Ethereum Staking Overview

The spotlight during the past week has continued to shine on Bitcoin – and with good reason. There were ongoing positive developments surrounding the flurry of new spot BTC ETF filings in June, which resulted in a number of major institutions (Blackrock, Fidelity, etc.) updating and resubmitting their filings to include custodians and BTC spot price surveillance mechanisms. As a result, enthusiasm continues to build towards a spot BTC ETF approval, and BTC continues to lead the charge in the crypto markets. This is evidenced by the ETH/BTC ratio, which has flatlined at the 0.60 level – this is the lowest level for the ETH/BTC ratio since July 2022.

Nevertheless, although “alt-coins” are under pressure relative to BTC (especially since several prominent alt-coins were alleged to be securities in recent SEC enforcement actions), Ethereum has arguably graduated from being an alt-coin to an institutional grade asset. ETH’s status as a commodity vs a security is hotly debated, whereas there is a more consensus view that many other tokens are true securities. Additionally, ETH beginning as Proof of Work before switching to Proof of Stake during the Merge provides an argument that ETH is potentially “sufficiently decentralized” and differentiated from other tokens.

Therefore, although the BTC ETF is likely to drive the crypto narrative in the near and medium term, ETH could emerge as the next institutional grade asset shortly thereafter. Part of the adoption thesis is driven by ETH being a differentiated asset to BTC: while BTC is “digital gold,” ETH represents a software platform akin to the ”App Store” with a token that has native staking yield. Other than Proof of Stake consuming less power / energy than Proof of Work and offering more potential blockchain security than mining, Proof of Stake has also introduced a staking yield that could be a foundational reason for institutional participation in ETH. In this piece, we give an overview of the ETH staking economics and landscape.

ETH’s staking yield is based on the “Ethereum economy” – or more specifically, from the activity of users and apps that use the Ethereum network. This is highly analogous to how US interest rates are based on activity in the US economy; in times of high growth + high inflation, US rates are raised (as we are seeing now), and in periods of low growth + recession, US rates are lowered (as we see during crises like 2008 and 2020). Ethereum’s staking yield programmatically achieves a similar result without the use of middlemen.

Ethereum, like Bitcoin, has protocol issuance of tokens which is paid out to participants that secure the blockchain by verifying transactions. For BTC, these are the miners, who are paid the BTC block subsidy (which is essentially a “yield” on the equipment/power investment a miner makes). For ETH after the Merge, these are the validators who stake their ETH and receive an ETH block subsidy for doing so. Issuance is a key part of the ETH staking yield.

Ethereum, like Bitcoin, also pays transaction fees to validators/miners. This comprises the other major part of the ETH staking yield. The difference is – Bitcoin is mainly used as a store of value rather than a means of payment, and BTC fees are therefore relatively small compared to the block subsidy. BTC will likely need to be subsidized by issuance for the foreseeable future unless an economy of users and apps develops on Bitcoin. Ethereum has the potential to have its network security “subsidized” entirely by transaction fees due to the blossoming economy of DeFi, NFTs, payments, gaming, L2s, and other smart contracts being built in the ecosystem.

Finally, we will examine different ways to participate in ETH staking, whether through solo staking or using pools.

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ETH Economic Snapshot

• The ETH staking yield is driven largely by the Ethereum economy – so let’s take a look at the drivers of the Ethereum economy. The main measure of activity for the Ethereum network is total ETH fees.
• Every on-chain transaction in the Ethereum network requires a small portion of ETH to be paid to the set of ETH validators. This fee compensates validators for including transactions into Ethereum blocks. The transaction fee consists of a “base fee” and a “tip.” Historically, the base fee has comprised ~80% and the tip ~20% of the total fee. In August 2021, the ETH community passed a protocol upgrade (called EIP-1559) where the entire base fee would be “burned,” or deleted, from existence. This makes the ETH monetary policy sustainable (and potentially deflationary), as burned fees offset new block subsidy issuance. Current inflation rate is -0.19%.

Staking Yield Breakdown

• What are the components that make up the ETH staking yield? The yield is comprised of two major components and one tertiary component.
• The first, and currently largest, driver is ETH issuance to validators. Unlike BTC, ETH does not have a supply cap, as the philosophy has always been for the protocol to issue enough ETH to incentivize validators to continually secure the blockchain. BTC issuance cuts in half every four years to reduce the inflation rate; ETH offsets inflation by the second yield driver.
• The second yield component is ETH fees (minus the 80% fee burn, which has been offsetting issuance since the Merge and has resulted in deflation).
• MEV is a third yield component which is currently negligible.

Staking Yield Sensitivity

• Let’s look at the mechanics of the ETH staking yield. As a directional proxy, more ETH staked means more issuance required (since there will be more validators that need to be given block subsidies for validating the chain). Orthogonal to amount of ETH staked is total ETH fees; the higher the ETH fees occurring in the Ethereum economy, the higher the staking yield will be and the more deflationary net issuance will be (since higher fees means higher ETH burn to offset block subsidy issuance).
• Even with 100mm ETH staked (83% of the supply) and zero fees (which is unrealistic), net issuance is only 1.51%. More realistically, with annualized fees of 1-1.5mm ETH, issuance becomes slightly deflationary in most scenarios, making the monetary policy sustainable over the long run.

ETH Staking Options

• There are three different ways to participate in the ETH staking economy. The first is solo staking – or setting up validator structure individually. ETH’s Proof of Stake mechanism was designed for users to set up nodes on consumer-grade hardware (e.g., not requiring high equipment, electricity, or bandwidth cost). This is the most “decentralized” way to stake.
• The second is to use a staking provider like Coinbase, Figment, orStakefish. These services set up validators on behalf of clients and stake ETH via pools. Some of these services are “non-custodial” where the client holds keys, while some are fully custodial and stake on behalf of client.
• The final way to stake is to use a “liquid staking token,” which stakes via a DeFi protocol and issues a receipt token representing staked ETH. This is highly popular and is dominated by a protocol called Lido. Overall, ETH staking is designed for maximum accessibility for all users.

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