What are Staking Rewards?
Aug 12, 2021 - 6 min read
Staking has become an increasingly popular way for holders of cryptocurrencies to grow their assets. For those who are new to the space, it is useful to understand the nature of staking rewards, the differences in staking conditions offered by blockchains, and the factors that affect the reward rates.
What are staking rewards?
With more than $145 bn worth of cryptocurrencies locked in staking, it represents a significant chunk of the overall crypto market. At first glance, staking cryptocurrencies may resemble a bank deposit: An asset holder commits his or her assets and receives a return on them with some periodicity. However, staking significantly differs from earning interest on bank deposits.
The staking of cryptocurrency is possible on proof-of-stake (PoS) blockchains. Proof-of-stake is an alternative to proof-of-work (PoW) protocol where new blocks are added and validated by miners solving mathematical puzzles. Bitcoin is the most famous example of a PoW blockchain. In PoS, the right to create and validate new blocks is given to those users who bond (“stake”) their assets in the network. Users who actively participate in adding new blocks are usually called validators.
For a PoS protocol to function in a secure and stable way, a blockchain should have enough assets locked in staking. This helps make sure that network participants have something to lose if they act incorrectly and bring harm to the protocol – for instance, by signing off on double spending transactions. To incentivize more users to bond their assets and to compensate them for provided service and inconveniences (staked coins cannot be used for any other purposes), blockchains pay out staking rewards. The rewards are usually paid with newly minted coins, according to a set level of inflation in the network.
Being a validator requires a certain level of expertise, commitment and investments in hardware, so many blockchains use some form of a “delegated” PoS protocol. Here, only a smaller group of users run validator nodes, while the rest can delegate their stakes to these validators. A validator then does the job of supporting the blockchain, receives the staking reward, and shares it among their delegators while keeping some of it as a fee for the service.
Average rates of return on staking vary among blockchains and their life stages, from more than 100% for some new projects with higher risks to 3-15% for more established blockchains. Within one blockchain, the rates can vary among the validators, depending on their stake size, number of delegators, and amount and quality of service provided to the network. Validators which misbehave are often punished by “slashing” their stakes which can also affect the delegators’ stakes.
What are the differences between various staking blockchains?
Blockchains offer different staking conditions for their users, and often even use their own terminology. One common feature is that staking is usually non-custodial, which reduces the counterparty risk. Major parameters where staking conditions differ include: minimal amount of stake required, bonding and lock-up periods, how soon and how frequently rewards are paid, and the penalties for slashing. Analyzing these parameters together with the reward rates can help crypto asset holders decide whether they wish to participate in staking and where it may be most advantageous to do so.
To date, the biggest network by staked value is Cardano, an open-source platform for peer-to-peer transactions. Cardano offers users the possibility to stake its native coin ADA either by running a “staking pool” or delegating to an existing staking pool. A stake pool receives a reward every slot it is selected as a slot leader and successfully creates a block. The probability to be selected as a slot leader increases with the amount of coins staked in a pool. Cardano does not have a minimal bonding and lock-up periods, which means that the users can move their staked assets in out of a staking pool as they wish. The current average return rate on delegating ADA is 6.33% yearly.
Polkadot and its canary version Kusama offer higher yearly returns on average (13.29% and 14.27%, correspondingly). Polkadot and Kusama use nominated proof-of-stake (NPoS) where asset holders (nominators) can distribute their stake among up to 16 validators. Validators are paid the same rewards for the same amount of work, which means that smaller validators usually pay out higher rewards to their nominators. Staking DOT and KSM also carries a lock-up period (28 days on Polkadot and 7 days on Kusama) which means that users do not get their assets immediately after unbonding.
Tezos is a blockchain platform for applications that uses so-called liquid proof-of-stake (LPoS). Users can delegate their whole account of XTZ to a chosen validator, or “baker”. Similar to Cardano, the delegated assets are not locked so there is no liquidity risk. However, there is a significant waiting time before receiving the first reward (from 23 to more than 30 days depending on a baker). The average yearly return rate is 5.5%.
How staking rewards are connected with market dynamics?
To achieve the required security level and robustness of a protocol, proof-of-stake blockchains need a sufficient amount of coins to be staked on the network. At the same time, coins that are staked in a network are removed from the market: they cannot be used for transacting, trading, lending, or other activities (such as using smart contracts). Staking removes liquidity from crypto markets.
To balance these needs, many blockchains have a target share of coins staked which they try to achieve by modifying the inflation rate or the share that goes to validators: If more coins are staked than desired, the inflation (validators’ share) goes down and staking rewards decrease, and vice versa. For instance, Cosmos has a target of 67% staked.
The willingness of users to stake coins depends not only on the staking rewards, but also on alternative ways of using coins, or the opportunity cost. Most crypto investors will choose the way of using their assets that they expect to bring the highest returns in the short or long run. They can also choose to use cryptocurrency as a means of payment as the acceptance of cryptocurrencies is growing.
To sum up, staking rewards are closely connected not only with the staking conditions offered by the blockchain but also with the market dynamics: the number of asset holders willing to hold and stake, the share of coins already at stake, alternative ways of using the assets, and other emerging opportunities. To better understand value of staking and earning staking rewards, it is useful to take all these factors into consideration.