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Lesson 2
6 min

What are staking rewards?

An introduction as to what staking rewards are, and how these incentives earned by individuals participating in blockchain networks can earn these by holding and validating cryptocurrencies.

Key Points:

  • Staking is the process of participating in a blockchain network by locking up a given amount of cryptocurrency, in order to support network operations
  • Proof-of-Stake and staking originated from a want to improve upon Proof-of-Work consensus models.
  • Several jurisdictions have recently set their eyes on regulating staking, so depending on where you live, options to earn income may be limited.

What is Proof-of-Stake?

As previously covered in our lesson about What is Proof-of-Stake, we outlined PoS is a consensus mechanism focused on incentivising network participants to behave in such a way that serves the interest of the network, following the rules as outlined in the blockchains respective protocol.

When we consider that a Proof-of-Work (PoW) blockchain is reliant on miners who are competing against one another to solve the cryptographic puzzle, PoS follows a different approach. Instead, PoS validators are chosen to validate specific transactions on behalf of the network. To do this, a validator must ‘stake’ an amount of their personal cryptocurrency holdings, where the cryptocurrency must be native to the chain, such as ETH for Ethereum and SOL for Solana, to be in with a chance.

How does PoS work?

Proof of Stake works by selecting validators based on the amount of cryptocurrency they are willing to lock up as a stake. Validators are rewarded for creating and validating blocks, while penalties deter malicious behavior. This consensus mechanism enhances security, energy efficiency, and decentralization in blockchain networks.

Proof of Stake vs. Proof of Work: Energy Efficiency and Validation

In a Proof of Stake (PoS) consensus mechanism, the computational effort required to verify blocks and new transactions is significantly reduced compared to Proof of Work (PoW). This reduction is largely due to the difference in how blocks are verified.

Proof of Work (PoW):

  • Competition: Miners compete to solve complex mathematical problems, requiring significant computational power and energy consumption.
  • Energy Intensive: The mining process is designed to be resource-intensive to secure the network against attacks. However, this leads to high energy inefficiency and significant costs, making it unfeasible for many miners.

Proof of Stake (PoS):

  • Validation: Validators are chosen to create and validate new blocks based on the amount of cryptocurrency they stake as collateral.
  • Selection Factors: The selection process considers the amount of cryptocurrency staked and the duration it has been staked, ensuring validators have a vested interest in maintaining the network's integrity.
  • Reduced Competition: PoS is less competitive than PoW as it doesn’t rely on solving cryptographic puzzles. However, validators still compete for the opportunity to validate blocks based on their stake and performance within the network.

In summary, PoS reduces energy consumption and computational effort by selecting validators based on their stake rather than relying on an energy-intensive, competitive process like PoW. This makes PoS a more energy-efficient and cost-effective consensus mechanism while still maintaining network security and incentivizing validator integrity.

Proof of Stake in Context: Ethereum 2.0

Ethereum 2.0 provides a prime example of a network transitioning from Proof of Work (PoW) to Proof of Stake (PoS). In September 2022, Ethereum completed this migration, and validators in the Ethereum 2.0 network are now selected to create and validate new blocks based on the amount of ether they stake as collateral. To become a validator for Ethereum 2.0, participants must stake at least 32 ether. Staking more than 32 ether does not increase the chances of being chosen as a validator.

Validator Role:

  • Transaction Verification: Chosen validators facilitate the checking and confirming of network transactions.
  • Maintaining Integrity: They maintain the integrity of the Ethereum 2.0 blockchain and vote on any proposed network changes.
  • Rewards: Validators are rewarded with additional ether for their contributions.

Selection Process:

  • Random Selection: Full nodes, or validators who have staked their ether, are selected randomly every 12 seconds.
  • Collateral: Validators use their staked ether as collateral, providing a financial commitment that discourages malicious or dishonest behavior.

The shift to PoS has significantly reduced the energy-intensive requirements of mining. Given the global focus on environmental concerns, this transition to a more energy-efficient and environmentally friendly approach is now securing the Ethereum network.

 

What are staking rewards?

Staking rewards are incentives given to participants for locking up their cryptocurrency to support the operations of a blockchain network. Participants, known as validators or stakers, validate transactions and perform other network functions, earning rewards in the form of transaction fees or newly minted cryptocurrency. This process, facilitated by Proof-of-Stake (PoS) consensus algorithms, allows users to earn passive income while enhancing the network's security and decentralization. However, participants should be aware of the risks, such as potential loss of staked assets due to malicious actors or network failures. In particular, staking pools have often been used to steal user funds. 

Advantages and disadvantages

Staking rewards offer several benefits for users. Note that several jurisdictions have recently set their eyes on regulating staking, so depending on where you live, options to earn income may be limited. 

  1. Passive Income: Staking provides users with an opportunity to earn passive income by staking their cryptocurrency and participating in network operations. Unlike traditional mining, which often requires expensive equipment and consumes significant energy, staking allows users to earn rewards simply by holding their cryptocurrency and contributing to the network's security.
  2. Network Security: Staking rewards incentivize users to act honestly and follow the rules of the network. Validators have a financial stake in maintaining the network's integrity, as malicious behavior could result in penalties or loss of staked assets. This helps to enhance the security of the network and protect against potential attacks.
  3. Decentralization: By allowing users to actively participate in network operations, staking promotes decentralization. Unlike traditional mining, which may be dominated by large mining pools or specialized hardware, staking allows anyone with cryptocurrency to contribute to the network's security and operation, thereby distributing control more evenly among participants.

Despite these benefits, staking rewards also come with risks:

  1. Risk of Loss: Participants risk losing their staked assets if they engage in malicious behavior or if the network experiences failures or attacks. It's essential for participants to carefully consider the risks involved and take appropriate precautions to mitigate potential losses.
  2. Volatility: The value of staked cryptocurrency may fluctuate over time, exposing participants to potential losses or gains.  What's more, the  number of rewards earned decreases the more popular a chain becomes with stakers. Just like your bank account interest varies with economic conditions, the initially promised percentage of rewards is not guaranteed over the long term. It’s important to note, that in some blockchain networks, “unstaking” requires an unbonding period - during which the user is not generating rewards, and the asset is not usable. This also means that it cannot be sold in the case of a market downturn until the unbonding is complete, which may result in financial losses.   
  3. Technical Complexity: Unless you are staking with a service provider such as Uphold, using our easy-to-use mechanism, staking often requires participants to possess a certain level of technical expertise to set up and maintain their staking nodes
  4. Slashing Penalties: Validators may face slashing penalties if they act maliciously, fail to validate transactions correctly, or go offline for extended periods. Slashing can result in the loss of a portion or all of the staked assets, serving as a deterrent against dishonest behavior and ensuring the network's security and reliability.

Lesson 22: A roundup

  • Staking rewards incentivize users to actively participate in network operations by validating transactions and creating new blocks.
  • Participants earn rewards in the form of transaction fees or newly minted cryptocurrency for their contribution to the network.
  • Staking rewards offer benefits such as passive income, enhanced network security, and promotion of decentralization.
  • However, users should be aware of the associated risks, including the potential loss of staked assets, market volatility, and technical complexities.
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