Generating passive income is the Holy Grail of crypto investments. The luckiest ones have been doing it since the late 00s or early 10s when Bitcoin traded at roughly 10 dollars. You can't repeat that, but fret not. There are ways to get on the money train and catch up with the pack – if not with the leaders.
Buying and selling tokens can yield high rewards but requires plenty of focus and dedication. For those who prefer a more straightforward way to earn income, staking might be an option. Let's explain the concept and delve into the mechanics to help you analyze the pros and cons and start reaping the rewards.
Proof-of-stake – a consensus mechanism behind staking
Staking is typically associated with Ethereum – the second biggest cryptocurrency by market cap and, more specifically, a decentralized blockchain platform allowing developers to build and deploy smart contracts and decentralized applications (dapps).
How does the proof-of-stake work?
In fact, the concept of staking has been around a bit longer than Ether (Ethereum's native token) and is linked to the proof-of-stake (PoS) – a consensus mechanism by which participants in a blockchain network agree on the validity of transactions and the ordering of blocks in the blockchain. Such an algorithm is necessary to ensure that all nodes in the network reach a joint agreement on the state of the ledger.
Apart from PoS, there are several other consensus mechanisms, such as proof-of-work (PoW), delegated proof-of-stake (DPoS), proof-of-authority (PoA), etc., each with its own way of achieving consensus and validating transactions, with varying levels of decentralization, security, and efficiency.
When was the PoS consensus mechanism launched?
The concept of staking debuted with Peercoin (PPC), a project launched in 2012. The cryptocurrency gradually moved from PoW to PoS and phased out PoW rewards, eventually relying solely on its PoS mechanism. PoS algorithms evolved into several variants, including delegated-proof-of-stake (DPoS), nominated proof-of-stake (NPoS), and others.
The mechanism (or rather a family thereof) is gaining traction due to its advantages over PoW, such as energy efficiency and scalability. It is estimated that today nearly 60% of public blockchains use the PoS or one of its variants.
When and why did Ethereum move from PoW to PoS?
Ethereum completed its long-awaited transition from PoW to PoS on September 15th, 2022, marking a critical milestone in the network's history. This shift, often referred to as The Merge, was driven by sustainability and scalability.
PoW relies on extensive computations and consumes tons of energy. PoS is far more efficient and scalable, allowing the network to process transactions faster and handle more users.
What is staking and how does it work in Ethereum?
Unlike proof-of-work, where miners perform energy-intensive mathematical operations to secure and verify transactions, PoS validators, aka stakers, lock up ETH tokens as collateral for a specified period of time to validate new transactions and add them to blocks, which then are added to the Beacon Chain – the new consensus model of Ethereum. Both miners and stakers get rewards for their effort, with validators receiving interest – denominated in Ether – on the coins they staked.
Validators are chosen to create new blocks and validate transactions based on the amount of Ether they hold and their reputation within the network. The more Ether a validator stakes, the higher their chances of being selected to propose and validate blocks. Validators are incentivized to act honestly, as any malicious behavior could result in their staked Ether being slashed.
Here's how staking works step-by-step:
Becoming a validator
A user can become a validator by locking up a specified amount of Ether (currently, the minimum for solo staking is 32 ETH) in a smart contract.
Validator selection
Validators are selected based on their staked amount. The more Ether a validator stakes, the higher their chances of being chosen to propose new blocks containing verified transactions.
Block proposal and verification
Once selected, the validator proposes a new block. Other validators on the network then verify the validity of this proposed block. They scrutinize transactions, ensuring they adhere to the rules of the Ethereum protocol. If all checks pass, the block is added to the blockchain.
Active participation
The validator is not a passive observer. They actively participate by running a node, which involves maintaining a copy of the Ethereum blockchain, validating transactions, and creating new blocks.
Rewards and performance
In return for the service, the validator receives a reward – usually in the form of additional Ether. These rewards are distributed based on the validator's staked amount and the overall performance of the network. Validators need to act honestly and efficiently. Misdemeanor or a misstep (going offline, proposing an invalid block, etc.) can result in losing some of the staked tokens.
The amount of ETH staking rewards can fluctuate depending on the number of validators participating at any particular moment. With fewer validators, the algorithm increases staking rewards to encourage more users to stake.
Unstaking ETH
At some point you may want to to withdraw your staked ETH and receive rewards. To unstake ETH, you need to provide your crypto wallet address where you want your money sent. You can set it up at the beginning or specify it later.
Then, you initiate the unstaking process by submitting a withdrawal request. The protocol requires a "withdrawal period" of at least four epochs (a unit of time in the Ethereum network, approximately 6.4 minutes) before you can move into the exit queue. The actual waiting time depends on how many validators want to take an exit – the limit is 16 validators per epoch.
How to stake Ethereum? The four types of staking
There are four main approaches to Ethereum staking, depending on your preferences and the amount of your ETH holdings. Essentially, staking requires depositing 32 ETH – let's admit it: a hefty amount – to activate validator software.
Being a validator is not just about money, though. Validators are responsible for keeping Ethereum secure for all its users by processing transactions, storing data, and adding new blocks to the network. How you participate in the effort is up to you (and your capital). You can choose from the following.
Solo staking, aka solo home staking
It's the most ambitious, impactful, and financially gratifying approach. It gives you full control over the process and yields the highest rewards (the Ethereum Foundation deems it "the gold standard for staking"). However, it's also the most demanding.
Solo staking involves running an internet-connected Ethereum node and depositing 32 ETH to activate a validator, which allows you to participate directly in the network's consensus. By staking on your own, you contribute to the decentralization of the Ethereum network, enhancing its resistance to censorship and attacks more than by engaging in other staking methods.
An Ethereum node consists of two types of software: an execution layer (EL) client and a consensus layer (CL) client. They work in unison with a set of signing keys to validate transactions and propose blocks. Since solo stakers are responsible for operating the necessary hardware to run these clients, it is advised that they use a dedicated home-based machine.
To set up a staking node, you'll need to choose a software client compatible with staking nodes – allowing nodes to interact with the Ethereum network. Popular options include Prysm, Lighthouse, Teku, and Lodestar.
As a validator, you must protect your private keys, implement necessary security measures, and keep your node available to avoid penalties. You also need to monitor your node's performance, update the software, and ensure the continuity of operations. On rare occasions, you may have to manage software upgrades and handle potential forks that might affect your staking setup.
Typically, solo stakers don't incur heavy penalties when they experience network disruptions or power outages. Such a risk exists, though, if a larger group of validators goes offline.
Benefits:
- complete control over your staking process,
- higher rewards received directly from the protocol,
- contributing to censorship resistance and the health of the Ethereum network.
Risks and downsides:
- a high minimum deposit for a single staker,
- technical complexity requiring advanced knowledge,
- possible penalties and missing out on rewards in case of a node dropout or malfunction.
Staking-as-a-Service (StaaS)
If you're eager to invest independently but without all the tech hodgepodge, staking-as-a-service may suit your needs. The StaaS acts as an intermediary platform that removes the pain of setting up a node alone, allowing you to earn rewards easily.
On the platform, users can easily engage in ETH staking, withdraw their earnings, and monitor their staked assets, with the provider handling the intricacies like setting up blockchain nodes, performing maintenance tasks, overseeing infrastructure, and upholding network security.
The approach is similar to solo ETH staking insomuch that it allows you to have your own validator keys without having to pool funds (combine your holdings with those of other users). Still, to enjoy this semi-independence, you need to stake a handsome amount of 32 ETH.
By using StaaS, you're buying convenience at the price of increased risk. Essentially, you're delegating node operations to an external party (the non-independence part) you have to trust. The platform operator guides you through the initial setup, such as key generation and deposit, followed by transferring your signing keys to the provider. This arrangement enables the service to manage your validator on your behalf, typically in exchange for a monthly fee.
Ethereum itself doesn't let you directly assign your stake to others – that's the gap StaaS services address. Staking-as-a-service is dedicated to investors with sufficient resources and crypto-savviness but without the proper technical know-how or infrastructural capabilities related to home-staking. StaaS lets you hand off that responsibility to third-party providers.
The tricky part is choosing a trustworthy platform. StaaS providers are plenty, each with its own set of pros and cons. Some solutions may incorporate additional code around the Ethereum clients that is not transparent or subject to audit.
What's more, StaaS arrangements can negatively impact network decentralization. Depending on the setup, you may even lose control of your validator, allowing the operator to potentially act dishonestly with your ETH.
Benefits:
- low technical entry barrier for staking
- high convenience, as StaaS platforms handle the complexities of running validator nodes
Risks and downsides:
- potentially lowest rewards – a downside exacerbated by fees,
- reduced control over node management and reliance on the StaaS provider's security practices,
- personal data exposure (you may be required to undergo identity verification),
- centralization concerns: heavy reliance on StaaS can lead to network centralization (if a large portion of validators are controlled by a few StaaS providers).
You can explore particular StaaS providers and their features on the Ethereum project's website.
Pooled staking
It doesn't take tons of wits to understand that a majority of crypto investors can't afford 32 ETH to lock up for staking. Enter the pooled staking, which allows investors to pool their stakes together and distribute rewards in proportion with their contributions.
Staking pools are a collaborative approach dedicated to users with limited resources who wouldn't be able to stake Ether independently. Still, in order to form a valid pool, the collective has to accumulate 32 ETH to activate a set of validator keys.
Like with StaaS, the Ethereum network doesn't natively support the pooling functionality, so pooled staking platforms emerged to address this gap. Essentially, there are two types of staking pools: smart contract-based and off-chain ones that don't involve a smart contract.
In a smart contract-based staking pool, participants deposit funds into a contract, which then trustlessly manages and tracks their stake. In return, the contract issues a token representing the staked value. In the second approach, staking pool is mediated off the main blockchain, on a separate system or platform that may often act intermediary, potentially introducing a layer of centralization.
In pooled staking, operations are overseen by an operator, who ensures the accurate and equitable allocation of rewards. The approach comes with several benefits, including increased opportunities for block validation and more stable returns. Most importantly, though, a staking pool is a welcoming place for non-whales who want to stake ETH and earn passive income.
Benefits:
- low financial entry barrier,
- convenience, with pooled staking platforms handling technical complexities,
- potentially increased security compared to solo staking: if one validator in the pool goes offline, the others can continue functioning, reducing the risk of penalties for downtime,
- diversification: some platforms offer staking pools for various cryptocurrencies, allowing you to diversify your staking holdings.
Risks and downsides:
- staking rewards lower than in solo staking plus a provider's fees,
- a low risk of the pool operator mismanaging funds (remember to choose reputable platforms with a good track record!),
- limited control over validator selection and node management.
Centralized exchanges
The most leisurely approach to staking ETH and earning rewards is through centralized exchanges that provide staking services. Custodial crypto platforms offer the convenience of a secure, user-friendly, and feature-rich environment with – usually – good-quality customer service. Obviously, the overall experience depends on the particular provider, so it's best to opt for reputable brands.
If you already have an account at the platform that supports Ethereum staking, check the requirements before you move on. To start staking, you need to deposit enough ETH to meet the necessary minimum, which can vary depending on the exchange.
Then, simply find the staking section on the platform and check the staking options. Follow the instructions to enroll and choose your desired staking plan. Once enrolled, your ETH will be automatically staked by the exchange.
You practically don't need to do anything else to earn staking rewards – the exchange will distribute them to you periodically, typically in ETH.
Staking ETH through crypto exchanges is a highly convenient way to earn rewards. You don't need to install an Ethereum client, set up your own validator node, or stake an exorbitant amount of ETH. You can get a taste of the market even if you're a newbie – although it's recommended to have some prior, theoretical knowledge about Ethereum staking.
There are some considerations, though. Exchanges charge fees for their Ethereum staking services, which will surely reduce your rewards. They also manage staking and validator selection, which limits your control over the process. Last but not least, you're trusting a third party with your money – but that's the fundamental risk of using CEXs.
Benefits:
- low entry threshold, both technical and financial,
- high convenience – practically no technicalities on a user's part,
- lower risk of losing your staked ETH through penalty (depending on the CEX management's selection of validators).
Risks and downsides:
- lower staking rewards and fees,
- practically no control over the validator node,
- reliance on a third-party provider.
What is liquid staking?
While staking your tokens, you can keep them liquid and tradable. This approach is known as liquid staking, and it allows users to stake their crypto assets and receive liquid tokens in return. These tokens represent those assets and potential rewards for your staked ETH.
Liquid tokens can be traded, sold, or used in DeFi protocols while your original staked assets remain locked. This provides flexibility and potential for additional returns.
There are several platforms, both custodial and non-custodial, supporting liquid staking. They include Lido Finance, Rocket Pool, StakeWise, Binance, and Coinbase.
How much can you earn by staking ETH?
Let's be clear, staking ETH is not a recipe for making millions from scratch. Potential rewards for staking on Ethereum vary and depend on the amount you invest, type of staking you choose, and your arrangements with third-party providers – if you don't opt for the stand-alone approach.
The post-Merge staking rewards on the Ethereum network stand at around 4–5% per year. So, if you stake 32 ETH (the minimum required to run a validator node), you could earn around 1.6 ETH per year in staking rewards. With 100 ETH staked, at a 5% rewards rate, you could potentially earn rewards of around 5 ETH per year.
This rate can fluctuate over time based on factors like the total amount of ETH staked and network activity. You also need to consider fees charged by pools or exchanges and possible penalties. Overall though, staking ETH can provide higher returns compared to traditional investments like savings accounts or government bonds, depending on current rates.
Top mistakes when staking ETH and how to avoid them
To maximize returns and minimize losses, you should approach the subject with caution. Remember to develop the necessary know-how before scaling up to more advanced methods of staking. Start easy with convenient solutions and move up the technology ladder only when you feel savvy enough. For better outcomes, consider the following top mistakes you should avoid during your staking activities.
1. Falling for the promise of unrealistically high rewards
Excessively high yields often indicate unsustainable practices or potential scams. Stick to reputable staking providers with reasonable reward rates.
2. Ignoring fees
Staking fees can eat into your rewards. Compare fees charged by different platforms – as well as the overall costs related to different staking methods – and choose the most optimal option based on expected returns and your know-how.
3. Neglecting security
If staking solo, ensure your validator node is secure with strong passwords and proper firewall configurations. For CEX staking, choose a reputable exchange with a proven security track record.
4. Staking without a plan
Determine your investment goals and risk tolerance before staking. Decide how long you plan to stake your ETH and choose a staking method (solo, StaaS, pool, or CEX) that aligns with your goals.
5. Failing to consider staking requirements
Ethereum requires a minimum of 32 ETH to become an individual validator. Pools and exchanges also have certain requirements. Be sure you have the required amount or you can purchase ETH to meet the threshold.
