Staking: Where Do the Rewards Come From?

Staking makes it possible to earn rewards for taking part in securing certain blockchain networks. Behind the rate shown in an app lies the specific work of validators, the rules for issuing the cryptocurrency and sometimes also income from transaction fees. To understand an offer, we need to know what role our funds play in the network and under what conditions we can get them back.

The principle can be explained well using Ethereum, whose native cryptocurrency is ether, or ETH. Other networks, however, may handle delegation, withdrawals and possible penalties differently. We therefore assess staking according to the specific blockchain and the service used. Merely holding a cryptocurrency in a wallet does not automatically entitle us to rewards.

Why the network needs validators' deposits

A blockchain needs rules by which its participants agree on the valid history of transactions. In the Proof of Stake mechanism, PoS for short, validators take part in reaching this agreement. Their software checks blocks and votes on the state of the chain; under the protocol rules, they may also be selected to propose a new block. In Ethereum, this participation is tied to depositing ETH into the protocol.

The deposit has an economic purpose. A validator can earn rewards for properly performing its duties, but certain rule violations can also put its deposited funds at risk. In Ethereum, for example, a validator can lose part of its deposit if it proposes more than one block for the same slot. An attack on the network can thus mean a loss of capital for the attacker itself.

The reward is therefore linked to operating and securing the network. If we use a service that runs a validator on our behalf, the technical work is done by its operator. Our participation may be limited to a few steps in an app, but that does not make the validator's duties disappear. What matters is how the service passes its income and any losses on to clients.

What rewards are made of

One source is new issuance. The protocol creates additional units of the cryptocurrency according to its rules and allocates them to participants who perform the specified tasks. This is how Ethereum rewards validators for taking part in consensus. The issuance of new ETH needs to be distinguished from the change in total supply, which is also affected by the burning of part of the fees.

Another source can be the fees users pay for transactions. With Ethereum, however, the validator does not receive the entire fee paid. The basic component, referred to as the base fee, is burned, meaning removed from circulation. The priority fee, on the other hand, goes to the block proposer. Higher total fees in the network therefore cannot automatically be equated with an equally large increase in rewards for stakers.

Income can also be supplemented by revenue from ordering transactions in a block, referred to by the abbreviation MEV. For example, an arbitrage opportunity between two exchanges may motivate transaction searchers to seek inclusion in a particular order or to offer payment for it. Part of this income may also go to the block proposer; how it is divided depends on the infrastructure and service used. It is not a fixed reward that every holder would receive evenly.

For a specific offer, we therefore look at which income the stated rate includes. If part of the yield consists of a temporary reward paid by the provider, we need to separate it from the blockchain's rewards. Once the promotion ends, this part may cease to exist without the rules of the network itself changing.

Why the rate changes and how to read APR and APY

Rewards are affected by the amount of assets committed to staking, the validator's performance and the protocol rules. In Ethereum, as the total active stake grows, the base reward for the same amount of staked ETH falls. On top of this comes the variability of income from proposing blocks and from their content. The result over a short period may therefore not match the long-term average.

The abbreviation APR usually expresses an annual rate without accounting for ongoing reinvestment of rewards. APY takes into account the assumption that rewards are put back to work and generate further rewards themselves. Neither abbreviation promises a guaranteed result. What matters is whether it is a historical figure, a current estimate or a time-limited offer, and whether fees have been deducted from the rate.

Let us imagine a model service with a gross annual rate of 4 % and a commission of 10 % of rewards. With a deposit of 10 ETH, a gross reward of 0.4 ETH would arise over a full year at an unchanged rate. The provider would keep 0.04 ETH and we would be left with 0.36 ETH, i.e. 3.6 % of the original deposit. The example does not account for other costs, outages or a change in the rate.

A commission on rewards has a different impact than an equally labelled fee on the entire deposited amount. When comparing services, we therefore need to know the basis of the calculation. If the app already shows the net rate after commission, we should not deduct it a second time. With APY, we also check whether the service actually reinvests the rewards and what costs are associated with this.

More coins need not mean higher value

The staking reward needs to be separated from the price of the cryptocurrency. Gaining additional units of an asset may be accompanied by either a rise or a fall in its market value. For the result in CZK, what is decisive is the value of the entire position at the moment we value or sell it.

In a simple model, we hold 100 coins at 1,000 CZK each, i.e. 100,000 CZK in total. After a year and the crediting of rewards, we have 104 coins. If, however, the price of one coin falls to 700 CZK, the position is worth 72,800 CZK. The number of coins rose by 4 %, yet the CZK value of the entire position fell by 27.2 %. For clarity, we do not account for other costs or taxes.

A separate question is the growth in the cryptocurrency's supply. If rewards arise from new issuance, additional units are added across the entire system alongside our coins. On a model network, the number of our coins may grow by 8 %, while the total supply increases by 10 %. Our share of the supply thus shrinks slightly. A high reward rate on its own therefore does not tell us how our relative position or the market price of the asset is changing.

How to take part in staking

The most direct route is running your own validator. In Ethereum, activating one requires at least 32 ETH. The operator provides the hardware, connectivity, updates and key management. It receives rewards directly under the protocol rules and is responsible for operation. Gross income, however, does not yet reflect its own costs for equipment and operation.

Other networks support direct delegation. The holder assigns their stake to a chosen operator who produces blocks, without having to run the necessary infrastructure themselves. For example, with standard delegation of ADA in Cardano, the coins remain under the holder's control and are not locked by delegating. Cardano does not apply slashing to delegated stake. These rules cannot automatically be transferred to other blockchains or to an intermediary's offer.

In Ethereum, validator operation can also be used as a service. In some arrangements, we keep control over the withdrawal address and entrust the operator only with the signing keys needed for validation. An operator error can still harm us. With a fully custodial service, by contrast, the provider also controls the funds and keys. The network's risks are then joined by the risks of the provider's security, its ability to meet its obligations and its withdrawal conditions.

For smaller amounts, there are staking pools that pool the funds of multiple participants. In Ethereum, these are solutions built on top of the base protocol, with their own operators, rules and sometimes also smart contracts. Knowing the name of the blockchain is therefore not enough. We need to know to whom or to which contract we are entrusting our funds and how rewards are divided among participants.

The way of participating also affects how control over the network is distributed. Thousands of clients of one platform need not mean thousands of independent operators. If a large share of deposits is managed by a few entities using the same infrastructure or software, their joint failure can affect a larger part of the network. When assessing security, the independence and diversity of operators therefore also matter.

What liquid staking adds

Some pools issue a token representing a share in the staked position. It is referred to as a liquid staking token, or LST. The underlying ETH remains committed to staking, while the token in our wallet can be transferred or sold under the conditions of the given solution. We thus hold a token tied to a position in a particular system whose functioning also depends on intermediaries and code.

The reward need not appear as a separate incoming payment. With one type of token, the number of tokens in the wallet grows; with another, the number stays the same and the amount of the underlying asset per unit changes. Lido's documentation describes this difference using the stETH and wstETH tokens. A balance with no visible increase in tokens therefore does not necessarily mean that rewards are not being credited.

Liquidity, however, comes with conditions. The market price of an LST may deviate from the value of the underlying ETH, and selling may mean accepting a discount. Getting ETH back through the protocol has its own procedure and may require waiting. There is also the added risk of a smart contract bug, changes in protocol governance and operator failures. Holding an LST therefore does not remove the risks of staking.

If we further use the token as collateral for a loan, we add another financial operation. In adverse conditions, there may be a risk of the collateral being liquidated. A higher combined yield in such a strategy does not come without additional risk and cannot be compared with simple staking based solely on the resulting percentage.

When we can get back to our funds

The conditions for entry and exit are as much a part of staking as the reward. For a specific network or service, we check the minimum deposit, the moment rewards begin and the exit procedure. In Ethereum, there are mechanisms both for withdrawing rewards and for exiting a validator. The withdrawal time depends on the validator's settings and on queues. Being able to request an exit therefore does not mean that all the ETH will immediately arrive in a wallet ready for ordinary use.

With a pool or custodial platform, the blockchain's rules are joined by the way the service processes withdrawals. We find out whether the estimated time covers the whole process, whether rewards still accrue while waiting and what could extend the withdrawal. At the same time, regular payout of rewards need not mean equally fast availability of the original deposit.

If a provider offers a fast exit, we need to understand its mechanism. It may use an available reserve, another buyer or the sale of a token representing the staked position. Each route has its own limitations. With an LST, for example, it is advisable to compare the selling price on the market with the option and duration of a withdrawal through the relevant protocol.

Downtime and slashing have different consequences

In Ethereum, ordinary inactivity can mean missed rewards and penalties for unfulfilled duties. A brief internet outage on its own, however, does not automatically lead to slashing. The consequences are affected by the length of inactivity and by the state of the rest of the network; they can be more severe especially during a period when the network cannot finalize blocks. This is why the quality of operation matters even if the funds remain under our control.

Slashing is a more serious penalty for precisely defined rule violations, for example proposing more than one block for the same slot or certain violations of voting rules. In Ethereum, it leads to the loss of part of the deposit and the forced exit of the validator. The size of the penalty may also be affected by whether a larger number of validators fail in a similar way during the same period. It is not merely a matter of a future reward not being paid out.

A violation can also occur due to a misconfiguration, not only in the case of deliberate fraud. For a user of a service, it is therefore essential to know who will bear the financial consequences of an operator error and what conditions apply to any compensation. A label such as "slashing protection" does not in itself explain the scope of coverage. The terms may limit the type of event, the amount and the method of compensation.

Lending has a different source of yield

When lending, we provide cryptocurrencies to borrowers, and the yield comes mainly from the interest they pay for them. For example, in Aave v3, suppliers deposit assets into a pool, and the interest they earn comes from borrowers' interest after deducting a portion allocated to the protocol. The rate is affected by the utilization of available funds. A deposit into such a product is not participation in the blockchain's consensus.

With a centralized lending service, what matters is to whom it lends and under what conditions it stands behind its obligations. With a decentralized protocol, we also assess the smart contracts, price sources and loan collateral. Not even collateral removes the risk: its value or liquidity may decline, and incorrect data may disrupt how the system functions.

The basic differences can be compared by purpose and source of income.

Purpose of funds

Staking in a PoS network: Participation in securing the network and reaching agreement
Crypto lending: Providing assets to borrowers

Basis of yield

Staking in a PoS network: Protocol rewards and any additional validator income
Crypto lending: Interest paid by borrowers

Specific risks

Staking in a PoS network: Validator operation and penalties depending on the network
Crypto lending: Non-repayment and insufficient collateral

Availability of funds

Staking in a PoS network: Network rules and any service involved
Crypto lending: Product terms and available liquidity

The table captures the basic mechanism. When an intermediary or smart contracts are used, related risks are added for both options. Lending, too, need not allow immediate withdrawal. Aave's documentation, for example, makes withdrawal conditional on sufficient unborrowed liquidity; if the deposit also serves as collateral for your own loan, withdrawal is further limited by the collateral required for that position.

A useful approach is to look directly at the source of the offered reward. Bitcoin uses mining, not native Proof of Stake. An offer of yield on BTC therefore requires an explanation of a different mechanism, such as lending or the use of another protocol. Likewise, simply depositing a stablecoin into a yield product cannot be considered a reward for validating Ethereum. What is decisive is how the funds are actually used.

How to assess a specific offer

Before taking part, we need to clarify several related questions:

• – Which network do the funds secure and where is the reward paid from?
• – Who controls the keys, runs the validator and is responsible for any losses?
• – Is the rate gross or net, and what assumptions does the APR or APY include?
• – How does exiting work and when can the original deposit actually be used?
• – Are we accepting only the risks of staking, or also the risks of a token, a loan or another protocol?

The answers allow us to compare like with like. A higher stated percentage may stem from a different asset, temporary incentives, a longer withdrawal restriction or a more complex strategy. Until we understand the source of income and the way of exiting, we do not have enough information for a meaningful comparison.

Conclusion

Staking links rewards with participation in operating and securing the network. The protocol rewards validators for performing specific duties and at the same time sets the rules for entry, exit and possible penalties. With a service or pool, it also matters who controls the funds and how rewards and risks are passed on to participants.

When assessing the result, we need to distinguish between the number of coins gained, the growth of their total supply and their market price. The stated rate captures only part of this picture. Rewards can keep accruing even while the CZK value of the entire position is falling.

Crypto lending works on a different economic basis, because the yield comes from interest paid by borrowers. We therefore compare staking and lending offers according to the actual use of funds, costs and availability of withdrawal. Only once we understand the mechanism and its risks does it make sense to evaluate the offered percentage.

This text is for informational and educational purposes only and does not constitute investment advice. Crypto assets are volatile and you may lose the entire amount invested.