What Is Staking?
A detailed guide to learning how to make passive income from your held cryptocurrency, the risks involved, and what you need to know before you get started.
How can you get started staking yourself?
Proof of Stake (POS) is an alternative consensus mechanism to Proof of Work. It allows users to stake their coins instead of investing computing power. The network then randomly selects users to help forge the next block of transactions. Through POS, a blockchain can be updated in a decentralized manner without the need for powerful computers and wasting power
Mining and Proof of Work
Before we get into staking, let us 1take a moment to understand the problem that staking is trying to solve. Bitcoin and other decentralized cryptocurrencies promise to send money digitally and without central authority.
Originally, the solution to managing a blockchain - a fancy term for an account ledger that is not controlled by a single entity - was found through mining. Mining is a type of competition in which powerful computers try to guess the solution to a mathematical question.
Whoever finds the solution first gets the right to write the next page of transactions, also called a block, to the ledger.
In mining, the more powerful the computer you use, the more guesses it can make in a second, which increases your chances of winning this contest. Thanks to the laws of mathematics and probability, it is highly unlikely that any one person or group will gain a monopoly on updating the ledger, and in this way decentralization is maintained.
The technical term for mining is "proof of work" - because by displaying the correct solution, miners prove that they have put in a lot of work, since there is no other way to get the solution except by using computing power to constantly guess it.
Proof of work is a so-called consensus mechanism, as it aims to reach an agreement on who gets to update the ledger among a group of people who do not really know each other or have any other basis for cooperation.
While the proof-of-work consensus mechanism may be a reliable and secure solution for managing a decentralized ledger, it is also very resource intensive. Running all those supercomputers just to guess a number consumes a lot of power, among other drawbacks.
An Explanation of ‘Proof of Stake’
Because of these drawbacks, other alternative consensus mechanisms have been proposed over the years. One very popular alternative is Proof of Stake. This means that instead of using electricity to run computers and try to win a contest, people use real coins.
But how does it all work? Well, basically you lock a certain amount of money on an ordinary computer that is connected to the network. Your computer is called a node in technical terms, and your locked funds are your bet. Once you place your bet, you enter the competition to see which node gets to forge the next block. You see that stakers forge blocks, they do not mine them.
The winner of this contest is determined taking into account several factors.
- How much money is wagered?
- How long were the coins used?
- Randomization (so that no single entity gets a monopoly on counterfeiting)
Generally, whoever wins the contest gets to counterfeit the next transaction block and is rewarded with coins for their contribution to the network.
It is important to note that there are many coins that use Proof of Stake, such as Tezos, Cosmos, and Cardano, and each coin has different rules for how it calculates and distributes rewards. In this post, we will mainly focus on how Ethereum's Proof of Stake model works.
Until 2020, the Ethereum blockchain was based solely on the proof-of-work method; however, in December 2020, a new blockchain called the Beacon Chain was established that is based on the proof-of-stake method: it is also known as Ethereum 2.0 and runs alongside the original Ethereum blockchain, Ethereum 1.0.
To sign up as a validator for Ethereum 2.0, you will need to deposit 32 Ether as collateral, for which you will in turn receive stake rewards. There is no way to secure more than 32 Ether on a single node. So if you want to increase your rewards, you can simply set up multiple nodes with 32 Ether each.
In a few years, Ethereum 2.0 will be fully launched and merged with Ethereum 1.0. This event, known as "docking," will take place around 2022, after which Ethereum will become a pure proof-of-stake network. Only after docking will you be able to cash out your staked Ether and rewards, which means that staking is mainly beneficial for long-term Ethereum holders. You are probably wondering now how much Ether will be rewarded?
In Ethereum 2.0, each validator involved in forging a block receives a percentage of the newly minted Ether when it is created. The more validators the network has, the smaller the share of the reward.
For example, if 1 million ETH is used, the maximum annual reward for each staker can reach 18.10%, but if 3 million Ether is used, the annual reward rate would drop to 10.45%. You can think of the total amount of new Ether awarded as a pie with a fixed size, and the more validators you have who want a piece of that pie, the smaller each piece becomes.
To simplify things, there are special betting calculators that try to estimate how much Ether you will earn if you bet a certain amount of ETH in a certain way.
Staking Pools and Other Solutions
All these risks I just mentioned are the reason why some additional solutions have been created for use. These alternatives allow ordinary people to stak ETH and earn staking rewards - without the considerable effort or risk of running their own node.
The easiest way for non-tech-savvy individuals to place stakes is to use staking services offered by exchanges. Certain exchanges allow you to wager your coins for a fee through their validators, even if you only have a small amount of money.
This eliminates the hassle of running your own validator, but you must cede control of your coins to the exchange. Some exchanges also allow you to claim your wagering bonuses immediately rather than waiting until Ethereum 2.0 reaches the docking phase.
Another option is to join a staking pool. Just like mining pools, staking pools are groups of people who join together to have a better chance of forging the next block. Staking pools also allow you to deposit less than the minimum stake, as all funds are pooled together.
When you decide to join a staking pool, it is important that you learn about certain aspects of the pool:
- Reliability of the validators
- Pool fees
- Customer support
- Size of the pool
- User reviews
- Whether or not you need to share your private keys with the pool
Additionally, you can purchase a pre-configured validator. Although the initial setup of these validators should be relatively simple, you will need to take care of ongoing maintenance, which can be quite tedious depending on your technical understanding.
Validator as a service (cloud staking)
These companies offer you the ability to run your own validator on their computers without having to set it up or maintain it. Since it is your personal validator, you still need to deposit 32 ETH and pay a certain fee for this service. The great thing about this option is that it's relatively easy to set up and you do not have to give control of your coins to another company.
Proof of Stake is an exciting new concept that allows everyday users to participate in securing a particular blockchain while earning passive rewards. With the transition from Ethereum to POS, this consensus mechanism is gaining massive momentum, but it is too early to tell how successful this transition will be.