What it means
A blockchain needs a way to agree on the next block without relying on a central authority. In proof of stake, validators put up coins as collateral, which gives them a financial reason to behave honestly.
The more they stake, the more often they are likely to be chosen, and the more they have to lose if they cheat. Selection is generally random but weighted by stake.
A validator with 1% of the total staked coins would expect to be chosen for about 1% of the blocks, although many networks add other factors such as how long the coins have been staked, to avoid giving too much power to the biggest holders. Validators earn rewards for proposing and approving valid blocks, normally paid in new coins and transaction fees.
If they sign conflicting blocks or are offline too often, the network applies a penalty known as slashing (the automatic loss of part of the stake), so reliable operation matters. Many people take part without running their own equipment, either by delegating coins to a validator or using a staking service.
This is convenient but brings risks, including the provider's fees, the possibility that the provider is penalised, lock-up periods that stop you selling quickly, and the usual price swings of the coin. The main advantage over proof of work is that it uses far less energy.
The main criticisms are that wealthy holders earn the most and may gain influence, and that its security rests on economic penalties rather than on physical cost, so the design has to be strong enough to keep attackers out.
In practice
Real-world examples.
Example
An investor holds tokens worth $10,000 and delegates them to a validator that charges a 10% fee. At a 4% reward rate she earns $400 a year before fees, and $360 after the $40 fee.
Example
A company runs its own validator node on a blockchain network and locks $320,000 of coins. It invests in backup servers and monitoring because a technical fault could lead to a penalty that would cost it part of its stake.
Example
A finance analyst reviewing a crypto fund's holdings discovers that a quarter of its assets are staked with a three-week withdrawal waiting period. She reports that this portion cannot be sold quickly in a market fall, which affects the fund's liquidity.
Formula
Calculation
In a simple model, a validator's expected share of blocks equals its share of the total stake, and its yearly reward follows from the reward rate:
Selection probability = Your stake / Total stake
Annual staking reward = Your stake x Annual reward rate
Suppose a validator stakes $320,000 of coins and the total staked is $64,000,000. The network pays an annual reward rate of 4% to stakers.
Selection probability = $320,000 / $64,000,000 = 0.5%.
If the network produces 7,200 blocks a day, the validator would expect 0.5% x 7,200 = 36 blocks a day.
Annual staking reward = $320,000 x 0.04 = $12,800.
If the validator pays 10% of that reward to a hosting provider, the net reward is $12,800 - $1,280 = $11,520.Case study
Seen in the real world.
Ashford Digital Assets is an illustrative, fictional treasury management company that decided to stake some of its holdings. It staked tokens worth $500,000 with a validator at a 5% reward rate and expected to earn $25,000 a year.
Three months later, the token price fell by 30%, and the company wished to sell. The tokens were subject to a 21-day withdrawal waiting period, so it could not sell until after the price had dropped further.
The company's board concluded that the income of $25,000 was small compared with the price risk and the liquidity limit. It reduced the staked amount to $150,000 and wrote a policy to stake only what it could afford to leave locked. The illustrative lesson is that staking rewards are paid for taking on risks, so they should not be seen as free interest.
Watch out
Common mistakes.
- Treating staking rewards like a risk-free savings rate, when the coin price can fall by far more than the reward earned.
- Ignoring lock-up and unbonding periods, which can stop you selling quickly when markets move.
- Choosing a validator on the lowest fee alone, without considering its reliability and record of penalties.
Questions
People also ask.
Is proof of stake more energy efficient than proof of work?
Yes, significantly, because validators do not compete using heavy computation, so the electricity used is a small fraction.
What is slashing?
It is a penalty in which part of a validator's staked coins is destroyed or taken for serious faults such as signing conflicting blocks, and it protects the network by making cheating costly.
Are staking rewards taxable?
In many countries they are treated as income or gains, but the rules differ widely, so check with a tax adviser in your jurisdiction.
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