Staking Primer

The concept of PoS was first introduced in 2011 by Sunny King and Scott Nadal in their Peercoin whitepaper. It emerged as an alternative to the energy-intensive PoW model, which requires miners to solve complex cryptographic problems using massive amounts of computational power to validate transactions and secure the network.

Over time, many industry participants argue that the capital expenditure and operational costs of mining Bitcoin have become a barrier for smaller players, leading to the centralisation of mining pools. Additionally, PoW as a consensus mechanism also has a challenge in scaling up its transaction throughput. As a result, the majority of newer blockchain networks have decided to adopt a different consensus mechanism than PoW, with PoS being the most popular alternative.

In PoS networks, those who help approve transactions and secure the network are commonly called “validators”. Validators are responsible for the same actions that miners do in PoW networks, such as validating transactions and securing the network. However, instead of deploying computational power, validators are required to “stake” the native token associated with the underlying blockchain network that they are participating in. In exchange for participating in the network, validators are rewarded with additional tokens.

There are numerous implementations of PoS. At its core, PoS validators are chosen to create new blocks and validate transactions based on the number of tokens they hold and are willing to "stake" as collateral. Validators are then incentivised to do the right thing as their staked tokens can be forfeited if they act maliciously or harm the network.

Instead of risking capital in the form of costs for mining hardware and electricity as they would in a PoW blockchain, validators in a PoS network risk their capital by staking the native token of the blockchain they are validating. This aligns incentives between the validators and the blockchain network while reducing the need to sell their rewards to cover expenses. The goal is to create a compounding loop that increases their market share (and consequently their rewards) if validators decide to stake their rewards.

Proponents of PoS argue that this compounding loop contributes to the safety of the consensus mechanism as validators have a vested interest in the long-term health of the network due to their staked tokens. This makes it expensive and unprofitable for attackers to compromise the network.

As institutions seek to expand their offerings in the digital asset space, staking creates opportunities to generate yield and introduce new products. For example, a staking index could be used as a total return benchmark if it tracked the performance of the underlying proof-of-stake asset and any staking rewards that were reinvested. Alternatively, a multi-asset staking index could track the yield associated with a basket of PoS assets.

Similarly, staking strategies can help with portfolio diversification, passive income generation, and contributing to the ability to earn a more predictable rate of return. Various models can be applied to include or exclude specific types of rewards, as well as variables related to validator fees, liquidity, and weighting.

Accurate and transparent staking data serves as the foundational backbone of staking-related strategies. Generally, datasets related to staking should include, at a minimum, details on the amount of tokens that are staked and the amount of tokens earned for each type of reward provided by the blockchain across a standardised time period.

Staking data providers should also be transparent about their methodologies and provide details on what is included or excluded in the calculation of their data. For the most accurate data, look to a provider that is running their own nodes and pulling data directly from the blockchain, rather than a provider that is reliant on third-party information.

We calculate the rewards as the staking return in a PoS consensus context. For each period of block validation and by a forward approach, we prove that the interest is given by the ratio of the average staking gain to the total staked coins. Some additional PoS features are considered in the model, such as slash rate and Maximal Extractable Value (MEV), which marks the originality of this approach. In particular, we prove that slashing diminishes the rewards, reflecting the fact that the blockchain can consider stakers to potentially validate incorrectly. Regarding MEV, the approach we have sheds light on the relation between transaction fees and the average staking gain. We illustrate the developed model with Ethereum 2.0 and apply a similar process in a POW consensus context.  For more information, see page 7 of this paper.