In the Staking Rewards Journal we are covering the most important trends in DeFi. With today’s article we will provide a brief summary about the fundamentals of Staking and an example of Staking as an implementation in layer 1 blockchains.
Staking fundamentals
Staking is an attractive and relatively low-risk way to generate a passive income on your crypto assets. But more than that, it is a way of actively participating and providing value to a decentralized network. It is our gateway to the decentralized economy. What does this mean?
At a very basic level, Staking is the act of depositing an asset and “locking” it as collateral in a protocol. By “locking it” one can provide a service needed for the long-term sustainability of the platform. This could be the provision of security, liquidity, governance resiliency, or many others. We will expand later on all the services that a Staker can provide to a network. Additionally, staked assets have value accrual mechanisms and give their holders a claim on the value generated by the protocol.
Staking at layer 1
Staking can take a variety of forms. The first one is to stake at the platform layer (known as blockchain layer 1). This is possible in blockchains that have a Proof-of-Stake consensus mechanism, such as Polkadot, Cosmos, Cardano, and importantly Ethereum 2.0.
By Staking assets in a Proof-Of-Stake (PoS) blockchain, one can serve as a validator to this blockchain. Validators are crucial for any distributed ledger as they have the power to organize transactions in blocks and write them into the “official” or canonical ledger. They play a similar role as miners in traditional Proof-Of-Work blockchains, with the difference that instead of executing energy-intensive computing calculations, validators leave collateral (a stake) to guarantee that all entries into the ledger are done according to the predefined rules. By doing this, they help achieve consensus and simultaneously secure the network. For executing this important work, validators are rewarded with native protocol tokens, which are provided by transaction fees paid by users or issuance of new coins (inflationary mechanisms).
One of the most interesting aspects of Staking is that it provides the right to provide work to the network. Staking acquires an additional meaning: a digital work agreement.
The basic way how Staking at layer 1 works is the following:
a) Collateralization
First, a user collateralizes value. Remember that blockchain networks represent value virtually as tokens or crypto assets. Blockchains enabled for the first time in history digital scarcity, a key property for managing and storing value. This digital scarcity, not possible in web2 or web1, is embodied in digital tokens that can’t be copied or manipulated. This crypto asset is then staked or locked in a protocol or network.
b) Digital Work
By locking the crypto asset, one earns the right to provide digital work for a protocol. The work could be, for example, to run an open-source software in a dedicated machine that synchronizes a digital, decentralized, ledger of transactions. This activity is performed by running a blockchain full node. In the Ethereum blockchain, as in other PoS platforms, the digital work consists specifically in validating and adding new blocks of transactions to the blockchain. Stakers in these blockchains are also known as validators, and fulfill a similar role to miners in Proof-of-Work blockchains.
Syncing this database is crucial for achieving consensus in a decentralized network. Another important aspect is that the more nodes are running, the more secure and resilient the network will be against external attacks. All of these aspects are crucial for the survival and growth of the platform at the absence of a central administrator.
c) Reward Entitlement
The right to produce work is represented through a digital bond, which is issued through the protocol. This bond entitles the “digital worker” to periodic payments, as long as the staker provides services to the protocol.
Digital, web3 bonds have similarities to bonds in the legacy financial industry, mainly because they entitle the holder to periodic payments. But they also have substantial differences, as they normally don’t have maturity (are perpetual) and don’t have counterparty risk: the protocol that pays out the returns is technically designed to be solvent and can’t default. For this reason, Ethereum 2.0 Staking rate can develop into the risk-free rate of the Ethereum economy.
What is the difference to traditional bonds?
Web3 internet bondholders are lenders of capital, labor, resources, and simultaneously owners and governors of the network.
Crypto assets earned through Staking are quite unique. They embody the right to produce work to a decentralized network and (often) governing rights. Simultaneously, they represent ownership rights and contain a claim on its future cash flows. We will expand on these topics in further articles as they all will be key features of the new web3 economy!