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SPIRIT Blockchain Research / 2022 Staking and Proof-of-Stake Consensus

In this piece, we dive into the concept of Staking, Proof-of-Stake (PoS) consensus, the opportunities provided by staking native tokens and potential risks involved.

Introduction

Staking is the act whereby a holder of a certain cryptoasset sets aside all or a portion of those assets to be used as collateral for the chance to validate blocks as part of the network’s consensus mechanism. From an investor’s perspective, staking can also be a way to earn rewards for putting these cryptoassets to work. By staking digital assets, a holder becomes an important part of a blockchain network’s security infrastructure. Staking is central to Proof-of-Stake (PoS), the newer consensus mechanism that powers Ethereum 2.0 and other high-performance blockchains.

Background

Over the past two years, the blockchain landscape has rapidly evolved into a multi-chain world. Since its birth in 2015, Ethereum has quickly grown into the world’s most used programmable blockchain that every day settles millions of transactions and tens of billions of dollars in volume. It is home to most decentralized finance (DeFi) protocols and non-fungible tokens (NFTs), among many other things. On the downside, Ethereum’s impressive growth is also the source of its challenges such as congestion and rising transaction fees, which has priced out millions of potential users. Developers have been working on an eagerly awaited upgrade that aims to vastly improve on scalability, security and energy efficiency, without compromising on decentralization.

Meanwhile, more and more high-performance blockchains have appeared on the scene. These Alternative Layer 1 platforms set out to tackle Ethereum’s scalability problem without compromising too much on decentralization and security. While block production in both Bitcoin and the current version of Ethereum rely on Proof-of-Work (PoW), these Layer 1s use Proof-of-Stake (PoS) as a consensus mechanism which has allowed them to scale quickly. The new PoS protocols’ native tokens have accrued tens of billions in value while each securing multi-billion DeFi and NFT ecosystems.

Proof-of-Work vs. Proof-of-Stake

To grasp the concept of Alternative Layer 1s and staking, it is important to zoom out and briefly look into why PoS was created. To do this, we have to start with PoW, best known for its implementation in Bitcoin. In the Bitcoin network, nodes and miners agree on blocks of data that contain valid Bitcoin transactions. Since Bitcoin is an open network, any node can propose blocks and announce it to the network. To obtain the right to add a new block to the Bitcoin blockchain, however, nodes must first complete the computationally complex task of PoW – also known as mining. The first miner to solve the task is then permitted to add a new block to the blockchain, and in return also receives a block reward (currently 6.25 newly minted BTC) as well as transaction fees from all transactions contained within the specific block. Bitcoin only accepts blocks that extend the longest chain which is why the “longest chain rule” is the network’s consensus mechanism.

Enter Proof-of-Stake, an increasingly popular alternative to PoW. The validation mechanism was created as a partial solution to the critiques of PoW mining, incl. lack of network scalability, high entry barriers to participation and a large energy footprint. While some of these points of criticism are partly unwarranted or at least debatable, PoS blockchains have undoubtedly caught on. Unlike in PoW, there are no miners in PoS. Rather, PoS assigns the right to create a block through a deterministic lottery process, instead of computational expenditure.

In theory, a protocol could simply select any node for proposing a new block. This is where the issue of identities comes in. Identities on the internet are difficult to verify. For example, a single individual can impersonate any number of people by running multiple instances of the same program to gain more influence. To remain secure, a blockchain must have a mechanism to keep out bad actors, or at least disincentivize malicious behavior. One approach to solving this problem is to make it more expensive for a single actor to pose as many different identities, also referred to as “sybil resistance”. PoW achieves sybil resistance by requiring each miner to solve a computationally hard puzzle. To participate in this capital-intensive process, miners need to build out expensive infrastructure and deploy large amounts of costly mining machines that consume large amounts of energy.

PoS protocols use an entirely different sybil-resistance mechanism. Instead of relying on a computationally intensive process, PoS uses the networks’ native tokens as a ticket to block production. PoS is the idea of selecting block producers with skin-in-the-game based on how many tokens they own, that is, the proportion of tokens they own relative to the total amount of tokens in circulation. The more tokens someone holds, the higher their chances of being selected to propose the next block.

Staking

As described, the PoS consensus mechanism requires the commitment, or staking, of tokens in exchange for the ability to validate transactions. Staking is the process of locking up a blockchain’s native token to contribute to its economic security. A validator participates in consensus by running software that confirms transactions and when chosen by the algorithm, proposes a new block. Producers of a valid block are entitled to receive staking rewards. Broadly speaking, the amount of funds staked increases a validator’s odds of being assigned the right to produce the next block. Hence, staking nodes with larger balances have a higher probability of being selected to produce blocks. Staking rewards from PoS block production are typically a combination of block rewards and transaction fees.

Active Validators vs. Delegators

In return for staking their tokens, holders receive staking rewards. For token holders, there are two different ways to participate in staking (i.e. PoS consensus), either by 1. running a validator node or 2. delegating tokens to an active validator.

An active validator participates in PoS consensus by running software that confirms transactions and when chosen, creates a new block. To become an active validator, nodes must meet certain criteria, such as holding a minimum amount of tokens, maintaining adequate IT infrastructure, ensuring high uptime of the nodes as well as the technical skills to upgrade the nodes in the event of protocol updates. The entire group of a blockchain’s active validators is usually referred to as a validator set.

Token holders that do not run their own validator nodes can also help secure the network and validate transactions by staking their tokens as a delegator. They can stake their assets with an active validator, effectively transferring the task of validation in exchange for a small fraction of the earned staking rewards (e.g. 5%). Once tokens are delegated, typically by locking them up in a smart contract, they will count towards the stake of the selected validator. Importantly, delegators typically remain in control of their tokens by continuing to hold the private keys themselves.

Staking Rewards

Since staking rewards are paid out in the native token, it is important to point out that the yield earned on staking a token in U.S. dollar terms (or in that of any other sovereign currency or cryptoasset) is difficult to predict. This is because 1. the staking rewards are based on current conditions of the network and annual issuance rates and 2. the native token price can be subject to significant price fluctuations against sovereign currencies. Put differently, this means that if the decline in the price of a PoS token exceeds the annualized staking reward, the value of the token investment in U.S. dollar terms will decrease. A common misconception is that staking rewards provide a guaranteed source of income or can be used as a passive income strategy. Bear in mind that the primary goal of staking is not to earn a constant yield, but to contribute to the network’s security.

Risks and Caveats

Since validators are entrusted with the crucial task of creating new blocks, PoS protocols put in place measures to discourage bad actors. A penalty mechanism called slashing is used to disincentivize misbehavior and downtime. While the details of slashing vary among protocols, it may entail the loss of a certain percentage of a validator’s tokens or a ban from future staking activities if a validator does not follow the rules.

While PoS protocols have a different security model than their PoW counterparts, they are by no means immune to attacks. To effectively control the network and approve transactions, a node would have to own a majority stake in the network, also known as the 51% attack. However, to gain the upper hand in a PoS blockchain, an attacker is required to purchase a significant portion of the circulating token supply. The fact that major PoS blockchains typically have 60-80% of their tokens staked makes it harder for attackers to acquire the necessary tokens in the market. More importantly, slashing penalties and a likely drop in the token price in the aftermath of a compromised blockchain would expose the attackers to large economic losses. Validators could also be subject to regulatory and legal risks, such as crackdowns by policymakers or a changing legal environment, resulting in restricted access for delegators or a discontinuation of validator nodes. While such risks are non-negligible, they are manageable, especially when compared to the above-mentioned counterparty risks.

There is one caveat when it comes to the meaning of staking. Over time, the term has been increasingly watered down and repurposed into a fairly misleading and vague version whose sole meaning is to lock-up tokens to reduce sell pressure. While this loose definition of staking is now widespread in the broader ecosystem, it has little to do with its original form where holders contribute toward a blockchain’s security and receive a reward for participating in a consensus mechanism with the risk of losing their capital.

Conclusion

Part of SPIRIT’s core thesis is that crypto is well on its way to a multi-chain future. We have high conviction in both well-established and more nascent Layer 1 blockchains and the crucial role these platforms will play for sound money, DeFi, NFTs and Web3.

Going forward, SPIRIT Blockchain will commit significant capital and resources in the form of staking to help secure the network of key PoS blockchains and help grow the decentralization of these protocols – both through an active validator role and through delegation. SPIRIT will also actively contribute to the governance of these networks and support the ecosystem.

Written by Manuel Trojovsky, Advisor Investment & Research