IMPORTANT
This session won’t take long, but is a prerequisite for Days 12 and 13 to work properly.
CORE CONCEPTS
Today we’ll discuss the difference between proof-of-stake and proof-of-work blockchains. You’ll also start earning some rewards by staking the Ethereum that is sitting idle in your wallet using a decentralized app called Lido. These rewards are currently about 4% APY (in ETH).
What is proof-of-work?
We haven’t talked much about Bitcoin so far. Bitcoin was the first cryptocurrency and remains the most valuable cryptocurrency by market cap. (Ethereum is the second largest.)
Both Bitcoin and the current version of Ethereum rely on a consensus mechanism known as “proof-of-work”. I won’t get into the details of how proof-of-work works, but the short explanation is that it requires computers to perform lots of brute force math in order to validate the current state of the blockchain. Whenever someone solves the problem, they earn a reward. The catch is that the problem gets more difficult the more computers are competing for rewards at any given time.
Here’s a crude analogy using a made-up game:
Imagine if you could earn $1 for guessing a random number between 1 and 100, but you were limited to only one guess per ten minutes. If you played continuously, then on average you could earn $1 every 500 minutes. If you enlisted 100 friends, then, depending on how well you coordinate, you could improve your earnings (across the group) up to the limit of $1 every ten minutes. But now imagine that, instead of the range of numbers remaining at 1-100, the range increases by 100 for every new person who starts submitting guesses. If you have 100 people guessing, the random number’s range is 1 to 10,000. If you have 1,000 people guessing, the range is 1 to 100,000.
This analogy is intended to illustrate that solving the proof-of-work computation gets harder the more people participate. But importantly, the more people who play the proof-of-work game, the more secure and decentralized the network is -- the less likely it is that any one entity can accumulate a large share of rewards.
Proof-of-work is an elegant solution for creating a decentralized ledger of record, but it has some serious problems. Arguably the biggest problem is high energy use. Bitcoin and Ethereum currently consume more energy than many nations.
Proof-of-stake is an alternate consensus mechanism -- and uses a small fraction of the energy of proof-of-work. Ethereum is in the process of live-testing a proof-of-stake network (the “Beacon Chain”), with a complete merge expected in the second half of 2022. Post-merge, Bitcoin will be the only major blockchain still running on proof-of-work.
What is proof-of-stake?
Proof-of-stake is a mechanism through which the owners offer their coins as collateral for the chance to validate blocks on the network. Coin owners with staked coins become "validators."
In the case of Ethereum, validators of the network explicitly stake their ETH into a smart contract on Ethereum. This staked ETH acts as collateral that can be destroyed by the smart contract if the validator behaves dishonestly or lazily. Once staked, the validator is responsible for checking that new blocks propagated over the network are valid and occasionally creating and propagating new blocks themselves.
Proof-of-stake requires significantly less energy. It also lowers the barriers to entry for new participants because there is no need for specialized computer hardware to validate new blocks. Virtually all new blockchains that have come about since Bitcoin and Ethereum use a proof-of-stake consensus mechanism.
One critique, however, of newer proof-of-stake chains is that they aren’t as decentralized as Bitcoin and Ethereum: a small number of wallets controlled by founders or early investors may own a disproportionate share of tokens.
As mentioned above, Ethereum is refining its proof-of-stake chain after years of R&D. It is planning to fully deploy the new mechanism later this year -- a gargantuan project known as "The Merge". Currently, the proof-of-work Ethereum and the new proof-of-stake Ethereum are running in parallel.
How you can stake your ETH today
Even though Ethereum’s proof-of-stake chain is still in testing, it is open for staking. The hurdle is that you need a minimum of 32 ETH and a specialized setup in order to become a validator on the Beacon Chain.
Or you can participate through a decentralized staking solution like Lido. That’s what we’re going to today.
Protocols like Lido have no minimum deposit. You are delegating your stake to a trusted validator. As that validator receives rewards, you get a cut. And, similar to the previous lesson where you staked your KLIMA tokens and received sKLIMA in exchange, the protocol gives you stETH (staked ETH) in proportion to the amount of ETH you staked.
Right now, Lido is able to offer a 4% APY (denominated in ETH). So, if you stake $100 worth of ETH, you’d accrue $4 after a year.
You also maintain the freedom to utilize the stETH via a variety of DeFi protocols (we’ll cover this in a subsequent lesson). It’s like being able to spend cash while it’s sitting in a high-interest savings account.
Mind the gas fees
Before we get started, it’s import to call out that we will be performing these transactions back on the Ethereum network and therefore paying Ethereum gas fees. These gas fees will be about $10-15 in total, regardless of whether you stake $1 worth of ETH or $10,000.
I recommend viewing this purely as a learning exercise and writing off the gas fees. It doesn’t make a lot of financial sense to pay $10 in gas just to earn $4 in rewards one year later!
Alternatively, if you are feeling ready to take on some more financial exposure to Ethereum, now could be a good time purchase more ETH and transfer it over prior to staking (ie, repeat portions of Days 1 and 2).
Staking on Lido
Go to the Lido homepage (lido.fi) and click the Stake now button. You can also check out its current usage stats at the bottom of the screen.
Lido supports staking a variety of tokens. Today, we’ll just focus on Ethereum, but we could also stake our MATIC tokens on the Polygon chain.
Click the Stake now button in the Ethereum box.
The MetaMask widget should pop-up now. Make sure you are connected to the Ethereum network (and not Polygon anymore). Connect your wallet and sign the transaction just as we’ve done with other dapps.
Now you’ve granted Lido access to look inside your wallet. It should show your current ETH balance. (You may also receive a pop-up offering an option to buy stETH somewhere else, which you can ignore for the purposes of this lesson.)
Enter an amount of ETH that you are ready to stake. Don’t put all your ETH in -- you’ll need to save some for gas fees. I entered 0.033, leaving about 0.02 in my wallet. The staking tool will also give an estimate of the transaction costs (gas fees). Finally, it shows the reward fee of 10% that is paid to the validator who you are delegating your fractional stake to.
Once you’ve entered the amount you’re prepared to stake, click the Submit button. MetaMask will pop up and you’ll be able to confirm and sign the transaction.
Wait a minute or two for your transaction to clear.
Congratulations! You staked some ETH and received stETH in return. You’re making the Ethereum network more secure and earning a modest reward in exchange for your service. Your rewards will accrue in the form stETH and be added to your balance automatically.
If you want to confirm what’s in your wallet, head over to Zapper and view its contents. You should see stETH, ETH, and WETH in it.
Lido is not the only decentralized Ethereum staking protocol. Rocket Pool is another popular alternative. If you are looking to stake ETH at more serious levels, defi experts often recommend using more than one protocol to diversify your exposure. Of course, all decentralized finance protocols have their inherent risks. Don’t put in more than you can afford to lose… and remember none of this is financial advice!