September 2022 marked the arrival of the Ethereum merge, the long-awaited upgrade of the Ethereum (ETH) network from proof-of-work to a proof-of-stake consensus mechanism.
Ethereum has run on a Proof-of-Work model similar to Bitcoin since its inception, which uses vast amounts of electricity to mine crypto. The previous consensus mechanism was a hurdle in letting Ethereum scale and it was also responsible for high transaction fees.
By upgrading from PoW to PoS, Ethereum network has significantly reduced its energy consumption. The shift to PoS has also helped boost the network’s transaction speeds.
What Is Ethereum Staking?
In a PoS consensus mechanism, staking is the process of actively participating in transaction validation. As compared to PoW, which requires miners to compete for rewards based on the amount of computational power they can acquire, PoS mechanism randomly selects validators relative to the total amount and time their ether has been staked.
How Does Ethereum Staking work?
PoS validators, unlike in PoW, don’t need to mine blocks to maintain the network. PoS validators create new blocks when chosen, and validate others when not. Once a participant has validated the latest block of transactions, other contributors can confirm the block is valid. When enough attestations are made, the blockchain network adds a new block.
To become a validator on the Ethereum network, participants need to lock up 32 ETH on the blockchain. At the time of writing, 32 ETH is worth around $45,313.
After validators are assigned the responsibility of validating transactions, creating new blocks and maintaining the overall functionality of the network, they earn a yield paid in ETH. If a validator fails to validate a block once assigned the responsibility, his yield is denied.
A validator can be penalized for engaging in malicious activity, such as colluding to validate blocks incorrectly. As a penalty, the network confiscates some or all of a validator’s staked ETH. This process is described as Slashing.
Ethereum Staking Pools
For an individual participant to put up 32 ETH for validating transactions on Ethereum is a pretty huge sum. This is where Ethereum staking pools come in. These pools provide a way for individual participants to come together and fulfill the minimum mark of 32 ETH required to become a validator. The combined yield is then divided pro-rata among those individual participants.
According to Statista’s data, Liquid staking project Lido beat major crypto exchanges Coinbase, Kraken, and Binance as the biggest staking pool for Ethereum in 2022.
Crypto exchanges also offer low or no minimum staking requirements, making it easy for anyone with any amount of capital to participate in staking. However, there are downsides to staking ETH on crypto exchanges as a percentage of your yield will be taken by the exchange itself. And centralized crypto exchanges are always at risk with regulations depending on which country you live. Other than regulations risks, centralized crypto exchanges are always prone to security breach and sudden bankruptcies. Well, FTX suffered both at the same time.
Pros of Staking
Passive Income – Staking Ethereum is an easy way to earn yourself some passive income. Once you put your ETH in a staking pool and agree to the terms and conditions, you’ll earn a part of the entire yield. Currently, the Annual Percentage rate on Ethereum staking is 4%. However, with the Shanghai upgrade happening soon, staking yield will increase many times.
Staking withdrawals – The upcoming Shanghai upgrade will enable withdrawals from Ethereum staking contracts, which are locked presently. The upgrade scheduled for March 2023 will significantly reduce the risk of staking ETH.
Environmental friendly – If you prefer staking Ethereum over mining bitcoin, you’d be taking part in an environmentally friendly process. Since staking Ethereum doesn’t require heavy computer machines that require a lot of energy, it would not bother your conscious.
Cons of Staking
Staking fees: One of the cons of staking ethereum is that you’ll have to put up staking fees. Different platforms charge different fees for allowing you to stake ethereum depending on where you are staking. However, the main disadvantage of staking on exchanges concerns security and fees.
Long term commitment: Once you have staked ethereum and are done with the process, you will not have access to liquidate your staking. Ethereum blockchain does not have this feature as of now. However, with the Shanghai upgrade approaching, this feature will be enabled.
Currently, the largest staked ETH service is Lido Finance. It accounts for nearly one-third of all staked ethereum. In exchange for you staking ethereum, Lido gives you an ERC-20 Token called stETH. Like, all other ERC-20 tokens, it is tradeable. stETH value is backed by ETH. However, the token has less utility than ETH.