Ethereum staking explained: risks, rewards, and how it works

Cryptocurrency staking is a way for people to help maintain a blockchain network and potentially earn rewards for doing so. Staking plays a crucial role in how transactions are recorded and how the blockchain is designed to operate securely without a central authority overseeing it. Participants who stake may receive rewards paid in the network’s native token for taking part in this process and are commonly referred to as stakers or validators. (See below for a refresher on blockchains and consensus mechanisms.)

Ethereum staking is a prominent example of proof-of-stake consensus. Think of Ethereum as an open-source app store that generates revenue as more users interact with applications on Ethereum, including tokenized assets, like stablecoins, or decentralized financial services. Ethereum’s native token, ether (ETH), is used to pay transaction fees for activity on the platform. Ether is the world’s second-largest cryptocurrency by market capitalization after bitcoin.¹

Unlike bitcoin — a “proof-of-work” network where miners compete using computational power to propose the next block of transactions — Ethereum’s proof-of-stake network assigns these same block proposal duties to stakers in proportion to their staked collateral; i.e., if a validator has 1% of all staked ETH, they’d have a 1% chance of being selected to propose any given block.

In other words, bitcoin’s security is dependent on the direct and ongoing cost of energy expenditure by miners, while Ethereum’s security is dependent on financial value in the form of ETH that’s locked in the protocol and can become a potential cost if seized. Staking seeks to financially incentivize participants to follow the protocol rules and discourage malicious behavior, as validators risk losing staked assets if they violate the rules.

Staking currently offers validators the potential to earn rewards of 2.5% to 3%² annually on ETH, but introduces incremental risks, most notably liquidity constraints and the potential for financial penalties if rules are violated. This article examines the mechanics of Ethereum staking and the potential advantages of exposure to staking via an exchange-traded product such as the iShares Staked Ethereum Trust (ETHB).

Ethereum is secured by a proof-of-stake consensus mechanism that determines who is eligible to propose the next block of transactions to the blockchain.

Validators are individuals or entities that pledge (stake) ETH as collateral to directly participate in Ethereum’s consensus process. Validators are required to run Ethereum client software to connect with other network participants and vote (attest) on their view of the blockchain.

The core responsibilities of a validator are to validate transactions, attest to the state of the blockchain, and to directly propose new blocks when selected to do so. Validators are compensated for timely performance of these responsibilities through a mix of new ETH issuance and transaction fees.

Each validator’s influence in the voting process is proportional to its share of staked ETH. As a result, the integrity of Ethereum’s transaction history depends on a broadly distributed validator set where no malicious group has the majority of the network’s stake. Ethereum’s security can strengthen as its validator set grows and stake becomes more decentralized.

Validators are incentivized with staking rewards for contributing to Ethereum’s security.

Staking allows validators to earn additional return through rewards, which can vary over time. Staking rewards are paid in ETH and come from two primary sources: (1) new ETH issuance and (2) transaction fees.³

Issuance Rewards: New ETH is issued programmatically by the network and paid to validators as compensation for securing the network. The amount of new ETH issuance is designed to grow as more ETH is staked, but it does so at a diminishing marginal rate, meaning that the staking rewards earned per validator falls as more ETH is staked. With ~30% of all ETH currently staked⁴ , a well-functioning validator is currently earning about 2.75%⁵ per year from issuance rewards today.

Importantly, issuance rewards should not be confused with Ethereum’s overall issuance rate, which is currently around 0.8%⁶ per year. This dislocation is because all new ETH issuance is paid to stakers but only a portion of the total ETH supply is staked. As a result, issuance rewards are much higher than Ethereum’s overall issuance rate as unstaked ETH holders experience modest dilution over time to compensate stakers for helping secure the network.

Transaction Fees: Validators also receive additional rewards in the form of transaction fees when they are selected to propose a block. Transaction fees have historically comprised a meaningful percentage of staking rewards, particularly in more volatile environments, but they’ve been declining and are less proportionally relevant today. Transaction fees have added about 0.1%⁷ to staking rewards over the past month, on average.

The majority of rewards are driven by new ETH issuance and a smaller, more variable contribution from transaction fees.

Before considering the risks specific to staking, investors should first evaluate and underwrite the value proposition of Ethereum. For many investors, Ethereum is a desirable network because of its flexibility and ability to support more sophisticated applications beyond simple value transfers. These applications include supporting decentralized financial services (DeFi), stablecoins (tokenized fiat currencies), and tokenized securities. Ethereum is the world’s leading smart contract blockchain and settlement layer in the crypto ecosystem⁸, and its annual settlement volume is now on par with traditional networks.

The decision to stake, or not, does not materially change an investor’s exposure to the price movements of ETH, which remain the primary driver of returns. Investing in ETH is expressing a view that more applications will be built on Ethereum’s open platform, with the idea of attracting more users, more revenue, and expanding the ecosystem in which ETH is utilized as money.

Staking introduces the potential to generate ETH-denominated rewards on top of existing ETH exposure, but this comes with additional risks, primarily: 1) liquidity risk; and 2) potential loss of capital through penalties or slashing.

Staked ETH is less liquid: Ethereum staking requires locking ETH in the Ethereum protocol, which means withdrawals can take a variable amount of time depending on network conditions, particularly the number of other validators attempting to exit at the same time. The Ethereum protocol limits the rate at which new ETH can enter or exit the validator set for security purposes. As a result, beginning to stake or withdrawing existing stake may take significantly longer during periods of elevated activity. While withdrawing staked ETH often takes several days under normal conditions, delays can extend to weeks or even months in more extreme environments.

Loss of Capital: Staking ETH exposes validators to the risk that a portion of their staked ETH may be reduced if they fail to complete their responsibilities assigned by the protocol. These reductions can range from “penalties”, which are relatively small losses due to operational issues, such as prolonged downtime, to potentially more severe losses in the case of a “slashing” event, which are specific protocol violations that pose greater systemic risk to the network.

In practice, historical data indicates that realized losses from staking have been limited. Validators have a 99.7%⁹ uptime rate — meaning the percentage of time validators are active and participating in network consensus — since Ethereum implemented staking in December 2020, and only 0.03% of all validators have ever been slashed. Of those 0.03%¹⁰ of validators that have been slashed, the largest realized loss was about 3%¹¹ of their stake. All of that’s to say, staking rewards have far exceeded losses, generating ~$10 billion¹² in net rewards to stakers since 2020. While this historical experience is informative, it may not be indicative of future results.

By accessing exposure to Ethereum through an ETP, investors can get exposure via a traditional brokerage account and potentially benefit from Ethereum staking without running validator infrastructure or interacting directly with the protocol. ETHB provides investors with exposure to staked ETH through the convenience of an exchange-traded product, reducing the operational, tax, and custody complexities associated with holding and staking ETH directly. For example, investors staking ETH directly must create their own custody set up or evaluate crypto exchange offerings. Holding the asset directly in a crypto wallet requires users to maintain passwords and/or private keys to prevent loss.

Like all financial investments, ETPs involve an element of risk. Including capital risks, tax risks, and liquidity risks. ETHB is structured similarly to the iShares Ethereum Trust ETF (ETHA), the world’s largest Ethereum ETP¹³, but differs in that ETHA does not participate in staking, while ETHB intends to stake the majority of its ETH and will distribute rewards less fees to shareholders. As a result, ETHB is designed to provide exposure to the price return of ETH plus potential staking rewards.

ETHB works with multiple professional validators to leverage their staking infrastructure, while the underlying ETH is still secured by Coinbase’s institutional cold storage vaults. This approach is intended to combine the potential benefits of Ethereum staking with the operational standards expected of an exchange-traded product.