Galaxy: Risks and Rewards of Ethereum Staking Economics

This report comprehensively outlines the mechanics of staking, how it operates on Ethereum, and crucial considerations for stakeholders participating in staking. This is the first part of a three-part series focusing on various staking activities’ risks and rewards, including re-staking and liquidity staking. The second report will detail operations on Ethereum and Cosmos, alongside significant risks associated with re-staking.

Introduction

Ethereum is the largest Proof of Stake (PoS) blockchain by total staked value. As of July 15, 2024, ETH holders have staked over $111 billion worth of ETH, accounting for 28% of the total ETH supply. The staked ETH amount, also referred to as Ethereum’s “security budget,” serves as a deterrent for network penalties against stakers in cases of double-spending attacks and protocol breaches.

In return for securing Ethereum, stakers earn rewards through protocol inflation, priority fees, and Maximum Extractable Value (MEV). Users can stake ETH seamlessly through liquid staking pools, preserving asset liquidity beyond developers’ initial expectations. Based on current staking trends, developers anticipate further growth in ETH staking rates over the coming years. To address this trend, significant protocol changes regarding inflation policies are under consideration.

This report will detail Ethereum’s staking landscape, including types of stakers, risks and rewards associated with staking, and predictions for staking rates. Insights will also be provided into proposed changes to network issuance aimed at curbing staking demand.

Types of Stakers

There are six main types of Ethereum users eligible for staking rewards, detailed in the table below:

Among these stakers, custodial stakers—those delegating ETH to professional staking node operators—are the most numerous. While the number of professional operators is small, they manage the most staked ETH among staking entity types.

Liquidity staking, re-staking, and liquidity re-staking pool protocols are not considered here as they do not directly operate staking infrastructure or provide funds for its use. However, these entities do earn a percentage of returns from stakers using their platforms. They act as intermediaries facilitating relationships between custodial stakers and professional (or amateur) stakers, making them crucial participants in Ethereum’s staking ecosystem. Lido, a liquidity staking protocol, is the largest staking pool operator on Ethereum to date, accounting for 29% of ETH staked. Understanding the risks of liquidity staking is crucial given its adoption and critical role on Ethereum.

The next part of this report will delve into staking risks based on techniques and entities used to earn staking rewards.

Staking Risks

Staking risks largely depend on the method and technology employed. The following categorizes staking methods and their associated risks:

• Direct staking: Users or entities directly manage their proprietary staking hardware and software. Risks of directly staking ETH include staking penalties and slashing risks. Penalties due to prolonged machine downtime may result in partial loss of staking rewards. Additionally, slashing events due to validator software misconfiguration can lead to partial loss of staked ETH balances, up to a maximum of 1 ETH.
• Delegated staking: Users or entities delegate their ETH to professional or amateur stakers for staking. Risks of delegated staking include all risks of direct staking, plus counterparty risks, as the entity to which you delegate staking may fail to fulfill obligations. ETH holders can delegate their ETH to minimally trusted staking service providers, such as entities controlled through smart contract code, though this introduces additional technical risks due to potential code vulnerabilities or system hacks.
• Liquidity staking: Users or entities delegate ETH to professional or amateur stakers and receive liquidity tokens representing their staked ETH. Risks of liquidity staking include all risks of direct and delegated staking. Additionally, liquidity risks may lead to disconnection events due to market fluctuations and delayed entry or exit of validators, causing significant deviations in the value of liquidity staking tokens from the underlying staked asset value.

Another risk to consider across these three staking methods is regulatory risk. The further ETH holders are from their staked assets, the greater the regulatory risk associated with staking activities. Delegated and liquidity staking require ETH holders to rely on different types of intermediary entities. Legislators and regulatory bodies may impose rules and frameworks on these entities’ operations, depending on their structure and business models.

In addition to regulatory risk, detailed descriptions of protocol risks associated with these three types of staking activities are also required. Protocol risks stem from networks penalizing users who intentionally or unintentionally fail to meet standards and rules of the Ethereum consensus protocol. Penalties primarily come in three types, ranked from least to most severe:

• Offline penalties: Penalties incurred when nodes go offline and fail to perform duties such as proposing blocks or signing block proofs. Generally, validators face penalties of a few dollars per day.
• Initial slashing penalties: Penalties imposed when validators’ actions violate network rules and are detected by other validators. The most common example is submitting two blocks for a slot or signing two proofs for the same block. Penalties range from 0.5 ETH to 1 ETH, depending on the validator’s effective balance, currently capped at 32 ETH. Protocol developers are considering increasing the maximum effective balance for validators to 2048 ETH and reducing initial slashing penalties in the next network-wide upgrade, Pectra.
• Related slashing penalties: Following initial slashing penalties, validators may face a second penalty based on the total staked amount slashed within 18 days before and after the slashing event. Motivation for related slashing penalties is measured by the staked amount managed by malicious validators. Related penalties are calculated based on the validator’s effective balance, total balance, and proportion slashed multiplier.

Apart from these three penalties, special penalties can be imposed on validators if the network fails to achieve finality. (For a detailed overview of Ethereum’s finality, refer to this Galaxy Research report.) When finality is not achieved, validators who go offline face more severe penalties. By gradually burning the staked shares of validators who have not contributed to network consensus, the network can rebalance its validator set to achieve finality. The longer the network fails to achieve finality, the greater the severity of penalties.

Staking Rewards

While stakers bear risks, they can earn approximately 4% annualized returns from staked ETH. These rewards come from new ETH issuance, priority fees attached by Ethereum users in their transactions, and MEV.

Note that over the past 2 years, stakers’ rewards have steadily declined due to two main reasons. Firstly, the total value of staked ETH and the number of validators have increased. As the value staked increases, the issuance rewards for validators are diluted, as shown in the graph below:

While issuance rewards can be calculated based on the total number of active validators and the amount of ETH staked on Ethereum, the other two sources of validator income are challenging to predict as they depend on network transaction activity.

Over the past two years, transaction activity has decreased, resulting in reduced base fees, priority fees, and MEV for validators. Typically, the higher the value of assets transferred on-chain, the greater the willingness of users to pay fees to prioritize these transactions in the next block, and the higher the profit from MEV obtained by reordering within the block. As shown in the chart below, the daily value of USD transferred on Ethereum correlates with transaction priority fees:

According to Galaxy’s calculations, MEV can increase validator yield by approximately 1.2%. Compared to other types of validator income (including new ETH issuance and priority fees), validator rewards from MEV account for approximately 20%. Some attribute MEV to additional value given to block proposers, which does not come from priority fees or ETH issuance.

However, others argue that if priority fees are used to fund successful front-running or reverse trading, it can represent MEV profit itself. To explain that priority fees themselves may contain MEV profits, other methods compared the value of blocks built with MEV-Boost software and those not built with MEV-Boost software.

The above chart shows that the scale of MEV may be much larger than 20% of validator rewards. According to Ethereum Foundation researcher Toni Wahrstätter’s analysis in October 2023, if validators receive blocks through MEV-Boost instead of building blocks locally, the median block reward will increase by 400%.

Staking Rate Forecast

Assuming Ethereum’s staking demand grows linearly as it has over the past two years, it is expected that the staking rate will surpass 30% by 2024. As mentioned earlier in this report, higher staking rates will reduce the returns from new ETH issuance. Ethereum’s liquid staking services enable users to stake easily and bypass staking restrictions like entry queues.

Users only need to purchase stETH to receive staking rewards. A large influx of stETH purchases can cause a disconnection between the value of stETH on the open market and the value of the underlying staked asset, leading to a premium on stETH until more ETH is staked on Ethereum. Unlike purchasing stETH, staking activities on Ethereum experience delays.

Each epoch (approximately 6.4 minutes) can only add 8 new validators to Ethereum or a maximum of 256 ETH in effective balance. Therefore, assuming maximum validator additions per epoch until the end of 2025, Ethereum would need over a year (specifically 466 days) to reach a 50% staking rate.

Historically, demand to enter the Ethereum staking queue has exceeded demand to exit. Although recent days have seen reduced activity in validators entering the queue, staking demand is expected to surge again for various reasons, including but not limited to additional returns from re-staking, increased MEV from DeFi activity recovery, and regulatory changes supporting staking activities in traditional financial products like ETFs.

Developers are aware that a resurgence in staking rates and declining staker returns is only a matter of time, so they are considering several proposals to adjust network issuance to suppress staking demand.

Discussion on New ETH Issuance Changes

ETH holders should be aware that future staking rewards will undergo significant changes. Ethereum developers are weighing multiple options to ensure Ethereum’s staking rate trends towards target thresholds, such as 25% or 12.5%. Ethereum Foundation researcher Caspar Schwarz Schilling explains that maintaining low staking rates primarily includes:

• Dominance of Liquidity Staking Tokens (LST): If staking rates increase, the amount of ETH concentrated in a staking pool like Lido could increase, posing centralization risks to an entity or smart contract application and risking excessive impact on Ethereum’s security.
• Credibility Reductions: Related to concerns about LST dominance, high issuance volumes entering a single entity or smart contract application could reduce credibility for large-scale slashing events on Ethereum. For example, if a slashing event affecting a majority of stakers were to occur, the protocol might face pressure from ETH holders who may wish for state changes to restore penalized staked ETH balances. Ethereum has only undergone one irregular state change in its history, following the infamous The DAO hack in 2016. While unlikely, irregular state changes in response to large-scale slashing events are not impossible. Indeed, some Ethereum researchers argue that under high issuance conditions, such outcomes are more likely.
• Trustless Native ETH: High issuance can lead to a shortage of native ETH circulating and a surge in liquidity staking tokens issued by third-party entities. Ethereum researchers indicate a preference to promote the use of native ETH for activities beyond staking, rather than less decentralized liquidity staking tokens.
• Minimum Viable Issuance (MVI): Despite being negligible compared to mining costs, staking costs are also not insignificant. Professional staking providers require hardware and software to operate validators, hence incurring operational costs. To stake through these providers, users must pay fees to them. Additionally, even if users obtain liquidity staking tokens through staking native ETH, they also assume additional risks due to staking failures through third-party staking. Therefore, keeping staking costs at a minimum benefits the network’s interest because additional costs associated with supporting staking activities mean higher issuance, thereby inflating ETH supply.

Ethereum developers and researchers are considering various proposals to lower Ethereum’s staking rate. These proposals include but are not limited to:

• Short-term reductions in staking rewards: In February 2024, Ethereum Foundation researchers Ansgar Dietrichs and Caspar Schwarz-Schilling reintroduced a proposal for a one-time cut in staking reward rates. The idea was initially proposed by Ethereum Foundation researcher Anders Elowsson. In their latest paper, Dietrichs and Schilling suggest a 30% reduction in staking reward rates. However, the specific figure depends on Ethereum’s staking rate. Considering the continuous increase in staking rates since February, researchers believe the theoretically proposed reduction in reward rates should be higher. This proposal can be implemented with simple code changes and aims to suppress economic incentives for staking in the short term. This proposal is intended as a temporary measure to pave the way for long-term solutions, such as target policies.
• Long-term staking rate targets: Implementing a new ETH issuance curve, the higher the staking rate exceeds target rate (e.g., 25% of total staked ETH supply), the higher the cost for validators to stake and earn rewards. This idea is based on research by Elowsson, Dietrichs, and Schwarz-Schilling. Several mechanisms can achieve target rates, each differing in issuance schedules and extent of issuance reduction. For more detailed information on issuance curves under staking rate target models, please read this Ethereum research paper.

None of the above proposals will be included in the next Ethereum hard fork, Pectra. However, Ethereum developers are likely to push proposals for changes in ETH issuance in subsequent upgrades. So far, discussions within the Ethereum community regarding issuance changes have been highly controversial and have not reached widespread consensus.

Primary objections to issuance changes include concerns that reducing staking income will harm profitability for large staking providers and individual stakers on Ethereum. Proposals affecting issuance to date have lacked sufficient research and data-driven analysis. It remains unclear what the exact target staking rate for achieving MVI should be and whether achieving this goal through issuance changes will reduce concerns about centralization in staking allocations or exacerbate issues by driving away independent stakers who thrive in ETH-issued formats.

To address some long-term concerns about profitability for independent stakers on Ethereum, Ethereum co-founder Vitalik Buterin shared preliminary research in March 2024 on introducing new anti-correlation rewards and penalties aimed at controlling node operator validation with fewer validators.

Since the launch of the beacon chain proof-of-stake blockchain on Ethereum in December 2020, its monetary policy has remained unchanged. However, prior to merging with the beacon chain, Ethereum’s monetary policy underwent several revisions over its approximately seven-year history.

Ethereum’s original block reward was set at 5 ETH/block. In the Metropolis upgrade in September 2017, it was reduced to 3 ETH. Then, in the Constantinople upgrade in February 2019, it was further reduced to 2 ETH. Subsequently, in the London upgrade in August 2021, mining rewards from transaction fees were burned, and then in the merge upgrade in September 2022, mining rewards were completely eliminated from the network.

Under the proof-of-stake consensus mechanism, changes to Ethereum’s monetary policy may be more controversial than changes to network issuance under proof-of-work. This is because the user base affected by changes is much more extensive. Unlike miners, issuance changes affect an increasingly broad group of ETH holders, staking service providers, liquidity staking token issuers, and re-staking token issuers.

As the stakeholder base involved in protecting Ethereum’s interests continues to expand, Ethereum developers are less likely to change Ethereum’s monetary policy as frequently as in the past. The contentious nature of these discussions may lead to increasing rigidity over time in policies and incentives related to staking. As a result, the window of opportunity to alter Ethereum’s codebase as the staking industry builds on Ethereum is narrowing, and changes are less likely to be sustained for long periods.

Conclusion

The staking economy built on Ethereum is still in its infancy. When the beacon chain was first launched in 2020, users staking ETH could not be assured of withdrawing ETH or transferring funds back to Ethereum. When the beacon chain merged with Ethereum in 2022, users gained additional rewards from staking through transaction priority fees and MEV.

When staking ETH withdrawal functionality was enabled in 2023, users could finally exit validators and profit from staking operations. There are further changes on Ethereum’s development roadmap that will impact staking businesses and individual stakers. While most of these changes do not affect staking economic incentives, such as increasing the maximum effective balance for validators in the Pectra upgrade, some will.

Therefore, careful consideration of the risks and rewards of staking on Ethereum is crucial as Ethereum’s development roadmap evolves and is implemented through hard forks. With a stakeholder base encompassing many more than during Ethereum’s PoW era, changes over time that affect staking dynamics may be more difficult to execute.

However, Ethereum remains a relatively new proof-of-stake blockchain expected to undergo significant changes in the coming months and years, necessitating careful consideration of how changes in staking dynamics will affect all relevant stakeholders.