platform or directly on the blockchain. On the other hand, custodial staking is the easiest way to start staking. Custodial staking service providers may, for example, offer staking with no lock-up period or no minimum required amount, which are often unavoidable in other forms of staking.

On non-custodial staking platforms, delegators retain possession of their private key and hence their staked coins[3]. This form of staking mitigates the intermediary in comparison to the custodian form. In addition, staking rewards tend to be higher on non-custodial platforms.

Staking Characteristics / Dimensions

Beyond the general concept of staking and its different forms, it is important to understand some of the common dimensions along which blockchains define their Proof-of-Stake mechanisms. This is the purpose of the current section. Detailed and comparative overviews of the most popular blockchains are to follow in the coming blog post.

Epoch: The epoch is usually defined as a period of time or a specific number of blocks. During an epoch, blocks are submitted, validated and at the end staking rewards are distributed. The length of an epoch varies considerably by blockchain. For instance, epochs on Cardano extend over a period of 5 days[4], whereas Ethereum has 6.4-minute-long epochs.[5]

Aggregated rewards: Aggregated rewards are the staking rewards on a blockchain that are to be distributed among all stake holders. Aggregated rewards are calculated differently on each blockchain and can depend on different variables, like inflation or the share of total staked coins on the network.

Staking pool: Direct stakers may operate staking pools through which indirect stakers can provide their coins. The pool represents the combined stakes. Indirect stakers receive a share of the rewards earned by the pool.

Slashing: Validators should be online all the time and avoid any misbehaviour to ensure network security and stability. However, if they have problems with their infrastructure and go offline or double-sign a block, the stakes in their staking pool can get slashed. Alternatively, aggregated rewards are reduced.

Individual rewards: Individual rewards are distributed among individual stakers. They usually depend on the individual stake made by the staker and can be reduced by any validator and/or third-party fees and slashing penalties.

Unbonding period: Some blockchains impose an unbonding period on stakers. The unbonding period starts when a staker initializes the withdrawal of their stakes. During the unbonding period, the coins are locked on the blockchain, and their owner cannot use these in any transaction or earn further staking rewards. Unbonding periods can be a few hours or even many weeks.

Activation period: On some blockchains, staked coins do not start earning rewards as soon as they are staked. Often, users may have to wait until the beginning of a new epoch for their stake to start earning staking rewards. The activation period then refers to the period between the staking commitment of the user and the integration of the stake into the active Proof-of-Stake consensus mechanism.

Compounding rewards: Some blockchains automatically distribute the earned rewards into the stock of staked coins, thereby increasing the number of staked tokens and allowing the staker to benefit from the compound interest effect. Reward distribution and crediting are not always automatic though. In some cases, they must be initialized by the validator.

The Economics of Staking

As previously discussed, staking is a crucial element of any POS-blockchain. Understanding its role requires a broader perspective that takes into account the different goals and trade-offs of the blockchain. This section will discuss the main economic challenges any POS is facing and introduces the Staking Trilemma.

When designing POS mechanisms designers usually have three different primary goals:

1. High security -> high staking volume. Staking is essential for ensuring the security of a POS-blockchain. By locking up their assets, individuals are incentivized to validate transactions and maintain the integrity of the network. The more assets staked in the blockchain, the more secure it becomes. Thus, POS mechanism designers aim for high staking volume.
2. High growth -> low fees. In order to achieve high growth, blockchain designers must create a system that is efficient and cost-effective. One of the main ways to achieve this is through low transaction fees, which are an important consideration for users when choosing a blockchain to use. By minimizing transaction fees, designers can make the system more attractive to users and encourage adoption. Thus, POS mechanism designers aim for low fees.
3. High valuation -> low inflation. Low inflation is crucial for coin holders, who want to see a return on their investment and avoid the dilution of their coins. In addition, inflation dilutes the rewards provided to stakers. Thus, POS mechanism designers aim for low inflation.

Unfortunately, POS mechanism designers cannot maximize all of these goals simultaneously. As explained below, they can only optimize for two at a time. In analogy to the well-known Blockchain Trilemma, we describe these trade-offs as the Staking Trilemma, and it is shown in Figure 2:

Figure 2: The Staking Trilemma

Source: Center for Cryptoeconomics

A blockchain that aims for maximal security must provide large rewards to compensate validators. These incur significant operational costs to provide the computational resource and opportunity costs for the locked assets. The blockchain has two options to finance these large rewards: increasing its coin supply or charging higher transaction fees to its users. Thus, if it wants to increase security, it must bear either lower growth or lower valuation. Similarly, a blockchain that aims to attract users using low fees can only do so by accepting lower security or using inflation to compensate individuals who provide the security. Lastly, a blockchain that prioritizes coin value must either increase fees or accept a lower level of security.

Hence, POS mechanism designers cannot achieve maximum values for all of their goals simultaneously, and they must carefully balance their priorities and implement strategies that support their long-term vision. The staking policy of the existing POS-blockchains is largely driven by this trilemma. In the upcoming posts, we will discuss how the different POS blockchains tackle this trilemma.

Sources:

[1]             https://www.forbes.com/sites/ninabambysheva/2023/02/09/ethereum-gears-up-for-next-big-upgrade-29-billion-of-ether-to-be-unlocked/
[2]             https://stakingfac.medium.com/what-is-nominated-proof-of-stake-889fc22bef8f

[3]             https://www.stakingrewards.com/journal/ultimate-ethereum-2-0-staking-guide/

[4]             https://cardanians-io.medium.com/cardano-staking-practical-information-3c86cbc73bd4

[5]             https://blockdaemon.com/documentation/guides/the-ultimate-guide-to-ethereum-2-0/