It has now officially been one year since the Ethereum Merge. Last year, the Merge upgrade ushered in the advent of a new era for not only the Ethereum network but for the broader staking landscape, as the world’s second-largest digital asset transformed from proof-of-work asset into by far the largest proof-of-stake digital asset by market value (worth approximately $200 billion at time of writing).
This article is part of CoinDesk's "Staking Week." Chen Fang is the chief operating officer of BitGo.
The transition to proof-of-stake not only significantly reduced Ethereum’s energy intensity, it allowed a larger number of holders to participate in the network and to earn rewards for validating transactions and securing the network by staking their holdings.
These rewards are no small matter — the recent Q2 2023 "State of Staking" report from Kraken finds that total staking rewards for all cryptocurrencies grew to $5 billion on an annualized basis during the quarter.
Staking is growing into a massive ecosystem, with the report showing that the top 35 proof-of-stake cryptocurrencies combine for a market cap of $288 billion, and that there is now $68 billion worth of value staked in these assets. One year in, it's clear staking continues to be an attractive option for Ethereum holders.
Generating competitive rewards in a risk-off market
The primary appeal of staking, in addition to helping to secure and further participate in the network, is that it creates the ability for participants to earn rewards on their holdings. Last year’s bear market or "crypto winter" was a painful downdraft for many crypto investors, as rising interest rates and the implosion of FTX caused broad losses across the market.
But just as equity market investors turn to more defensive stocks with higher dividend yields like utilities and consumer staples during times of turmoil, staking is an appealing strategy for Ethereum and proof-of-stake token holders during a risk-off market environment. Staking allows these holders to generate a return while retaining their assets.
With staking, holders no longer need to sell in order to generate a return. Staking can thus help to soften the blow of a bear market, allowing holders to weather the storm until asset prices return to more attractive levels.
According to Ethereum.org, the current annual percentage rate (APR) for staking is 3.9%. The rate has declined slightly as the number of validators has increased, but with MEV Boost (the middleware validators use to increase staking rewards by selling block space to an open market of block-builders) enabled, the returns are higher, ranging from 4.2% and 5.6% over the past six months.
Over 90% of nodes currently have MEV Boost enabled. Beyond increasing rewards, this feature is also creates competition among block builders, allowing validators to sell their blockspace to the highest bidder. Additionally, MEV Boost democratizes the staking process by allowing smaller validators to participate, which in turn increases the network’s censorship-resistance.
These rewards are competitive with the yields investors can find in traditional yield-bearing financial instruments like 10-year Treasury bonds or dividend stocks. Ethereum’s APR narrowly lags the 10-year Treasury’s current 4.5% yield and easily surpasses the average yield for the S&P 500, which currently sits at 1.5% (though many of the equity market’s most popular dividend stocks sport yields ranging from 3-5%). These rewards put Ethereum in the conversation with these income-producing TradFi assets, and they have been conservative and consistent over time.
Ethereum upgrade: removing barriers to entry
While the Merge transformed Ethereum into a proof-of-stake asset, staking on Ethereum didn’t evolve into its fully-realized form until the Shapella upgrade in April 2023. The implementation of Shapella enabled Ethereum stakers to withdraw their holdings for the first time since staking began in December 2020.
This gave early stakers the ability to unlock their holdings and withdraw the staking rewards they had accrued over time, while removing uncertainty going forward. This was of particular concern to institutional investors, who champion liquidity above all else, especially in a market where prices can be volatile.
The benefit of this upgrade is clear, as the amount of Ethereum staked continues to increase over time.
In the run up to Shapella, some market participants and media outlets predicted that there would be a large outflow from staking and sell-off of Ethereum, since some holders had been locked in for almost two years.
However, the opposite turned out to be the case: since the upgrade in April there has been a net inflow of over nearly 7.5 million ETH into staking. This increase illustrates the powerful effect that removing the uncertainty surrounding the time frame for making withdrawals has had on demand for staking.
Further, the percentage of the total supply of ETH that is staked is now 22.4%, up from 14.5% before Shapella. Many Ethereum participants believe that this percentage will continue to increase going forward, perhaps reaching 50% as soon as May 2024.
The number of validators has also surged since the Shapella upgrade, nearly doubling from roughly 430,000 validators right before the upgrade to over 840,000 today.
Entry and exit queues
There were initially long queues to enter staking positions, as stakers jostled for positioning prior to Shapella upgrade going live. These queues were exacerbated when Kraken shut down its staking program as part of a settlement with the U.S. Securities and Exchange Commission (SEC). Kraken stakers exited en masse and migrated to other services, compounding the bottleneck.
As the situation has normalized, the exit queue has reduced by a significant margin from a matter of days to under one hour, meaning that stakers now have the freedom to exit relatively quickly if needed. At time of writing, there are just 27 validators in the exit queue.
At the same time, the entry queue for staking has also decreased since Shapella to more normalized levels from a high of 46 days. The entry queue currently stands at just over eight days, with nearly 20,000 validators looking to begin staking. In U.S. dollar terms, this represents about $1.5 billion worth of ETH sitting on the sidelines and a healthy demand for staking. Other observers expect the proportion of ETH that is staked to increase significantly over the next few years.
One challenge that Ethereum is contending with in the wake of the Merge is that with growing interest in the network and growing desire to participate in it, there are now 840,000 validators. While this is beneficial to the core principle of decentralization, the sheer number of machines and their wide-ranging geographic dispersion inevitably leads to strain on the network, resulting in increased latency and longer waits to reach consensus.
In one way, this is a good problem to have — the number of validators and nodes are growing because interest in Ethereum is growing. However, to improve the experience of using Ethereum from everyone and to compete with other blockchains, Ethereum developers will need to reconcile this issue.
Developers are working on solutions that would fix this problem while still fitting in with the founding principle of decentralization, such as increasing the maximum cap on the number of ETH per validator to 2,048 (up from 32 ETH), which would significantly cut down on the number of machines currently operating on the network.
While long entry queues for validators are a potential challenge, they also indicate the high demand for staking ETH and are in place to make sure the network is secure. Upcoming upgrades that will bring lower gas fees, greater speed and account abstraction to the Ethereum network are on the horizon, further increasing Ethereum’s appeal.
Network participation has climbed steadily since the transition to proof-of-stake. Before the Merge, there were approximately 205 million unique Ethereum addresses. This number has increased to 245 million today.
The number of unique Ethereum addresses and the number of validators have grown substantially since the Merge, as has the total amount of Ethereum staked, indicating that these improvements are bringing new users into the ecosystem and opening the network to more participants.
With increased accessibility, improved flexibility and UX, the ability to earn rewards and the opportunity to participate in blockchains in a new and meaningful way, staking empowers Ethereum holders and will continue to play a pivotal role in the future of the network.