Ethereum 2 Matters – Validator Economics

Nov 18, 2019 - 5 min read

Many cryptocurrency users see Proof-of-Stake as a source of “passive income” – a perception which is far from the truth. This article will outline what a validator is expected to do and what it gets rewarded and penalized for.

What is needed in order to stake?

First and foremost, each validator in the network requires exactly 32 beacon-ether (ETH2) in order to validate transactions on the new Ethereum blockchain – no more, no less. The 32 ETH2 is what the validator has at stake, hence the term: Proof-of-Stake. Staking more than 32 ETH2 requires setting up additional validators.

Running the validator software (an Ethereum light client) will be possible on a consumer-grade laptop. This is deliberately done to ensure that private individuals with 32 ETH can participate in securing the blockchain – which strengthens the decentralization of the blockchain.

Perhaps the more difficult part of running a validator is acquiring the technological expertise to set everything up correctly and securely. Validators will need to make sure that their funds are protected against cyber attacks, that their laptop has maximum uptime, and that the software is always kept up to date and does not sign off on invalid transactions or otherwise behave maliciously.

Which factors need to be considered when calculating the business case?

Although browsing various websites will give indications of how much one can earn by running a validator, these numbers are generalized and based on many different assumptions. There are several internal and external factors which will affect the economics of running validators:

– Total amount of validators
– Penalties and slashing
– Average uptime among all validators
– Average uptime for own validator(s)
– Number of transactions with extra fees (after the implementation of EIP-1559 and sharding)
– Upfront- and running hardware costs
– Hosting costs and reliability
– Workload in updating software and maintaining the infrastructure

How big are the rewards for validating?

Of all these factors, arguably the most impactful on rewards earned for validating transactions is the total amount of validators.

The formula for rewarding validators with newly issued ETH2 will decrease per validator for each validator that is added to the total set of validators in the blockchain. This might not come as a surprise, as it is the case for most blockchains built on a PoS consensus mechanism. The difference is that the total issuance of new ETH2 also changes: It increases with the number of validators. This “flattens” out the curve (Figure 1).

The minimum amount of validators required to launch the beacon chain is 16’384 (note that this number may still change). Theoretically, this means that if just enough validators deposit ETH into the deposit contract on the current Ethereum chain, the beacon chain could launch with only half a million ETH2 in it, providing gross returns of more than 20% for early validators. At the other end of the spectrum, the return could quickly reach a gross return of less than 6% with a stake-to-circulation ratio of just 10%.

Figure 1 – Staking rewards in Ethereum 2

Can validators lose their stake?

The short answer is “yes”.

Validators are expected to be honest, meaning they do not try to attack the network, and are online most of the time. There are several ways validators can lose (part of) their stake:

• Offline (scenario 1): Being offline while a supermajority (2/3) of validators is still online (meaning the chain still finalizes) will lead to small penalties. Overall, validators are expected to be net profitable in terms of eth2 as long as their uptime is more than roughly 50 to 67%.

• Offline (scenario 2): Being offline at the same time as >1/3 of all validators will lead to harsher penalties, called “inactivity leak”, since blocks do not finalize anymore. As per the current model, validators will lose up to 50% (16 ETH2) of their deposit after 21 days. This ensures that blocks start finalizing again at some point, since inactive validators will be kicked out of the network as soon as their balance falls below 16 ETH2.

• Malicious behavior: Behaving maliciously – for example signing off on invalid transactions, will lead to slashing of the stake. The minimum amount that can be slashed is 1 ETH2, but this number increases if other validators are slashed at the same time. The rationale behind this is to minimize the losses from honest mistakes, but strongly disincentivize coordinated attacks.

Is it a good idea to become a validator?

This is a more difficult question to answer.

On one hand, becoming a validator not only supports the network, but also provides holders of ETH with the possibility to achieve additional returns on their holdings. On the other hand, with the rise of DeFi platforms such as Dharma, Compound and Maker – one should consider the opportunity costs of staking, as staking can tie up liquidity that then cannot be deployed elsewhere. With the current design, staking might be particularly attractive to long-term holders of ETH that would otherwise simply leave their ETH in cold storage.

Furthermore, with the launch of Ethereum 2 and its one-way bridge, validators are actually not staking ETH, but ETH2 – only available on the Ethereum 2 blockchain. This means that deciding to stake ETH2 also implies exposure to a new crypto asset. While at some point in the future, every ETH in existence will be switched over to the new Ethereum 2 chain, ETH and ETH2 will initially be the native tokens of two completely different blockchains. Market prices for ETH and ETH2 may not be the same, and eth2 will initially not be transferable.

Ultimately, each holder of ETH must decide if and when to convert to ETH2, taking all unknowns and risks into consideration.

Bitcoin Suisse