Latest news about Bitcoin and all cryptocurrencies. Your daily crypto news habit.
Chapter 19 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.
The yield one earns when staking Ethereum is in some ways similar to an interest rate. Of course, it is not technically an interest rate, in that it is not formed as the result of a credit relationship, however it does result in a passive income stream. The staking yield is also counterparty risk free, like the lightning network rate in Bitcoin. However, Ethereum staking is much more passive and the scale of this activity is much larger, making the Ethereum staking yield economically significant. While staking, there is the risk of getting hacked as the private key needs to be on an online machine. On the other hand, stakers can have a separate withdrawal key and staking key, protecting their funds to some extent, as only the staking key needs to be kept on the online machine. However, an attacker could always submit malicious votes with the staking key, which could cause most of the coins to be lost.
Ethereum staking launched in December 2020. However, at the time the staking network was somewhat of an experiment and not used as the consensus system for Ethereum, it was a separate blockchain running in parallel to the main Ethereum chain. However, you could still use “real” Ethereum and earn real Ethereum from staking in the experimental network. In September 2022, the Merge occurred. This meant that the staking network was used as Ethereum’s consensus system, and it was no longer an experiment or test system. However, coins can still not be withdrawn from the staking network and this feature is expected to be added in a year or so.
At the end of October 2022, around 14.6 million Ethereum was staking. These funds were worth around US$22.9 billion. This represented around 12% of the outstanding Ethereum supply. The variable yield obtained by the stakers in late October 2022 is around 5.5%, based on the average rate over the previous month.
When staking launched in December 2020, the yield was around 13%. This higher rate was needed to attract deposits into the staking contract. As more deposits came in, the rate gradually declined, until the late summer of 2022, when the yield reached a low of 4.5%. Since then, after the Merge, the rate has climbed up moderately, to the 5.5% level. Although the yield had these gradual trends, on a day-to-day basis the rate can be quite volatile as network conditions change, however the rate is reasonably stable across several weeks. This 5.5% rate is quite high for an asset like Ethereum and is likely to attract the attention of many investors.
Staking Yield Algorithm
The precise yield one earns from staking Ethereum is determined by a number of factors. It can be influenced by part of the transaction fees users pay, the tips, as well as staking network conditions such as the participation rate of the stakers and the staking performance. The full details of the factors that determine the yield will not be covered in this book. Most of the mechanisms which determine the yield are designed to try and ensure the highly complex staking system achieves the consensus needed to keep Ethereum working. Therefore, economic considerations do not seem to be the primary concern of the designers when these parameters were set.
However, by far the most important principle determining the yield is the number of coins staking and this can be considered an economic factor. The key consideration is that the amount of newly issued Ethereum which is awarded to stakers is approximately proportional to the square root of the number of coins that are staking. Therefore, the fewer coins are staking the higher the staking yield and vice versa, according to this quadratic relationship.
This can be thought of as a stability mechanism. If yields in DeFi become more attractive, driving stakers away and into DeFi, the staking yield will climb in a quadratic fashion. The yield will eventually get so high that the outflow of capital ceases. On the other hand, if the DeFi yield opportunities are poor and there is a flow of Ethereum into staking, the yield will decline. A high yield would no longer be necessary to attract stakers and a yield too high could result in too much Ethereum unnecessarily being issued, which could cause the price of Ethereum to decline. Therefore, as more people stake, the staking yield declines.
It is not yet clear if the number of coins staking will change with the economic cycle. For instance, if falling US Dollar rates will push investors to purchase Ethereum and start staking. Alternatively, rising US Dollar interest rates could cause stakers to leave. The history only shows the number of staking coins increase, as this is all the protocol allows at the moment. Technically, the protocol does allow stakers to exit, however, if this occurs now, the coins are trapped in a kind of limbo, therefore for all intents and purposes, until the network upgrades, the staking balance is only likely to increase.
The cryptocurrency cycle could also impact the number of coins staking. In booming times, the number of coins staking could be low, as investors are instead earning high yields providing liquidity in DeFi and obtaining more exposure to Ethereum using leverage. Then the economic cycle could turn. With fewer opportunities available, more coins could start staking, which is a relatively safe activity compared to engaging in leverage and the staking yield could then decline.
On the other hand, the above is mostly speculation and the impact of a bull or bear market on the number of coins being staked is not clear. There is no precedent here. An alternative idea is that a bear market crash could see people needing liquidity. Therefore, the number of coins at stake could decline, as people need unstaked Ethereum. After the liquidity crunch is over, coins could return and stake again.
When considering the staking yield and the issuance of new Ethereum to compensate these investors, it is important to consider the Ethereum supply. While newly issued Ethereum is created and allocated to stakers, this does not mean the Ethereum supply will get out of control. The maximum inflation rate, if almost everyone stakes and stakes perfectly is only around 1.6% per annum or about two million coins per annum.
1.6% is therefore the lowest rate a staker should ever expect to earn. If this yield is too low that shouldn’t be a problem, because everyone is already staking. On the other hand, if this 1.6% level is too high, too many coins may stake and there could be a problem. Guaranteeing a yield of at least 1.6%, across economic cycles, does potentially seem a bit unsustainable for a potentially appreciating currency and this could be a small risk. However, it may be necessary, as network security needs to be funded.
Ethereum has also implemented a transaction fee policy where a significant proportion of the transaction fees are burnt, which can reduce the supply of Ethereum. Therefore, if demand to use the Ethereum network is high, despite the newly issued coins and staking yield, Ethereum could be a deflationary currency.
The post Reckless – Chapter 19: The Proof Of Stake Interest Rate appeared first on BitMEX Blog.
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.