The purpose of this article is to explain the basic concept of why there is staking and how it works. It is primarily targeted at people who are new to the crypto space. As we all started out once as beginners, an effort was made to keep the language as non-technical as possible and concentrate rather on the fundamental principles. It is, however, in order to answer the question of what staking is, necessary to start by explaining a few basic terms that are essential in understanding blockchain technology.
TL;DR: If you have a cryptocurrency that supports staking you can link your holdings together with others to strengthen the network and benefit from a quasi interest rate. No need to send or lock anything. Your assets stay at your full disposal in your wallet at any time.
A blockchain is basically a growing list of records that is amended in fixed time intervals (20s in the case of Cardano) with the latest information. These stored amendments are the blocks of the chain of events. Every new block is cryptographically linked to the previous one and represents a number of transactions that occur between the different participants in the network. Because of the interconnectedness of these blocks, no one can tamper with previous entries because such changes would not match with the current state of the blockchain and would therefore be denied by the protocol. This means a blockchain is immutable and represents all the transactions from its beginning to the present moment. To avoid fraudulent entries in a newly created block, like double-spending, where one participant tries to send all their available coins to several different receivers at the same time, all participating parties have to come to an agreement which transactions are valid and which are not. This is called a consensus.
Consensus means that a number of honest parties agree with each other on the validity of the transactions. As long as more than half of the network consists of honest players that agree with each other, the integrity of that system is intact. So a system has to be designed in a way that it is more favorable to be an honest player and that it discourages bad behavior. This is done by offering an incentive to every participant who creates a new block that is accepted and validated by the network. They will receive a reward in the form of extra coins by the protocol.
The rewards come from transaction fees which users of the system have to pay, and from coins that come newly into circulation. As with most cryptocurrencies, there is a maximum set value of how many coins there will ever be. Not all of those coins are available from the start but rather come into circulation over time at a predetermined rate. This means that a crypto-currency, similar to government-issued fiat money, initially has a certain amount of inflation to it, but when the supply of new coins decreases, it will eventually have a deflationary character and become more valuable over time. Also in the case of 3rd generation crypto-currencies that have extra abilities such as representing smart contracts or being used for decentralized applications dapps, the value of the coin is expected to grow with the increase of usefulness.
Now, in order to achieve having enough participants with honest behavior, different methods can be applied. In older generation blockchains a method called “proof-of-work” (PoW) is being used. A participant has to deliver work in the form of computational power to have a chance of receiving rewards. The participant (miner) has to continuously run very high powered computers that try to find a solution for a given cryptographic riddle. Once a solution is found the miner is granted the right to write the newest block and receive the reward for it. It is very costly in terms of energy to be able to participate in a profitable manner in such a system. This means that an attempt to write wrong data onto the chain where one would have to have control over more than 50% of the network’s computing power would be so expensive that the possible fraudulent gains might not outweigh the cost of the attack.
On the one hand this makes the system secure against fraudulent behavior since it would be too expensive to get so much computing power for one actor. On the other hand this makes the overall economic efficiency very bad since the biggest part of the used energy is simply wasted without purpose. For instance the bitcoin network alone uses approximately the same amount of energy as the whole country of Austria*. Also due to the high cost the number of participants is very limited. As a consequence, these systems tend towards centralization where only a few big players can participate and thus the possible risk of a malicious attack by a group of big players is rising again.
In an effort to solve those problems a new type of validation of honest players has been introduced with the “proof-of-stake” (PoS) system. With proof of stake everyone that holds the native asset of the respective protocol (in the case of Cardano that is its currency ADA) is entitled to produce blocks and in return receive rewards. Since there are currently about 26B ADA coins in circulation it is impracticable that every one of these coins is participating for itself. Hence, the system works by bundling these coins together into pools who then get the right to participate in the protocol on their behalf. Out of all the participating coins, every 20 seconds one is randomly chosen by the algorithm to have the right to mint a new block. The stake pool to where that coin was delegated mints that block on behalf of the winner-coin and if it succeeds in doing so, will get the respective reward. Since the chances for a single coin to be elected are only very slim (1:26B every 20 seconds), some might never be the lucky ones and others maybe more often. That is why the pool acts as an intermediary and divides the gained rewards to all of its delegators in a proportionate manner. So every delegate gets the rewards proportionate to their involvement (stake/delegation). To keep the network decentralized and not let a small group of individuals get too much control, the system is designed to have multiple stake pools, and penalizes pools that get too big by capping their rewards. This “saturation” level is currently set at ~220million ADA.
Currently, there are around 2,500 pools and they are all in a contest to make the next block for their represented coins. A pool that holds many coins will have an overall higher probability to be chosen for slots, but also has to divide the rewards among this bigger number, whereas a pool with less delegation has a lower probability, but when it does get picked to produce a block, those rewards will be split between fewer delegators.
Over time, the rewards for both small and big pools will even out. There are, however, several factors in which the pools differ from each other and which have an effect on the overall paid out rewards. Mainly these are the performance of a pool, the fixed fee, the epoch fee and the saturation level. The impact of those factors and what to look for when choosing a stake pool are described in this article.
One factor that has a significant impact on the security of the proof of work system and has to be explained, is the pledge. The pledge is the amount of coins the respective stake pool operators have in the pool themselfs. Only stake pool operators have to lock up an amount in order to show their involvement and be able to participate. The amount of pledge is a strong indication of the intention to represent an honest participant. If an operator has little to no personal investment (“skin in the game”) in the pool, they have less or little to lose themself in case their pool doesn’t perform well or even harms the stability of the network. It is therefore advisable, in the interest of all, that delegators choose pools that have a substantial investment themselves to prove their stake in the game.
In the hope that this article was helpful to you and awoke an interest in participating as well, we’d like to invite you to check out our webpage where you can find all the information about our stake pool or have a look at this guide that aims to educate on the essential things to look for when deciding where to delegate.
Happy staking, everyone!