What is Ethereum staking? How does it work? Detailed explanation by Digimagg

In September, Ethereum (ETH)) undergoes "the merge," transitioning to a proof-of-stake consensus, departing from its current proof-of-work system akin to Bitcoin (BTC). This update aims to address issues such as high energy consumption, scalability, and transaction fees. Shifting to proof of stake is expected to slash energy usage by 99.95% and enhance transaction speeds. But what does proof of stake entail? And how can everyday investors engage in Ethereum staking?

What is Ethereum staking?

You've likely come across the concept of cryptocurrency miners who verify transactions on proof-of-work blockchains like Bitcoin. These miners use powerful computers to solve complex mathematical puzzles, consuming significant amounts of electricity. Some prominent cryptocurrencies, notably Bitcoin, have faced considerable criticism due to their escalating energy consumption.

Staking presents a primary alternative to proof of work. Even after Ethereum transitions to proof of stake, numerous volunteers will continue to validate transactions on the blockchain. However, unlike the energy-intensive process of solving mathematical puzzles with high-powered computers, Ethereum staking involves locking up ETH on the blockchain—staking it, essentially—to earn the privilege of validating transactions and receiving additional ETH as a reward.

How does Ethereum staking work?

Becoming a validator, also referred to as a staker, entails network participants locking up 32 ETH on the blockchain, which translates to a substantial amount exceeding $50,000 at current ETH prices.

Once validated, participants are randomly tasked with validating transactions, creating new blocks, and upholding the blockchain's overall functionality. Stakers receive a yield in ETH in return for staking their ETH. This yield diminishes if a validator fails to validate a block after being assigned the responsibility.

Moreover, validators risk penalties through "slashing"—whereby the network seizes some or all of a validator's staked ETH—for engaging in malicious activities such as colluding to validate blocks incorrectly. These incentives theoretically motivate validators to act responsibly to earn passive income and avoid slashing.

In practice, Ethereum validators have been engaged in staking for several months. The Beacon Chain, the upgraded proof-of-stake network set to merge into the primary Ethereum network around September 15, was initially launched on December 1, 2020. Since then, investors have had the opportunity to participate in staking on the network, with their staked ETH remaining locked up until after the upgraded blockchain becomes operational.

Ethereum staking groups

With the current prices, acquiring 32 ETH presents a significant barrier for most average investors interested in Ethereum staking. Many individuals may not have the capacity to lock up such a large amount of ETH to become validators.

This is where staking pools come into play. They offer a solution by enabling individuals to collaborate and pool their resources to meet the minimum requirement of 32 ETH to become a validator. Subsequently, the rewards are distributed proportionally among the participants of the pool.

While Ethereum lacks a native protocol supporting staking pools, numerous major cryptocurrency exchanges like Kraken and Binance.US, as well as third-party providers, offer staking pool services. For instance, Binance.US users can stake their Ethereum and earn a 6% annual percentage yield (APY).

Staking pools, whether offered through cryptocurrency exchanges or other platforms, open up opportunities for more ETH holders to participate and generate passive income.

As illustrated in the chart below, over 13 million ETH is presently locked up in staking contracts, a substantial portion of which is through third-party mining pools. This equates to approximately $22 billion worth of ETH, representing nearly 11% of the total supply.

It's crucial to emphasize that the merge won't enable existing validators to retrieve their staked ETH. Withdrawal will solely be feasible following the completion of the Shanghai upgrade at a subsequent time.

Lido DAO and Ethereum staking

Existing Ethereum validators have avenues to access liquidity before the subsequent upgrade takes place.

One such option is Lido DAO, which offers a liquid staking solution. Here's how it operates: Participants lock up their tokens in exchange for receiving liquid tokens known as stETH, or staked ETH.

Introduced in December 2020, shortly after Ethereum's Beacon Chain enabled staking, Lido has emerged as the predominant market leader for Ethereum liquid staking, capturing over an 80% market share earlier this year. It is also decentralized, unlike many other liquid staking alternatives.

Through Lido, stakers not only receive ETH staking rewards but can also leverage the stETH tokens they receive to earn additional yield or trade within the decentralized finance ecosystem.

Although the stETH/ETH ratio ideally should be 1-to-1, this parity hasn't always been maintained. During the contagion crisis, which ultimately led to the centralized crypto lender Celsius filing for bankruptcy in June, stETH was trading at a discount to ETH of up to 8%. This discrepancy reflected extreme market fear and the realization that Celsius held a significant amount of stETH on their balance sheet, seeking liquidity amid the suspension of customer withdrawals.

What earnings can you expect from staking Ethereum?

The returns from staking Ethereum (ETH) are not fixed but rather fluctuate based on the number of validators participating at any given time. When there are fewer validators, the protocol increases rewards to encourage more stakers to join.

Presently, stakers are earning approximately 4% to 7% annually. However, some analysts anticipate that this figure could rise to 8% or higher following the merge before eventually decreasing again.

Regarding dollar gains, the yield percentage earned depends not only on this base rate but also on the price of Ethereum, which has exhibited significant volatility. ETH has experienced a decline of over 54% in value this year alone.

Is investing in Ethereum staking advisable?

If you plan on holding Ethereum for the long term, staking could prove to be advantageous. The additional yield obtained can augment your overall ETH holdings.

However, there are circumstances where staking may not be appropriate. One drawback is the loss of liquidity as the ETH becomes locked up for an extended period.

While platforms like Lido can mitigate this issue, there's no guarantee that market sentiments won't unexpectedly alter, causing the stETH/ETH ratio to deviate from the 1-to-1 ratio. The instability witnessed in the stablecoin market meltdown in May 2022 serves as a cautionary example.

The key factor to consider here is your investment horizon and willingness to hold onto ETH. Ethereum, like other cryptocurrencies, entails considerable volatility and risk, making it imperative to conduct thorough research and brace yourself for the unpredictable nature of such investments before diving in.