From Miners to Stakers: How Staking Secures the Ethereum Blockchain

• One of the defining features of public blockchains is their ability to operate without any central authorities. To accomplish this — while also governing how their networks function — they incorporate a set of algorithms and economic incentives, together known as consensus mechanisms.
• The Bitcoin network is secured by miners through a Proof of Work (PoW) consensus mechanism, while Ethereum is secured by stakers through a Proof of Stake (PoS) consensus mechanism. Unlike PoW, where miners secure the network through computational power, PoS involves stakers demonstrating “skin in the game” by putting their token capital at risk.
• Stakers earn rewards for the service they provide in maintaining the blockchain. Token holders who stake their assets and validate transactions can therefore generate income. However, staking rewards are typically modest relative to token price volatility, and price variability should be considered the primary source of risk and potential return for most crypto asset investments.

Public blockchains offer a new way to organize digital commerce, based on open-architecture platforms without any central authorities. Unlike corporations, which are overseen by boards of directors and governed by their countries’ laws, public blockchains are global decentralized computer networks, secured through cryptography and economic incentives. The mechanisms used to align economic incentives and keep the networks functioning properly are arguably the core innovation of this new technology.

Proof of Stake vs. Proof of Work

Blockchains store the same information on every node across their networks.[1]  To come to agreement about the correct information to store on the network, the nodes must arrive at a consensus, without the help of a central authority. To govern this process, every public blockchain incorporates a “consensus mechanism”: a prescriptive decision-making algorithm, grounded in economic incentives, which brings the nodes into agreement.[2]

Bitcoin’s consensus mechanism is called Proof of Work (PoW). Under PoW, specialized service providers called miners compete to solve a computational problem, with the winning miner gaining the right to update the blockchain and earn token rewards.[3] These puzzles are solved by brute force (i.e., through repeated guessing) and therefore require significant resources, including upfront capital expenditure and ongoing electricity costs. As a result, solving the puzzle provides proof to other network participants that the winning miner has a vested economic interest and can be trusted to update the chain. For their services, miners earn token rewards.

Ethereum originally used the same PoW algorithm but transitioned in 2022 to a new consensus mechanism, Proof of Stake (PoS). This approach also relies on economic incentives; however, instead of solving an energy-intensive computational problem, network participants demonstrate their vested economic interest by “staking” their Ether, the native token on the Ethereum blockchain. Stakers are responsible for validating transactions and updating the blockchain. Those who perform these duties correctly are rewarded with additional tokens, while those who act against the interest of the chain can see their stake “slashed” (i.e., penalized and reduced). Because stakers’ economic interests are aligned with the healthy functioning of the chain — they have “skin in the game” — they can be trusted to validate transactions and update the network. Unlike mining, staking consumes a small amount of electricity[4], and is considered by some to be a more environmentally friendly approach to blockchain consensus.

Although Bitcoin remains the largest public blockchain by market capitalization, PoS networks have gained in popularity. For example, more than half of the protocols in our Currencies Crypto Sector and Smart Contract Platforms Crypto Sector use a PoS consensus mechanism. On a market capitalization basis, PoS-based chains account for about 30% of the total market cap of these Crypto Sectors, and 90% of the market capitalization excluding Bitcoin (Exhibit 1).

Exhibit 1: Excluding Bitcoin, PoS now dominant consensus mechanism

Ethereum Transactions and the Role of Stakers

On a PoS blockchain like Ethereum, stakers are responsible for validating that all transactions conform to the network’s rules.  Without this service, the blockchain couldn’t function.

To better understand the role of stakers, it can be helpful to consider the mechanics of an Ethereum transaction. As shown in the stylized description in Exhibit 2, an Ethereum transaction involves roughly eight steps (Exhibit 2). While users initiate the process and some steps can involve other specialized service providers[5], most of the steps require the active involvement of validator nodes. Because all Ethereum transactions (or other changes of state) occur through the coordinated action of validator nodes, in effect, stakers are responsible for running the blockchain.

Exhibit 2: Validator nodes are responsible for processing transactions

For providing these services, stakers earn rewards in the form of additional tokens, which come from fees paid by users and from new issuance. On Ethereum, fees are divided into base fees and priority fees (“tips”). The network automatically burns the Ether paid as base fees, designed to benefit all users through a reduction in token supply. Stakers earn priority fees[6] as well as newly issued Ether (Exhibit 3). Ethereum staking involves a variety of additional complexities not discussed here; for additional details, please see the Technical Appendix.

Exhibit 3: Ethereum staking rewards come from priority fees and new issuance

Staking Rewards and Income

Because of the token rewards, stakers can potentially generate income from their assets. In traditional markets, the best analogy might be to agricultural land. The land itself has a market value that may rise or fall in price over time, but it can also be put to productive use by planting crops. In the same way that staking rewards are a payment for the service of validating a blockchain, crops can be considered a payment for the service of farming agricultural land. In both cases, an asset owner is offering a useful service and generating service income.

Ethereum stakers currently earn an average reward rate of 3.1% (Exhibit 4).[7] According to calculations from data provider Allium, Ethereum’s staking reward rate has trended lower over time as the share of Ethereum supply has increased (when staked supply declines, the protocol offers a higher reward rate to incentivize staking activity). The day-to-day variability in the staking rewards also reflects changes in network congestion and priority fees: when network traffic increases, users typically pay higher fees to confirm their transactions.

Exhibit 4: Ethereum stakers currently earn an annualized reward rate of about 3%

For an Ethereum holder staking their tokens and providing validation services, staking rewards can be considered a source of income. For example, since the start of 2023, the spot price of Ethereum’s Ether token has increased by 173%.[8] Over this period, we estimate that staking rewards have averaged about 4.5% annualized.[9] Therefore, the hypothetical return for an Ethereum staker — including both price returns and staking income — would have been 192% (Exhibit 5)[10]. The calculation assumes that stakers correctly performed their responsibilities (i.e., earned all rewards and did not experience slashing) and did not pay any third-party fees.[11] In practice, the income earned by an Ethereum staker will depend on these assumptions.

Exhibit 5: Staking rewards can be considered income from assets

Although staking rewards can contribute incrementally to a token holder’s returns, compared to other assets, Ethereum’s staking reward rate is relatively low in the context of its volatility. In other words, investors should consider the token price itself, rather than the staking reward, to be the primary source of risk and potential return. For example, Exhibit 6 shows Ethereum’s staking reward rate relative to its volatility, compared to a variety of currency market “carry trades” and the dividend yield on certain equity indexes. Investments held primarily for their income typically have a high yield relative to their price volatility (otherwise gains/losses from prices changes will overwhelm the income returns). Ethereum has a relatively low staking reward rate relative to its price volatility — comparable to the dividend yield on U.S. equity indexes. These types of investments are typically held primarily for potential capital gains from price appreciation, rather than income returns.

Exhibit 6: Ether staking reward is modest compared to the asset’s volatility

Staking reward rates vary significantly across PoS blockchains. For example, several smaller networks (by market capitalization) offer nominal staking reward rates of 10%-20% (Exhibit 7). However, recall that staking rewards are typically funded through a combination of transaction fees and newly issued tokens. In many cases, high staking reward rates are only possible due to high token supply inflation, which may have implications for price returns. Therefore, investors should also potentially consider real (inflation-adjusted) staking reward rates (in the same way that analysts often consider real interest rates in the context of bond markets or currency markets). Ethereum’s supply growth is close to zero, so its nominal and real staking reward rates are roughly the same — about 3%. In contrast, while Filecoin (FIL) offers a nominal staking reward rate of 23%, circulating supply is expected to increase by 20% over the year[12], implying a real staking reward rate of just 3% (Exhibit 7).

Exhibit 7: High nominal reward rates often paired with high inflation

What’s at Stake

Consensus mechanisms are to blockchains what laws and property rights are to traditional business enterprises: one cannot exist without the other. As the crypto industry evolves, Grayscale Research expects that PoS consensus and staking will become an increasingly important part of the ecosystem. Although staking reward rates are typically low compared to crypto asset price volatility, they can be a source of additional income over time, so many token holders will be willing to serve as validators to earn these rewards.

Technical Appendix

While conceptually straightforward, in practice staking involves additional complexities, several of which are discussed below.

Four ways to stake

There are four ways to stake Ethereum: Solo Home Staking, Staking as a Service, Pooled Staking, and Centralized Exchanges. Solo Home Staking is the most impactful and trustless method, offering full control and rewards, but requires at least 32 Ether, a dedicated computer, and some technical know-how, enhancing network decentralization. The discussion above takes a Solo Staking perspective. Staking as a Service allows users to delegate hardware management while earning native block rewards, requiring 32 Ether and with withdrawal keys usually remaining with the user. Pooled Staking enables users to stake any amount of Ether, earning rewards through simplified processes involving third-party solutions and liquidity tokens, allowing easy exit but carrying third-party risks. Centralized Exchanges offer minimal oversight and effort, suitable for those uncomfortable with self-custody, but involve higher trust assumptions and centralization risks, consolidating large pools of Ether and providing a fallback option for earning yield.

Bonding/unbonding queues

The bonding/unbonding queues in Ethereum involve validators waiting to begin staking or to unstake due to the network's processing rate limit per epoch, known as churn (Exhibit 8). These queues protect the stability of Ethereum's PoS consensus. Queue durations increase if validators join faster than they are processed and decrease if fewer validators join. Churn is the rate limit on validators entering or exiting per epoch, adjusted based on the number of active validators to maintain consensus stability. An epoch is a period of 32 slots, each 12 seconds long, totaling 6.4 minutes, during which validators propose and attest blocks. Sweep refers to the time taken for funds to be withdrawn to a specified address after exiting the validator queue and becoming withdrawable; the more validators there are, the longer the sweep delay.

Exhibit 8: Validators often must wait to enter and exit

Liquid staking derivatives

Liquid staking derivatives (LSDs) were created to address the lockup nature of staked Ether, providing liquidity to staked assets that would otherwise be inaccessible. When users stake Ether with a liquid staking provider, they receive an LSD token representing the staked Ether. This token is fungible, transferable, and can be used in various decentralized finance (DeFi) activities. LSDs unlock the liquidity of staked Ether, allowing users to earn additional yield through DeFi activities such as lending, providing liquidity, and using it as collateral, while still earning staking rewards.

­Restaking

Restaking involves using already-staked Ether to simultaneously secure the Ethereum network and other decentralized protocols, earning additional rewards. The purpose of restaking is to help less developed protocols leverage Ethereum's robust validator community without incurring high costs and resources. Restaking was introduced by the third-party protocol EigenLayer, not through an Ethereum Improvement Proposal (EIP) or the Ethereum Roadmap.

[1] Light nodes store only a subset of the blockchain’s information.

[2] Fork choice rules and social coordination can also be considered part of the consensus mechanism.  

[3] There can be more than one winning miner, which results in orphan blocks.

[4] Source: Ethereum.org.

[5] In the initial stages, searchers, builders, and relayers may be involved in preparing transactions.

[6] Priority fees are earned by the block proposer.

[7] For comparison, the U.S. agricultural sector earned a yield of about 3.5% over the five years ending in 2022, defined as net farm income as a percent of farm assets. Source: USDA, Grayscale Investments. Data as of latest USDA report, February 2024.

[8] Source: Artemis. Data as of July 28, 2024.

[9] Source: Allium, Grayscale Investments. Data as of July 28, 2024. Simple average of annualized staking reward rate since January 1, 2023.

[10] In order to reach a hypothetical return for an Ethereum staker, we took the price change of ETH and the staking rewards across all validators over the time period and added the returns. This return is hypothetical and does not reflect the actual return of any investor. Actual returns may be higher or lower. This hypothetical return does not include fees, the inclusion of which would impact returns.  See Important Information for additional details.

[11] Total returns include gains from Maximum Extractable Value (MEV), which is an additional of potential earnings for block producers based on the ordering of transactions.

[12] Source: Token Unlocks, Grayscale Investments. Data as of July 29, 2024.