Ethereum Staking Yields Explained

Ethereum launched in 2015 as a proof of work protocol, similar to bitcoin, which requires miners to solve complex mathematical problems to validate transactions. However, it transitioned to a proof of stake consensus mechanism in September 2022, a highly anticipated event dubbed ‘the merge’. 

Ethereum relies on validators instead of miners. The protocol randomly selects a validator to create a new block of transactions, and others to attest (confirm) that the block is valid. To participate, validators must lock or stake a minimum of 32 ether (worth $75,990 as of 5th september 2024) in a smart contract. The higher the stake, the greater the chance of getting selected. Staking pools like Rocket Pool allow those who can’t meet this threshold to contribute to the protocol’s governance.  

In return, validators receive ‘block rewards’ in the form of ether, Ethereum’s native token. The protocol also penalizes bad behavior, such as failing to validate transactions or attesting invalid blocks, by confiscating a portion of a validator’s stake (a process known as slashing).  

This article explores the sources of block rewards and estimates the potential return, in terms of an annual percentage rate, that stakers can expect to earn.

Sources of rewards

Ethereum pays rewards for consensus-related tasks and the execution of transactions.

Consensus rewards

At the end of every epoch- a period lasting six minutes during which blocks of transactions are proposed and attested- the protocol rewards or penalizes validators based on their behavior.

• Proposer rewards- Proposers are randomly selected validators who earn rewards for proposing the next block to the chain.

• Attester rewards- Attesters are validators who vote to approve proposed blocks and checkpoints (at the end of each epoch) when transactions become immutable. As the protocol selects every validator to attest once per epoch, these rewards are paid most frequently and account for the greatest share of yields earned by validators.  

• Sync committee- After 256 epochs elapse (roughly 27 hours), the protocol selects validators to join the sync committee, which is responsible for ensuring that all nodes (entities running Ethereum’s software) have the latest version of the blockchain. While these rewards are relatively large, validators earn them infrequently, so they contribute least to overall yields. 

Given proposer and sync committee rewards are more random than attester rewards, their value to stakers typically fluctuates in the short term. But they should even out over the longer term.

Execution rewards

Rewards paid for execution activities are also variable and depend largely on demand for block space, the number of transactions each block on the Ethereum chain can hold.  

• Tips- Users can pay tips in addition to their transaction fees, known as gas fees, to encourage validators to include their transaction in the next block. 

• Maximal extractable value (MEV)- validators can earn MEV for including, excluding or reordering transactions in the blocks they create. Third parties called ‘searchers’ identify the majority of MEV opportunities and pay higher gas fees, which they share with validators. Here are a few examples of these opportunities:  

  • Frontrunning- The searcher identifies a profitable trade before execution and submits its own order first with a higher gas fee.  

  • Arbitrage- If two decentralised exchanges (DEX) list the same token at different prices, the searcher can buy the cheaper one and sell it on the other DEX.

  • Liquidation- Borrowers must pay a liquidation fee if the value of their collateral fluctuates and the intermediary has to sell it to repay lenders. Searchers monitor DEXs and claim this fee by being the first to process the transaction. 

ETH staking yields

Execution rewards are directly proportional to the number of transactions on the protocol - the greater the volume, the higher the tips and opportunities for MEV. That said, MEV rewards are only available to validators running software called MEV Boost, which allows them to outsource block creation. Currently, 89% of validators run this software, a percentage that is constantly rising. In contrast, consensus rewards are inversely related to the volume of ether staked on the protocol.

Below we show a snapshot model of ETH staking yields in the current market environment. Issuance represents all consensus rewards while execution rewards are consisting of Tips and MEV:

Demand for Ethereum block space is at historically low levels after the Dencun upgrade reduced fees on Layer-2s (chains that process transactions on behalf of the original protocol to overcome deficiencies) by up to 100 times. While this outcome suggests the upgrade was a huge success, the amount of ether removed from circulation after being used for transaction fees, known as the burn rate, has decreased and inflated overall supply.

Based on historical data, CoinShares expects 320,000 validators to join the network over the next year, which would set the annual percentage rate (APR) earned by stakers at around 2.8%. That said, the Ethereum community has recently started discussing modifying the rate at which the protocol issues new ether, which could affect the APR. 

Ether’s yield doesn’t just provide investors with a comparison with other protocols, it also sets a floor for lending rates offered by decentralised finance apps (dapps). Lending is riskier than staking, so dapps are reluctant to set interest rates below the yield. After all, if these rates are lower, investors could borrow from dapps and stake the funds, earning a return from the difference.   

Conclusion

CoinShares expects the yield on Ethereum to fall over time as validators stake more ether. Given the current low demand for block space, execution rewards are likely to account for 80% of returns. Meanwhile, validators will continue to join the network as the popularity of staking pools like Lido increases.