What is Staking? How do I do it?
A deep dive into how token lockups and network staking work across web3
Staking is a strategy that is used across crypto and web3 that empowers users to engage with this new technology. Since Ethereum’s Merge, it has also become one of the technical underpinnings of the ecosystem.
In this deep dive, we’ll walk you through different areas where token lockups have become fundamental to web3: DeFi, user flows in dapps, DAOs, and, most importantly, protocol staking: securing an entire network.
‘Staking’ proper should be thought of as what happens at the network protocol level, as in Ethereum’s Proof of Stake. A deeper explanation of this is below, but simply put, users ‘lock up’ some amount of crypto assets by depositing them into a smart contract (a public computer program that runs on a blockchain network); most commonly, the user will expect to receive some sort of privileges or rewards over time in exchange for their stake, and can withdraw their tokens as and when they wish.
This pattern of locking up tokens in exchange for access, privileges, or rewards occurs in a lot of ways across the ecosystem, and it’s confusing to call them all ‘staking’. Often, when you see a reference to ‘staking tokens’, it might be more accurate to just say ‘locking up’, or ‘depositing’.
Getting oriented in the world of Decentralized Finance can be challenging, especially if you’re not someone who has a formal education or interest in finance. Remember, money is one thing; it’s the medium of exchange. Finance is entirely another, and has to do with the ways that money within markets interacts, often on a very large scale. Decentralized Finance takes traditional financial markets and tools and makes them accessible for use with blockchain tokens.
One of the great innovations that DeFi has brought has been automations in access to liquidity. These automations have had huge changes at the level of the individual, trying to get a loan or trade one asset for another, as well as on a macro-level, solving the problem of how we coordinate these asset exchanges across an entire economy.
In today’s financial world, a brokerage or financial institution will use software to manage orders to buy and sell; DeFi takes that power out of the hands of private companies, and instead provides public trading interfaces anyone can use. These smart contracts and protocols allow users to trade one token for another by balancing the value between two linked 'pools' of those tokens, known collectively as a liquidity pool (or 'LP,' for short).
This first step is called providing liquidity. Most DeFi protocols will give liquidity providers a token in return for their deposit: an 'LP token'. This token, which in the case of Uniswap’s v3 protocol is an NFT with fancy graphics, serves like a receipt or a ticket at a coat check: the holder can prove they deposited those funds, and they can use that token to withdraw them.
On some platforms, the LP doesn’t receive one single token; rather, they get some amount of 'platform-native tokens' corresponding to the value deposited in the pool(s). The benefit of this model is providing the user with liquidity while their other tokens are locked up, a pattern we’ll see again.
Not content with that level of complexity, DeFi took this a step further by asking: what if you could lock up your LP tokens, too?
This meta-level, where you’re locking up LP tokens or platform-native tokens, rather than contributing to a multi-token pool, is called staking on most DeFi protocols. (Even SushiSwap, which has Japanese food-branded naming schemes for everything, labels this part of the flow ‘staking’ in the actual UI.) Most often, through staking LP tokens or the protocol’s native tokens, users are offered the ability to accrue some sort of ‘reward token’, the value of which is highly variable from platform to platform.
The rewards collected by those participating in staking are often called 'yields', and the activity of participating in this system with the intention of reaping yields from staking is known as 'yield farming'. The wordplay, puns, and metaphors arising from this are many, and sometimes border on the nonsensical.
The flow outlined above has been baked into most DeFi token trading platforms, but is by no means limited to that use case. As more projects develop that use tokenization for monetary aspects of their operations, you will begin to see this pattern implemented more and more:
Initial interaction > Receive token > lock up token > receive platform rewards
There are already plenty of rewards programs in the world; imagine if you could lock up your airline miles and earn extra, or instead of a punch-hole card at your local coffee place, you lock up rewards tokens to get bags of coffee or a nice mug.
Another sub-field that has existed for some time in traditional finance and economic development is that of microloans. Web2 supercharged this model, whose spiritual predecessors include the world’s many traditional circular lending systems, and opened the door to massive numbers of contributors and recipients.
The transparency, as well as the built-in set of financial tools, offered by blockchain technology represent the potential for another huge technological leap for microloan and direct-financing organizations:
- GivETH is an organization (and a DAO–see below) that fairly closely resembles a traditional Web2 microloans platform, allowing direct investment in projects, but with the added traceability and transparency offered by conducting these transactions on-chain. In addition, their platform has a native token, which holders can stake, receive rewards, and increase the liquidity flows throughout the entire system.
- EthicHub could be described as a microloans platform, but it might be more useful to think of it as a direct investment entity, specifically providing loans to subsistence coffee farmers who cannot access capital through traditional finance. Without that capital, they are unable to improve their infrastructure or, in some cases, simply get their product to market. EthicHub, too, has found it convenient to create a dual funding system, allowing both fiat contributions as well as participation through DeFi, featuring a native token and staking structure.
- DoinGud is still growing as a project, but is notable in its innovative usage of NFTs: the platform is an art gallery, a publication platform, and an NFT sales platform all in one, with part of their proceeds going to specific, established social causes in need of funding. While their tokenomics plan has yet to be fully released, their roadmap includes staking tokens in order to participate in governance.
So far, we’ve clearly outlined ways that locking up tokens can be used in financial applications, but locking up tokens so that you can vote? We’ll explore this topic in the next section.
One of the use cases that token lockups have already found is in DAOs, and DAO governance. This is a whole topic in and of itself, but here are some high-level concepts so you get the idea.
- DAO stands for Decentralized Autonomous Organization. One way to think of it is: if a public blockchain network is the decentralized equivalent of a public database, a DAO would be the decentralized equivalent of a club, or an NGO, or maybe even a company, or partnership.
- DAOs, as a concept and a functioning model, are still very much in their early days, and people are figuring out how to make them work well, what they work well for, and how they may–or may not–fit into existing legal definitions of groups and societies.
- This topic is known as DAO Governance, and is subject to a lot of conversation, investigation, and debate. Many DAOs use some sort of voting system to allow its members to collectively make decisions. (In fact, one well-known DAO, Aragon, specializes in developing tools to support other DAOs in these functions.)
- This couples well with the technology of public blockchains, as the protocols by which the votes are taken and counted, as well as the results of those votes, are all completely public and available to be observed and audited; no closed doors.
- Often, DAOs will issue what is known as 'governance tokens,' which will allow the holder to participate in voting (like the example of DoinGud, above). There can be different ways to acquire those tokens, and in fact, in the initial DeFi scenario explained above, often those 'platform-native' tokens that one receives through a DeFi platform are also governance tokens.
- Another pattern often seen is that the platform’s tokens can be used as fungible assets, like any other cryptocurrency; this is the case with ENS. Some DAOs allow these fungible tokens to then be locked up, at which point they become governance tokens–or the user is issued governance tokens in exchange for their stake.
These are a couple of common ways–and by no means is this an exhaustive list–that DAOs employ ‘staking’. Another issue entirely is the question: when is a network… a DAO?
This comparison between networks and DAOs is often made as a joke, but it’s an interesting question of definitions. In the next section, we take a look at some of the ways that a network and a DAO may be, in fact, quite similar.
We’ll come back to our philosophical considerations in a moment. First, let’s provide some technical context to understand staking at the network level.
With over 456,000 validators staking 32 ETH each–more than $22 billion at today's rates–Ethereum's Proof of Stake (PoS) mechanism is the biggest example of staking in the blockchain ecosystem. Unlike the governance and financial applications we’ve seen so far, this staking mechanism provides an additional function: securing the entire network. There are a number of networks that do this, such as Polygon or Algorand, but let’s take a look at Ethereum’s, which serves as a blueprint for so much in the blockchain space.
The ten-second version: When Ethereum was launched, it was a worldwide network of people who were all running software on their computers (known as nodes) that synced the data of a shared database–a distributed ledger. These nodes would reach consensus about what the current state of that database was. The main challenge to this project was security: how do you prevent a bad actor from gaining control over the database and changing it to suit themselves?
Ethereum took a cue from Bitcoin before it, which had solved this problem through a security system known as Proof of Work(PoW). What’s PoW? To greatly simplify it, you couldn’t modify the ledger without solving a really, really difficult math problem, and the more computational power that was added to the network, the harder the math problem got–-so you couldn’t beat this by “brute forcing” it. This security system, effective as it is, creates an “arms race” of buying better and better and faster computers, in order to have the most power, to have the most likelihood of solving the math problem and getting a reward, in cryptocurrency. This inefficiency also has a direct correlative effect on the amount of electricity the network uses (a lot).
From fairly early on, the Ethereum community realized that they needed another consensus mechanism. The solution that was arrived upon is called Proof of Stake. Again, to put it simply: those who wish to participate in confirming blockchain data across the network must first stake 32 ether into a specific smart contract. These tokens are held as a guarantee that they will run their node in compliance with the network’s requirements. If their node goes offline for too long, or if it behaves in a manner that appears to be prejudicial or in bad faith to the network’s operations, then the node operator’s stake can be slashed, in other words, burned and taken from them, in whole or in part. They lose their stake, and they lose the ability to operate a node and keep bringing in ETH.
And 32 ether is no small thing to lose.
Any set of instructions on this topic will always be incomplete, with the speed with which new protocols and platforms are being built on top of the functionality of Ethereum’s staking system. That said, the official instructions and method for self-hosting a node are somewhat fixed, and can be consulted here. For a more entertaining and detailed look at what it’s actually like to set up and run your own node, check out Coogan’s story here.
But if you don’t have the 32 ETH to put up for a full node (and most of us don’t), there are a number of ways to participate and stake smaller amounts of ETH. Let’s take a look at two popular solutions.
Network staking is a pretty clever security system, but it has its drawbacks. There are three big problems that are addressed through the clever mechanism of liquid staking:
- Minimum deposit: As already mentioned, what if you want to stake but don’t have 32 ETH?
- Locked assets: If you stake your ETH in the network, you can’t use it for anything else.
- Coordinating pools of small-scale stakers into groups of 32 ETH while allowing them to pull out of the stake when desired
The way liquid staking works is this: Let’s say Rana has 3.5 ETH that she wants to stake. She deposits her ETH into the liquid staking platform of her choosing. As others do the same, the protocol or staking platform bundles up 32 ETH at a time, deposits it to the Ethereum staking address, and spins up a node. Thus, our first problem is solved: Rana is now participating in staking, and will receive, proportionally, the rewards that correspond to her based on the amount of ETH she deposited.
There is an additional feature enabled at this point, often touted by liquid staking proponents: now that Rana has her ETH locked up, accumulating rewards, she can take the liquidity that she was given in the form of her staking tokens, and do something else with it, like staking it in an additional DeFi protocol that allows her to reap even more rewards.
But how does Rana get the rewards from the staked ETH? Well, when she deposited her 3.5 ETH, she got something in return: just like with our DeFi example above, she got a sort of LP token, which links her to her stake and the returns she’s owed. How the token works differs from one liquid staking solution to another, but Rana is given an equivalent value in those tokens to the amount of ETH she staked; in other words, she still has the liquidity of her ETH, even though it’s been staked. Thus, our second problem has been solved.
Lastly, how do you coordinate all this? While it can sound like a lot to keep track of, this is where smart contract technology does a lot of the heavy lifting. Projects that provide liquid staking have a series of smart contracts that manage the different parts of the operation: taking the users’ deposits, providing them with their corresponding liquid staking token, managing the issuance and balance of those tokens, etc. Other parts of the operation, relating to ‘how the project is run’, can be run through a DAO, thus increasing visibility and credibility into what is, essentially, a shared resource.
Wait… What about when someone wants to pull out their ETH?
Liquid staking providers don’t currently offer this functionality, because they can’t. When the Ethereum network made the switch from Proof of Work to Proof of Stake, they focused on getting Proof of Stake running properly first, before moving on to the process by which users could withdraw already-staked ETH. For now, all staked ETH remains staked.
Withdrawal functionality is scheduled to be released in the Shanghai upgrade, which could happen during 2023. In the meantime, users wishing to get rid of their liquid staking tokens and “change them back” to ETH would have to do so through a swap, which they can do right from their MetaMask wallet by clicking or tapping the “Swap” button.
For some users, liquid staking seems the obvious choice: they want the flexibility of staking the amount they want, when they want to, and still having the liquidity of their ETH to engage in other DeFi activities.
Another option, though, and the more appealing one for some users, is what’s known as custodial staking. Like it sounds, under this system, someone else is holding your ETH and staking it on your behalf.
You might have heard that MetaMask is a “self-custodial” wallet; this refers to the fact that with MetaMask, you, and you alone, are in control of your Secret Recovery Phrase (SRP), which grants access and control to your wallet addresses and the tokens assigned to them. No one can stop you from exercising that power; unless, of course, you share your SRP with them.
That’s not the case with custodial staking; in this format, you are essentially entering into a client-provider relationship with the staking entity. You give them ETH, which they promise to stake, and then return to you the agreed-upon rewards.
This may sound disadvantageous compared to liquid staking, but there are circumstances where it’s the obvious choice. Institutions, businesses, or foundations, for example, may wish to rely on a technically capable third party to manage their ETH stake for them. Additionally, these entities may be legally required to stake through an entity that has certain kinds of insurance, backing, or other guarantees. Maybe holding the keys themselves is, in fact, a liability.
Another driving factor for custodial staking is that many people are unaware of the existence of self-custody wallets and decentralized staking protocols. They understand crypto to be a new kind of money, and therefore expect to deal with a bank or investment firm-like entity in order to interact with their crypto; that’s what they’re comfortable with. Even those who do have knowledge of, and even have and use, a self-custody wallet, may choose to stake with a custodial provider for the convenience of being able to quickly convert their rewards to fiat currency, or quickly add more to their staking position from fiat.
These, then, are the three main methods of staking ETH available today: “solo” staking, whether it be on a physical computer in your home or on a cloud computer; liquid staking through a protocol or provider, and custodial staking, often through a centralized exchange, or CEX.
That said, this is web3, and who knows what might be built next.
…given all that context, the question begins to take shape: If a network consists of a given number of people locking up their tokens into a decentralized protocol, which gives them rewards, and that community is governed by a system of votes and governance bodies who publish their voting protocols and their results on a public blockchain… How is Ethereum, for example, not just one big Decentralized Autonomous Organization?
And if we can use this technology to coordinate and manage a database that ensures billions and billions of dollars worth of value transparently and on a global scale, what’s stopping us from using this technology to build a world that’s better for us all?
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