The Anatomy of Staking Yield

If you follow cryptocurrency, you’ve likely come across the term staking in relation to various crypto assets and applications. As the ecosystem has grown, we find that the word staking has become more of an umbrella term, referring to multiple different practices among users, leading to confusion in an already complex industry.

The two main uses of the word staking refer to:

1. Depositing tokens into an application to support a service offering for users, and

2. Locking tokens on a network to propose, attest, and add blocks to a blockchain

The former helps form the foundation of sectors like Decentralised Finance (DeFi), which strives to replicate financial services traditionally offered by institutions and intermediaries, but within cryptocurrency platforms using open sets of collaborators (we’ve written more on this here). The latter however, supports the ongoing operations and security of the Proof-of-Stake (PoS) blockchains that DeFi applications often depend upon to settle transactions. It is a revenue-generating task inside PoS networks that, combined across all chains, has garnered $15 billion in annualised rewards thus far in 2022.

In this article, we’re going to dissect staking according to the second definition above, where PoS blockchains employ stakers to generate and secure their transaction record. Particularly, we’re going to address how these stakers — often called validators — earn yield in exchange for their efforts, and what factors may affect that yield.

In PoS systems, new blocks are added to the chain by specialised network participants called validators, who are required to both run certain software and lock (or stake) tokens, as a sort of collateral, in order to participate. The software outlines the system’s protocol rules, and among a broader set of instructions, they determine which validators get to submit new blocks and when.

The protocol automatically assigns validators to future time slots, where the likelihood of being selected is proportional to a validator’s total share of the locked (or staked) tokens on the network. Once a new block is proposed, if valid by the rules and approved by other validators on the network, the validator receives a reward. Otherwise, if the submitted block is invalid, the assets locked by the validator are reduced (or slashed) as a penalty for violating the protocol rules.

Let’s say you’re a validator and you’re lucky enough to be chosen by the protocol to submit a new block to the chain. You add the block, it’s valid, and everyone agrees — you earn the block reward. The block reward is made up of the amount of new token supply issued in the block, plus the sum of transaction fees offered in the block (1).

Given there are effectively no operational expenses for staking and it only involves the locking of assets, the staking yield equation is somewhat simple to calculate:

However, there is both known and unknown information that these variables are derived from, making it slightly more challenging to forecast a staking yield. For example, transaction fees (as part of the block reward) are generally a voluntary payment by users, often reflecting both the amount of pending transfers on a network and the time sensitivity of a user’s transaction.

Additionally, new token issuance in PoS blockchains has historically been a dynamic measure based on the total network stake, which can be particularly challenging to predict in an emerging industry that continues to experience rapid development. When fully illustrated, the specifics of a validator’s yield calculation look more like this:

Take note of the final bubble of the equation relating to penalties called slashing, a common incentive mechanism for PoS systems that is designed to encourage validators to act in good faith. These penalties generally result from breaking protocol rules, and while they are oftentimes not factored into network staking yields, we find it to be an important consideration, especially because some of the behaviours constituting a penalty may be accidental, such as temporarily having a node go offline. The mechanics associated with slashing vary per protocol as validators are subject to different sets of rules, however, the punishments are generally realised through either a reduction in validators' locked assets or their rewards.

Validators are selected to add blocks to the chain based on their proportion of staked tokens, therefore a major factor in forecasting yield is the total amount of staked tokens on a network. In other words, your share of the total amount of staked tokens determines your share of the total rewards. This means to have a consistent share of a network’s total rewards, a validator’s staked balance would need to mimic changes to the total amount staked on the network.

However, even if a validator’s share of total rewards is held constant, the total reward itself may change over time. This is because the component parts of the rewards are not fixed, namely the issuance of assets and transaction fees per block.

For example, if a protocol reduces its inflation rate (the amount of tokens printed/minted each year), decreasing the amount of new supply released in each block, the total rewards released to all stakers would be reduced. Similarly, if transaction volumes slow, the competition among users to bid their transactions into blocks is lowered, decreasing the transaction fees per block.

Note that the rewards available to stakers would alternatively increase with a higher inflation rate and greater transaction fees. These factors are both unpredictably variable and tend to change bi-directionally over time according to user and developer behaviour.

In the case of Ethereum’s future plans of a Proof-of-Stake Blockchain, the issuance rate of new ether will be dynamically adjusted based on the total amount of staked assets, a design choice meant to encourage staking [with higher supply inflation] when validator participation is low and discourage staking [with lower supply inflation] when validator participation is high.

The above figures show that despite the total issuance rewards nominally increasing as the total amount of stake grows, both issuance and total yields compress, meaning the available rewards are increasing slower than the total amount staked.

In the end, staking yields depend on;

1. The total amount staked, and

2. The total amount of rewards released to stakers

However, each of these factors is subject to changes, especially the rewards released to stakers, which in turn are based on:

1. The inflation schedule of the protocol, and

2. The transaction fees of users

Staking yields are delivered in-kind, meaning the issuance and transaction fees rewarded to validators are denominated in terms of the staked token.

In the event a token’s price in dollar terms crashes, there is no direct effect on a network’s staking yield. The dollar price of the token isn’t directly tied to: the total amount of staked tokens, the inflation rate, or the transaction volume. Thus, the amount of tokens delivered to stakers will remain the same, however, the value of those tokens measured in dollars will certainly decrease.

It is worth noting that a decrease in prices may change the behaviour of certain parties that could indirectly affect the staking yield. For example, a reduction in price may cause less speculation among investors, resulting in less lending or trading activity in a network’s suite of applications. The change in users’ behaviour could then result in less transaction volume on the network, reducing the portion of staking yield derived from transaction fees.

The CoinShares Research Team believe that staking is a promising revenue generation tool for investors, potentially dampening the negative impact of dilution in inflationary PoS assets. However, it is unclear whether staking will be a reliable real-earnings strategy for business ventures, and also whether these staking assets will continue to accrue value beyond their speculative developmental stages.

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(1) Note: some PoS protocols “burn” a portion of transaction fees, effectively removing them from supply and excluding them from the block reward.