Ethereum’s merge – we’ve all heard about it. The momentous and risky shift of the world’s second-largest blockchain from Proof-of-Work to Proof-of-Stake consensus systems had the crypto world buzzing.
But for those slightly greener to the fundamentals of the shift, one may ask – what is staking? And why is it such a big deal?
What is staking?
In the Proof-of-Work system, the security of transactions is provided by miners. Miners work to solve complicated maths equations which validate new transactions while simultaneously mining new tokens, which are then used to reward them.
The Proof of Stake consensus mechanism requires users to “stake” (or deposit) a certain amount of currency to validate. Each user commits some of their funds to a different staking wallet or smart contract to become a validator of a node.
“If we have a bunch of computers, they all say different things. How do we determine what is true and what is not,” said Jake and Stake, Bankless DAO contributor. “Blockchains use these systems to reach a consensus on data spread out over a distributed network.”
“To benefit from staking, you have to be validated; you have to be producing blocks; you have to basically commit economic resources to the protocol.”
Running around the clock, validators ensure an agreement between nodes of the transactions on the blockchain, reducing the possibility of a blockchain hack. A transaction has to appear on at least 51% of the nodes on the blockchain to be validated, which makes the blockchains with a large, varied amount of validators more secure.
“For PoS networks, attacks can be extremely expensive as an attacker would need to acquire or control more than 50% of the network’s native tokens,” said Johannes Kaske, Technical Expert at METACO. “Considering the market cap of ethereum, this makes an attack very unlikely.”
The more staked, the more validator nodes are active. Rewards are then distributed at random to validators in return for their service.
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Connection is critical
Staking is the act of depositing (or investing, depending on who you talk to) the money in the blockchain to become a validator. On the surface, to some, it may seem like any other investment which generates a passive income, but unlike those, it comes with active responsibility.
As long as the validator is connected to the internet and, therefore, the blockchain, the user associated can earn rewards on their investment. However, if the validator loses an internet connection, their earnings may be at risk.
“In crypto staking, making sure your validator node is up is critical,” said Hugh Brooks, Director of Security Operations at CertiK. “The network can economically punish you for failing to adhere to its rules.”
“This is where staking differs from regular interest-bearing systems: the latter is a passive investment; once you’ve deposited your money into a bank account or Certificate of Deposit or even a DeFi protocol, there’s no expectation of further work. Your job is done; you sit back and collect the rewards.”
“Running a validator node that secures a blockchain with billions of dollars of assets is a very different thing. Stakers have a definite role, and they’re putting their assets on the line to validate transactions on the network. The game theory and mechanism design of ethereum staking is a much more complex system than a simple interest-bearing account.”
Some crypto exchanges offer users weekly “staking rewards,” which differ slightly from the act of staking. Users can choose to allow staking within their hot wallet using their regular account, meaning they will receive rewards based on the amount they have stored. The exchange conducts the staking itself. This releases the individual user from the responsibility of a constant connection. However, rewards are usually lower due to a cut taken by the exchange in return for the service.
Why is it significant for ethereum?
The crypto community is somewhat divided over the ramifications of the shift. At the heart of DeFi, decentralization seems open to interpretation yet forms a large part of the pushback from critics of ethereum’s shift.
For many, the act of staking is synonymous with centralization.
According to some sources, it allows the control of a few entities heavily invested in the currency, working to their benefit regarding reward allocation. The idea is that as they have more funds, they have more to stake, increasing the number of validator nodes in their control.
Others believe the opposite, reasoning that the barrier to entry for staking is much lower than for mining. According to the Ethereum Foundation’s website, the energy and hardware requirements can be so low that staking validators can use devices like RaspberryPi to function.
However, the debate around decentralization is essential and has caused ethereum to enter into problems with the SEC. Already the receiver of criticism in 2018 due to its ICO, the shift to PoS has, for Gary Gensler, Chairman of the SEC, put the blockchain back into his jurisdiction.
Currently, 47.76% of ethereum nodes are located in the United States, followed by Germany, which accounts for 19.86%.
According to the SEC, there is the possibility of ethereum being regarded as an unregistered security due to a clustering of the blockchain’s nodes, causing most transactions to take place in the US.
However, in other parts of the world, the understanding is different. Yves Longchamp, Head of Research at SEBA Bank, explained that from the Swiss and European point of view, ethereum could be considered a utility token, and rewards could be more like interest from a bank deposit than a security.
“If you park your money at a bank, you also get an interest rate. And that is not a security,” he said. “So it could be like a deposit. And the reward we get is just an interest rate we get because the world has an interest rate. That’s pretty much the Swiss way of looking at it.”
However, a rule by the SEC that ethereum is a security could have significant implications for the rest of the crypto world.