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Here's what Ethereum's Merge means for investors who want to generate extra cash flow from crypto staking, according to 2 industry experts

Markets Insider 9/21/2022 insider@insider.com (Lisa Kailai Han)
Kazi Awal/Insider © Kazi Awal/Insider Kazi Awal/Insider iStock; Insider © Provided by Markets Insider iStock; Insider
  • Ethereum recently revamped its protocol from a proof-of-work to a proof-of-stake model.
  • Industry analysts have predicted that this upgrade could triple current Ethereum staking yields.
  • Here's how staking will change in light of Ethereum's Merge — and what that means for returns.
  • This article is part of "Master Your Crypto," a series from Insider helping investors improve their skills in and knowledge of cryptocurrency.

Ethereum's long-anticipated Merge on Thursday, September 15 — where the blockchain transitioned its protocol from a proof-of-work to the much more energy-efficient proof-of-stake consensus model — will certainly be immortalized as one of the most important events in crypto history. It represents the next evolution of digital assets and future growth in the space, according to Thomas Perfumo, head of strategy at Kraken, which is currently the fourth largest cryptocurrency exchange in the world.

There's another reason the Merge was so important, Perfumo told Insider — eventually, it will single-handedly increase the total market cap of staked crypto assets from 25% to 30% to over 50%.

For context, proof-of-work protocols like Bitcoin verify blockchain transactions by having miners solve computation puzzles, while proof-of-stake systems like those employed by Solana, Cardano, and Polkadot choose validators at random who've staked — or locked up their crypto assets — for upwards of two to three weeks. While validators are randomly chosen, they're more likely to be selected if they have a bigger stake and they've held their stake for a longer period of time than others.

How investors make money from staking

Similar to holding a dividend stock, investors who stake their cryptocurrencies are theoretically able to benefit in two ways — from the underlying asset's price appreciation, and from the additional reward they earn each time they verify a transaction, known as the annual percentage rate, or APR.

Because Ethereum validators also earn gas fees, higher transaction volumes mean a higher yield. And since each block only has a fixed number of rewards, the reward rate dwindles as the total number of validators and staked cryptos competing for those rewards increases.

Since validators take risks through their exposure to the underlying asset, investors shouldn't buy crypto solely for its potential APR, Perfumo said. "But if you have conviction in Ethereum over your time horizon and you feel like staking offers you a way to increase the rewards on the asset while you hold it, it sounds like a good idea," he added.

Before the Merge, Ethereum holders were able to stake on its Beacon Chain, with one big caveat — they were unable to withdraw their assets, which means the percentage of Ethereum staked has only grown over time. But withdrawals should be allowed once the Shanghai fork of the Merge is complete within the next six to nine months, Perfumo estimates.

While theoretically, every crypto holder can stake by themselves as opposed to staking on an exchange, in practice, it's much harder to solo stake because validators have to constantly monitor the software or risk paying an inactivity penalty. Ethereum also requires all solo validators to hold at least 32 ether before they can stake, and costs of nodes and servers can quickly add up, said Perfumo.

On the other hand, exchanges like Kraken and Lido — which take a fee on yield — allow users to contribute an amount of their choice, and can also minimize slashing penalties through redundancy mechanisms. Because Lido gives users one derivative ETH token for every ether they stake, users are even able to unstake their coins by simply trading back the two currencies. But since these exchanges effectively manage custody of a user's assets, Perfumo emphasized the importance in choosing a trusted exchange to minimize counterparty risk.

Lido currently lists its Ethereum APR as 3.8%, while Kraken advertises its Ethereum yearly rewards rate ranging between 4% to 7% due to variability between transaction demand and validator supply, Perfumo explained. He added that rewards differ between blockchain protocols since newer ones might offer higher base yields to circulate currency supply, while more mature networks with large validator networks like Ethereum offer a smaller percentage of new tokens relative to total supply.

Stakers will now earn all the rewards post-Merge

One of the biggest post-Merge takeaways is that the pool of rewards for validators has now increased substantially, said AD, a pseudonym used by Lido's head of marketing and community.

"The yields are expected to go up because the fees that used to flow to miners will now come to the stakers," he explained to Insider. "You're going from a yield that's currently around 3.8% — it varies a little bit — but our modeling shows that it will potentially double or even triple." Lido's estimates are in line with estimates made earlier this year by other crypto analysts that post-Merge staking yields could swell to between 7% to 15%.

However, Perfumo says that the exact post-Merge rewards rates are difficult to predict, especially as ether becomes more liquid in a few months.

"If people are allowed to unstake, the reward rate is going to be more variable, in the sense that it can go up and down, depending on how many people are staking. It's possible that over time, the reward rate may skew to the downside because the liquidity of being able to unstake encourages people to stake," he explained.

Additionally, platforms might lower reward rates to compensate for the fact that mining is much higher in energy consumption than staking. "You don't have to have such a big incentive model to encourage validators to work on the platform," Perfumo said.

Since he believes that Ethereum rewards may not necessarily increase post-Merge, Perfumo emphasized that investors should still keep their personal time horizons in mind when it comes to Ethereum staking, and only consider staking if they're comfortable with locking down their assets for at least another six months.

This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.

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