Most people talk about staking in terms of APY (aka financial rewards), but not in terms of purpose and where those rewards come from/will go. Let’s get up to speed using Solana as an example.
The need for staking: The decentralized dream is nodes around the world faithfully contributing to a blockchain, but the challenge is incentivizing participants to behave. For both proof-of-work and proof-of-stake, the work or the stake is used to decide who gets to add to the blockchain and get the resulting financial reward. In proof-of-stake, the incentive to not act maliciously is via putting tokens at risk (“staking”) which can be lost (“slashed”) should you act maliciously.
How is staking APY determined? by the designers of the blockchain protocol. Many, including Solana, start with high APYs to attract participants which then help secure and decentralize the blockchain. Over time, that APY changes usually based on a predetermined proposal.
Let’s concretize this: Solana currently has ~1775 validator nodes. When you stake SOL, you are delegating your SOL to one validator, which is a fancy way of saying you’re putting your voting power behind a validator you think is trustworthy. Should the validator do a bad job (e.g. software crashes) or act maliciously (e.g. double validates one transaction), the capital put at stake by the validator and those who delegated to it should get slashed, thereby creating a financial disincentive (notably, Solana slashing is not live yet).
Solana stakers earn based on the formula below. Every epoch (~2 days), staking rewards are computed and distributed proportionally to validators based on staked-weight.
This confusing formula essentially says the staking yield is determined by:
Inflation rate - based on a proposed schedule found here, in short it’s around 7.2% right now eventually going down to 1.5% at steady state. Inflation higher, staking yield higher (in absolute, not real terms)
Validator uptime - the more the validator you delegated to stays up, the more staking rewards you receive
Validator fee - the validator can choose to take 0-100% of the fees generated by successfully validating transactions. The lower a fee they take, the higher your staking rewards
%SOL staked - the less %SOL staked by everyone in the system, the higher your staking rewards should be since they split the pool among fewer people
According to Solana’s models, the annual staking yield over time decreases until it is between 1.5%-2% at steady state. At steady state, the hope is that the validators and stakers are sufficiently decentralized with enough fees going through the system such that they don’t need nearly any staking incentive at all. There are a lot of assumptions baked into this, but that is for another article!
Proof-of-work v. Proof-of-stake primer:
Proof-of-work: distributed hardware performs cryptographic computations (“the work”) to validate transactions and update the blockchain. Bitcoin and Ethereum are examples
Proof-of-stake: distributed validators (which are nodes running software) put their own crypto at risk (“the stake”) for the chance to validate transactions and update the blockchain. Most recent L1s including Solana and Polkadot are examples of this
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