What staking is
In a proof of stake network, validators lock up coins as a deposit that backs their work of proposing and confirming blocks. In return the protocol pays rewards. People who do not want to run a validator themselves can often take part through delegation or through a staking service, which passes on part of the rewards. The overall idea and the security reasoning are summarised in the comparison of proof of work and proof of stake; this article concentrates on the money side.
Where the reward comes from
Staking rewards usually have two sources:
- New issuance. The protocol creates new coins and distributes them to validators. The issuance rules differ by network and may change through governance, so a network’s current rate should be checked at its source.
- Transaction fees and similar income. Users pay fees for block space, and part of that income goes to validators. On some networks there are additional rewards linked to extracting value from transaction ordering, which tend to vary a lot.
If issuance is the main source, staking is a way of sharing in the creation of new coins. This has an important consequence: rewards are not new wealth in an economic sense when they come from issuance. Holders who do not stake are diluted relative to those who do, which is why stakers are sometimes said to be protecting their share, not simply earning a profit. A similar logic applies to Bitcoin’s own issuance rate, although the mechanisms differ.
How yield is expressed
Staking yield is usually quoted as an annual percentage of the staked amount. A simple illustration with made-up numbers:
- You stake 1,000 coins.
- The network pays 4 percent per year in rewards before costs.
- After one year you receive about 40 coins, so the stake is about 1,040 coins.
The figure is only a nominal gain in coins. Whether you are better off in dollar terms depends on the coin’s price, which can move by far more than 4 percent in either direction. A positive yield in coins can still be a loss in currency terms. Yield is also not a fixed promise. It often falls when more coins are staked, because the same total rewards are shared among more participants, and it can rise or fall with fee income.
Compounding happens if rewards are added to the stake automatically. On some networks that is manual or done through a service, and it affects the effective figure.
Validator costs and the net picture
Validators have costs, and net returns are lower than headline yields:
- Hardware or cloud servers, plus a reliable internet connection and monitoring.
- Time and expertise to keep the software updated and secure.
- Fees to a staking provider or a delegation commission, often a percentage of the rewards.
- Possible tax obligations on rewards, which differ by country and are outside the scope of this article.
Large operators spread fixed costs over many deposits, which is one source of the concentration concerns raised in proof of stake designs.
Risks
Slashing. Some misbehaviour, such as signing conflicting blocks, can lead to a part of the stake being destroyed. Honest mistakes in setup, such as running the same keys on two machines, have caused slashing in practice. Smaller penalties apply for being offline.
Lockup and exit delays. Many networks require stakers to wait through an unbonding or exit queue before they can withdraw. During that period the coins cannot be sold, even if the price is falling. This is a liquidity risk that headline yields leave out. Wider liquidity effects on markets are covered in the discussion of market liquidity.
Price risk. The staked asset can fall in value, and the reward does not protect against that.
Counterparty and smart contract risk. Staking through an exchange or a service means trusting it with the coins or with the keys, which links to counterparty risk. Liquid staking tokens add a layer of contracts and a second token whose price can drift from the underlying coin. A bug or failure in those layers can cause losses.
Governance and rule changes. Reward rates and rules can be changed by the network community. Past yields say little about future ones.
Regulatory uncertainty. Different jurisdictions treat staking services differently, and that can change; see regulatory news for how such developments get reported.
Yield is not free money
Higher quoted yields typically signal higher risk, newer networks or heavier dilution. A network paying a large percentage is often creating many new coins, which can weigh on the value of each coin. A yield should be read together with the issuance schedule, the share of coins staked and the size of the lockup, which are the elements that tokenomics basics teaches readers to check.
Staking and the market
Staked coins are removed from immediate circulation, which some argue reduces the supply available to trade, while others point out that liquid staking tokens can partly undo that effect. The link to price is not clean. As with mining, the economics of the participants affect the network, but they do not guarantee any price outcome.
Cryptocurrency prices are volatile, rewards are not guaranteed, and people can lose some or all of what they stake. This article is educational and is not financial, tax or legal advice.