Protocol staking to earn rewards is an increasingly popular strategy amongst digital asset holders to augment their holdings with minimal risk.

This article answers fundamental questions related to protocol staking and the associated rewards (‘block rewards’) generated, namely:

1. Why are block rewards paid?

2. Who pays block rewards and who receives them?

3. How are block rewards calculated?

4. When are block rewards paid out?

‍

Let’s start by clarifying what a blockchain is, how blocks are created, and the validation process:

• BLOCKCHAIN: A blockchain is used to record transactions. Transactions are grouped together to form blocks. Once a block is added to a blockchain it cannot be modified so it is important that all transactions in a block are correct.
• NEW BLOCK CREATION: To add a new block, someone has to 1) group transactions together to create a new block, 2) confirm all transactions in the block are correct, and 3) share the block with others for them to also confirm the transactions in the block are accurate.
• VALIDATORS: Those that are proposing and/or confirming newly created blocks are called “validators”. A validator must 1) have computing resources and 2) deposit or “stake” some amount of the blockchain’s virtual currency.

‍

Now let’s define block rewards in the context of the workings of a blockchain:

• BLOCK REWARDS: When a new block is created, the blockchain issues new virtual currency which is distributed to validators. This payment is called a “block reward”. Validators miss out on rewards if they fail to participate in the block creation process and can lose their stake if they act dishonestly.
• REWARD RATE: The amount of virtual currency earned as block rewards depends on 1) how much new virtual currency a blockchain issues when a block is created, and 2) how much a validator has staked.

‍

Now that we understand block rewards, let’s discuss a few pros/cons which highlight the appeal of protocol staking:

‍

Pros:

• SECURITY: Block rewards are distributed to validators for ensuring all transactions being added to a blockchain are correct.
• INCENTIVE ALIGNMENT: Since a validator’s block rewards are in the virtual currency of the blockchain, their incentives are aligned with users of the blockchain.
• STABLE: It is important to distinguish block rewards from transaction fees which are paid by users of blockchain to use it. Transaction fees fluctuate based on the usage of the network while the rate of block reward issuance tends to be constant over short and medium time frames.

Cons:

• INFLATION: Block rewards increase the supply of a virtual currency. In theory an increase in supply without a proportional increase in demand will reduce the value of virtual currency. However, over time, the value created by a secure/uninterrupted blockchain should exceed the cost of block rewards.

‍

Conclusion

A useful analogy for block rewards is defense spending. Similar to how a nation allocates a portion of its budget to defense to protect its people and resources, a blockchain must spend a portion of the value it creates to secure its data and users.

In summary, block rewards from protocol staking allow token holders to increase their supply while securing and governing the underlying network, helping to drive the growth and adoption of the Web3 ecosystem.