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Introduction to Sustainable Staking

Staking allows DeFi users to earn sustainable yield by setting aside digital assets to become a validating node for a proof-of-stake (PoS) blockchain, like Ethereum. Users can stake in several ways, each with their own pros and cons.

In November 2021, staked ETH hit an all-time high of $109.91 billion. Digital asset users are clearly demonstrating increasing interest in yield generation via staking. However, there are several ways to stake digital assets, and some are more sustainable than others. For this reason, understanding staking basics is necessary to discern sustainable ways to generate yield in DeFi. Even so, modern versions of “staking” confuse sustainable versus unsustainable yield opportunities.

In this article, we will explain the difference between sustainable and unsustainable staking. We’ll also cover the basics of staking and introduce our upcoming product, Diversified Staked ETH (dsETH). dsETH abstracts active management of staked ETH into a single token.

  • What is staking?
  • Types of staking
  • Introducing Diversified Staked ETH (dsETH)

What is staking?

Staking is the process by which network participants agree to set aside digital assets, usually in a “staking pool,” to become an active validating node for a blockchain network. Staked tokens serve as a guarantee of the legitimacy of any new transaction added to the blockchain. By staking, participants are selected to add the latest batch of transactions to the blockchain and in return earn a percentage-rate reward over time. These participants are called validators, securing the blockchain network. The validators are chosen by the network according to its specific rules. Often, users with the most digital assets staked for the longest time are rewarded.

Staking is only available on blockchains that use proof-of-stake (PoS) consensus mechanisms. These include Ethereum (ETH), Cosmos (ATOM), Solana (SOL), and Polkadot (DOT). On these blockchains, stakers are rewarded in the chain’s native token.

Index Coop's latest white paper covers staking and other forms of yield generation in DeFi. Read "The Definitive Guide to Earning Yield on Digital Assets” here.

Misuse of the word “staking”

@cobie describes the misuse of “staking” in his article, “ApeCoin & the death of staking.” Staking dates back to 2012 at the inception of the first PoS protocol, Peercoin. Back then, staking involved offering coins as collateral for the chance to validate blocks on the blockchain. In exchange for risking their collateral, “stakers” would receive a reward. In this way, PoS chains pay individual stakers for chain security.

Over time, Cobie says, “the word ‘staking’ has been repurposed and redefined.” Modern staking provides holders with rewards simply for not selling their coins. Less coin sales mean a higher price. In this way, chains pay holders “not for anything practical or technical” but instead for reducing potential sellers’ liquidity. Critics of this version of “staking” draw parallels to Ponzi schemes in that payers manufacture a buy-and-sell pattern.

Actual staking—sustainable staking, that is—distributes rewards to users in a blockchain’s native token in exchange for security provision via acting as a validator. Digital asset users should assess whether their staked assets are being used to provide security before staking with a platform.

Types of Staking

There are three types of staking: solo staking, staking through a centralized exchange, and liquid staking. Users should evaluate the accessibility and relevance of centralization risk to each. They can then choose the type most in-line with their accessibility requirements and tolerance of risk.

Solo staking

Solo staking means running a node for a particular blockchain and depositing a certain amount of the native coin to activate a validator. These stakers participate directly in network consensus. They receive rewards directly from the blockchain for keeping their validator functioning properly.

Solo stakers maintain their own keys and hardware which allows them to determine the amount of risk they are willing to take on. In other forms of staking, this is decided by the platform used to stake.

  • Pros: Solo stakers participate directly in the robustness, security, and decentralization of a blockchain on a grassroots level. Because they directly participate, they receive the entirety of the yield generated; no middlemen take a cut. Direct participation also allows solo stakers the most control over their funds.
  • Cons: The minimum deposit is high for some blockchains (for example, 32 ETH is required to become a validator for Ethereum). Also, there is great operational overhead to maintain the hardware necessary to run a validator.
Solo Staking APY and Requirements by Asset matrix

Staking using a centralized exchange (CEX)

Centralized exchanges (CEXs) like Gemini, Coinbase, and offer staking pools. These provide a convenient way for digital asset users to stake without having to deposit a certain amount of a coin nor manage any hardware. Additionally, staking-as-a-service platforms like EverStake and Figment enable users to maximize yield rewards. They find the highest interest rates for users’ assets.

Users can simply deposit funds into a staking pool and allow the CEX to stake them and return yield to the user’s wallet automatically. While CEXs may be more convenient for users, digital assets staked on CEXs are often locked up for certain periods. "Locked up" assets cannot be transacted, traded, or used as collateral elsewhere while they are in use.

  • Pros: Staking using a CEX provides users with the most convenience of all staking options. They deposit funds to a staking pool and reap the rewards automatically, requiring no claiming nor active management. Additionally, most staking pools on CEXs do not require a minimum deposit, so users can earn yield on any amount of coins staked.
  • Cons: Users of CEXs face centralization risk. When they deposit funds to a CEX, they lose direct control over these funds. If the CEX is exploited by a malicious actor, users can lose access to their staked funds and the yield generated on them.

Liquid staking

Liquid staking solves the illiquidity problem present in staking options that require tokens to be “locked up.” Liquid stakers deposit coins to a liquid staking provider in exchange for a receipt which is redeemable for the staked tokens. This receipt represents the staked tokens that can be transacted, traded, or used as collateral elsewhere. The value of the receipt is equal to that of the staked tokens. Since liquid staking tokens reflect the value of underlying assets, they are sometimes referred to as liquid staking derivatives.

Liquid staking platforms like Lido, Rocket Pool, and Stakewise let users stake assets from several networks like Ethereum, Solana, Kusama, and Polygon. On most platforms, stakers’ assets remain in their possession, meaning they can be withdrawn at any time after a specific vesting period.

  • Pros: Liquid staking allows users an accessible price point because there is no minimum amount of coins required to stake. The most important pro, of course, is that users retain liquidity. With this liquidity, they can use their tokens as collateral throughout DeFi. The composability of tokenized derivatives allows for enhanced lending projects such as Interest Compounding ETH Index (icETH).
  • Cons: Without redemptions, stakers will temporarily rely on peg stability of their liquid token. Once Ethereum’s next update after The Merge, the Ethereum Shanghai Update, is completed, staked ETH will be 1:1 redeemable.

Introducing Diversified Staked ETH (dsETH)

On September 2, INDEX holders voted to build and launch Diversified Staked ETH (dsETH). dsETH will enable token holders to access the ETH liquid staking tokens through a single token. dsETH will also be the first Index Coop product built on a Managed Balancer Pool, a new primitive developed in partnership with Balancer.

With dsETH, users can instantaneously distribute their stake across the top liquid staking protocols and earn an aggregate staking return. Rather than selecting a single liquid staking token and concentrating risk, dsETH token holders benefit from its innate diversification both at the asset and the issuing protocol layer. dsETH methodology is weighted towards protocols with more node operators and balanced distribution of stake, with the objective of encouraging decentralization and competition in the on-chain liquid staking market.

Index Coop is currently building dsETH. For information on dsETH’s expected launch date and other updates, subscribe to our newsletter.

white background dseth imprinted triangle

About Index Coop

Index Coop is a decentralized autonomous organization (DAO) that powers structured decentralized finance (DeFi) products and strategy tokens using smart contracts on the blockchain. We offer a suite of sector structured products, leverage and inverse products, and yield-generating products. We aim to create products that are simple to use, accessible to everyone and secure. Our products are built on Set Protocol, a twice-audited, self-custodial DeFi tool that allows for the creation and management of Ethereum-based (or ERC-20) tokens. Among users, partner protocols, and our composable products, Index Coop maintains one of the largest partnership networks in the DeFi ecosystem.

How to buy Index Coop products with fiat currencies:

  • First, you’ll need to create an Ethereum wallet like Argent, Metamask, Gemini, or Rainbow.
  • Next, you’ll set up your new wallet and connect your bank account.

You can also earn or buy DPI tokens directly via your favorite decentralized exchange.

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