This article intends to be a quick guide for the current staking sector with a focus on Ethereum, the associated misconceptions and what the future of staking may look like.
- Ethereum’s staking yield is akin to the FED Funds rate for DeFi
- Proof of Stake is not a consensus mechanism
- Staking “yield” is mostly a made-up concept for an easier mental model
- Liquid staking tokens provide tangible advantages over solo-staking
- Squad staking will help solo-stakers and promote greater decentralisation
- Ethereum may put a limit on the total number of validators
- Restaking (and Liquid Restaking) are potential game changers
In 2021, Morgan Stanley predicted that staking could be a $40bn industry by 2025 and as the understanding around Proof of Stake mechanisms evolves, this forecast seems more likely. Below we show the current size of the staking market by blockchain.
With the successful completion of the Shapella upgrade, Ethereum is now a fully-fledged Proof of Stake network and is by far the largest. There are currently 575k validators helping to secure the Ethereum network with an additional 56k patiently waiting to join over the next month. Now that withdrawals have been enabled, it can be argued that the Ethereum staking yield is akin to the FED Funds Rate — it essentially sets a floor rate for the borrowing of ETH within the DeFi ecosystem. Why would one lend their ETH (an inherently risky activity) for less than the staking yield? If borrowing rates are lower, participants can borrow ETH for a lower rate, stake the ETH and keep the spread, this will drive up the demand for borrowing until the rates reach near par. As shown below, the issuance rewards provide an average annual yield of ~4.2% and this will continue to drop as more validators join the network.
But before we proceed further, what is Proof of Stake? Many believe it is a type of consensus mechanism but in reality, it is only part of one.
Proof of Stake is a Sybil Resistance Mechanism
Proof of Stake (like Proof of Work) is used to protect against Sybil attacks. A Sybil attack is a form of assault against a computer network service in which the attacker creates many fictitious identities and uses them to wield a disproportionately large influence over the service. An example of this attack would be bots voting on a poll on Twitter. Twitter’s Sybil resistance mechanism is to require an email address when signing up or other forms of KYC (obviously not effective enough as bots can do this as well). However, Proof of Work requires proof that an enormous amount of work has been done before adding to the chain. Ethereum’s Sybil resistance requires validators to stake 32 ETH (also not an easy thing to do). Combine the fact that bad actors will see their stake slashed if they misbehave, leaving a more crypto-economically secure protocol.
Now that we’ve tackled one misconception, let’s quickly cover another — “staking yield”.
Misconceptions of a Staking “Yield”
From a high-level view, stakers can expect to receive ETH rewards from two sources:
i) the consensus layer
ii) the execution layer.
As the names imply, the consensus layer rewards validators who complete consensus-related tasks while the execution layer rewards validators for the execution of transactions. For greater detail on these rewards see here but for consensus tasks, over the long term, a validator’s expected proportion of rewards earned for each task are as follows:
However, despite what many believe validators don’t receive a “yield”, instead, validators are randomly chosen (proportional to how much ETH they have staked) to perform certain tasks. Depending on the task and the timeliness of its completion this leads to the validator being rewarded with a nominal amount of ETH regardless of how much ETH they have staked. The fact that the rewards are completely separate from the amount of staked ETH makes the notion of a yield unfit as a technical descriptor. The ETH itself is not being used to generate returns, rather it’s used as “access rights” to be allowed to perform tasks in exchange for rewards. However, if a validator can probabilistically expect to earn 2 ETH per year by locking up 32 ETH then the idea of a “yield” makes for an easier mental model when referencing a longer time span. However, the “pooling” of staked ETH muddies the water even further.
The idea of a staking pool is not well defined but we will use the term here to describe any type of staking that explicitly relies on more than one participant. For the first type of pooled staking, we will reference centralised staking providers (think CoinBase or Binance).
Centralised Staking Providers
Centralised entities make it easier to contribute towards staking on Ethereum through an easy-to-use interface, eliminating the need for specific hardware or know-how to run a validator and lowering the amount of ETH needed to contribute towards staking (from 32 ETH to as little as a fraction of 1). Another overlooked advantage of these centralised services is the smoothing of rewards — if any of the validators in this pool are randomly chosen, the rewards are distributed evenly among all participants. This makes the payouts less sporadic and provides a more consistent revenue stream — this is yet another reason why the term “yield” is thrown around so much.
Even though the minimum amount of ETH required to stake on the network is 32, the “maximum” is also 32 ETH. What this means is that a minimum of 32 ETH is required to spin up a validator but staking more than 32 in one validator, while possible, has no advantage — a second validator would need to be created in order to make use of the additional 32 ETH. This means that ETH itself isn’t “pooled” but rather the validators are. However, it should be noted that different centralised staking providers operate their services differently. Some may indeed pool ETH, choose when to pay out rewards or adjust any other dynamics they see fit. The regulatory concerns surrounding increased deviation from Ethereum’s native protocol are out of the scope of this report.
Liquid Staking Tokens (LSTs)
Liquid staking tokens offer a similar service to their centralised counterparts — easy to use, no hardware or operator knowledge needed, removing the 32 ETH requirement and smoothing of rewards. In addition to these benefits, it is also permissionless (anyone can buy the token on the secondary market) and can be used within DeFi (as collateral or otherwise). Additionally, rewards from staking are then used to create more validators, effectively compounding the rewards which a solo staker with “only” one validator would be unable to do.
Similar to centralised staking providers, the paths taken by the competing Liquid Staking DAOs may differ. There are different incentive mechanisms, fee take rates, operator selection methodologies and governance procedures. In fact, Lido’s recent upgrade introduced a staking router architecture which allows for an even more diverse group of staking operators who can each further differentiate their services even within the protocol. This was enabled through DVT which will be discussed in greater detail later on. Holders of Lido’s stETH can also natively exchange their stETH for ETH much more quickly than a solo-staker withdrawing from the Beacon Chain thanks to an internal buffer. The combination of all the benefits stated above is why LSTs are the most popular form of staking right now (~36% market share).
Around 15–25% of all staked ETH is operated by individuals or institutions. These entities need to be tech-savvy enough and possess at least 32 ETH in order to self-stake. Below we outline the benefits and drawbacks of solo staking vs “pooled” staking.
Despite the disadvantages, solo-stakers are arguably the most important validators since they contribute the most towards the decentralisation of Ethereum. In order to prevent staking from predominantly becoming an industrialised enterprise, solo-staking needs to be easier and less risky. This is where Squad Staking enters the picture, trying to achieve even greater decentralisation for both solo and pooled staking.
The term “Squad Staking” emerged from the arrival of a novel technology known as Distributed Validator Technology or DVT. DVT, as the name suggests, is a technology that allows the process of validation to be performed on a distributed number of devices as opposed to a single machine. It allows for multiple participants to come together and share control over one (or more) validator(s) hence the term “squad”. This reduces the requirement of 32 ETH since, for example, 4 participants each with 8 ETH can now cooperate with each other and spin up one validator. Secondly, it reduces downtime risk since if one of the nodes goes offline there are three more backups. This reduces the chances of missing rewards or being penalised and provides greater resilience and stability to the Ethereum network as a whole. DVT uses a combination of four key technologies:
Distributed Key Generation Scheme (DKGs)
The private key is encrypted, split into N parts and distributed among N participants. This ensures that no one group member has full control over the validator.
Shamir’s Secret Sharing
This is an algorithm that allows the reconstruction of the private key without requiring the knowledge of every key share. For example, if there are three operators and the threshold for signing is 2 out of 3, then even if one computer goes offline or is not trustworthy, two nodes remain active and can sign messages.
Multi-party computation (MPC)
Multi-party Computation allows the cluster of operators to sign messages and perform computations without rebuilding the complete private key on a single device. This eliminates the risk of centralising the private key, thereby maintaining the decentralisation of the validator setup.
Istanbul’s Byzantine Fault Tolerance
This algorithm establishes a consensus on a block by designating one of the nodes as the leader who will propose the block to the network. If the leader is offline then another leader will be chosen before the proposal round is finished.
DVTs will allow more individuals to participate in consensus while reducing some of the risks associated with solo-staking. Below we highlight the benefits and drawbacks of DVTs.
As there are multiple nodes assigned to one validator, this increases the surface area for things to go wrong. It also introduces some latency in communication although this can be mitigated by using direct peer-to-peer communication rather than a singular gossip network.
DVTs can also be offered through a liquid staking provider (as Lido and Rocketpool have done) which adds benefits such as increased liquidity, smoothing and compounding of rewards but still mitigates some of the drawbacks of traditional LSTs (no control over keys or assets). Centralised exchanges can even use DVTs to offer their customers staking in a more decentralised (and potentially regulatory-compliant) manner. Obol Network is expected to launch its instance of this technology later this year while the SSV network and Stakewise are already live on the mainnet. Expect DVT or “Squad Staking” to become one of, if not the, most popular form of staking on the Ethereum network.
Re-staking is probably one of the most anticipated yet controversial applications coming to the Ethereum ecosystem. Once again, as the name implies, re-staking involves taking staked ETH and staking it again but for another purpose outside of validating Ethereum blocks. Restaking will also be available for liquid staked tokens like Lido’s stETH, Rocket Pool’s rETH and others. This would mean that an Ethereum validator would perform additional services for another customer (besides Ethereum) and in turn be rewarded for these additional services but they would also open themselves up to additional slashing risks if they act maliciously while providing these services. The optionality that re-staking offers is considerably large, it can be used for:
Bridges — instead of trusting a single bridge operator who may steal your funds, one can choose to trust a bridge operated by restakers who will get slashed if anything goes wrong.
More formally, restakers can verify off-chain whether bridge inputs are indeed correct, and if enough restakers agree, then the inputs are accepted. But if they are accepted and wrong then when someone challenges, the input can be reverified and restakers will be slashed.
Scaling Layer-2s — key components of scaling the Ethereum network through Layer-2s are Data Availability and Sequencers. Data availability ensures that enough data is posted to the chain such that the state can be recreated and verified. If not enough data is posted then restakers will be slashed. Sequencers order the transactions coming from a Layer-2 which give them a lot of power to act maliciously if they choose to censor or front-run users’ transactions. Once again, if the sequencer role is performed by a quorum of restakers, then their ETH will be on the line, incentivising good behaviour.
Securing other blockchains — Restaking also enables validators’ staked ETH to be used as crypto-economic security for alternative protocols, in exchange for protocol fees and rewards while maintaining the slashing risks.
The above examples are only a fraction of the possibilities, restaking can be used for strengthening trust in oracles, MEV Management, creating a futures market for blocks, guarantees on inclusion of event-driven actions and much more. The design space for these services is limited by the imagination. Validators can opt-in to whichever service(s) they feel comfortable providing while other validators can delegate their staked ETH to the ones who choose to provide these services. Liquid staking tokens are also likely to adapt to these offerings — even now one can purchase an ETF like LST which derives its yield from a diversified basket of other LSTs. In this same line of thinking, we can imagine LSTs offering different types of restaked products each with different risk/reward structures.
However, there are concerns surrounding the introduction of restaking as the Ethereum protocol would be unaware of this middleware running on top of it. For instance, if there is a network issue and this causes a large portion of restakers to be slashed then this could reduce the security of the Ethereum network as stakers are then force-exited due to having less than the required 32 ETH. The rehypothecation of crypto-economic security is a new concept which requires further formal research and testing to fully understand but we will briefly touch on the high-level concepts here.
As it currently stands, Ethereum is currently securing around $400bn-$500bn with $33bn of staked ETH (implying a 13x security leverage), this works because the total value secured is not what is protected by staked ETH. Rather, the total value transferable out of the system in a short period of time during the “attack duration” is what is being protected by staking. Using this framework one can get provable guarantees on what the crypto-economic conditions are for safety but this is beyond the scope of this report. To further ease any qualms with restaking the concept of dual staking arises, where a separate token is created that takes the leverage security risk away from staked ETH.
Restaking also changes the incentives for staking. Ethereum has an ethos of minimum viable issuance, that is what is the minimum amount of issuance required to keep the network secure. As more validators enter the network more ETH is issued but ETH rewards per validator decrease (ceteris paribus), this reduces the incentive for more validators to join until an equilibrium is reached. If validators can then earn additional rewards through restaking this morphs the incentive structure and may not be ideal for the goal of minimum viable issuance. Although this additional incentive layer may be mitigated by the Ethereum network potentially limiting the total number of validators in the future in an effort for faster finality.
Restaking is clearly both an exciting and challenging endeavour and is currently being pioneered by EigenLayer. The introduction of this middleware to the blockchain landscape will shape the spectrum of trust as traditionally centralised applications can borrow Ethereum’s security to enhance their offerings. Staking is a relatively new industry yet the pace of progress is incredibly fast, in a short period of time we already have delegated PoS, liquid staking and DVTs with restaking, liquid restaking and dual staking coming soon. While there are many questions still to be answered, one thing we can be certain of is the level of innovation in this space continuing to grow.