Staking is an innovative way to reach consensus within blockchain networks without spending a lot of energy, as it happens with mining. It comes with several advantages, including increasing network throughput.
However, most good things come with drawbacks, and staking is not an exception. Sure, it comes with many benefits and advantages over mining, but are there any negatives?
In this guide, we focus on the impact that staking has on the circulating supply of a token that implements it as a consensus mechanism. We will define circulating supply before moving on to how it relates to staking.
Does staking reduce circulating supply?
Staking reduces circulating supply, but before discussing how that is possible, it is worth defining the term circulating supply.
Circulating supply is the number of coins or tokens available to the public and circulating in the market. In simpler terms, they are the coins that can be bought in the market.
Users should be careful to differentiate circulating supply from total and max supply. Total supply is the number of tokens the network has released into circulation, including coins currently in circulation and those locked up in escrow within smart contracts.
On the other hand, max supply is the full amount of coins/tokens that will ever be available, and this number includes those currently in circulation, locked up in escrow, and those that are yet to be released into circulation.
For instance, Bitcoin has a max circulation of 21 million, but its circulating supply as of the end of 2021 is 18,873,743, which is about 89% of the max supply. Bitcoin does not employ staking, and therefore its circulating supply is equal to the total supply.
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Back to the question of whether staking reduces circulating supply, and the answer is yes! When coins are locked away, they are removed from circulation, meaning they are not available to the public or in the market.
They become illiquid in the period that they are at stake.
Ethereum, the leading smart contract platform, introduced staking in December 2020, and since then, it has seen over 8,564,150 coins locked in an escrow smart contract.
This figure represents about 7% of the total supply of Ethereum that is currently out of circulation, with potentially more to be staked.
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Does staking increase supply?
Staking does not automatically increase supply. In fact, staking may lead to a reduced circulating supply owing to the percentage of locked coins away from the public.
However, depending on the token metrics a particular project employs, it could be possible that the reward from staking constitutes newly minted tokens that are liquid as opposed to those that are staked.
Expectedly, there is a reward for staking, which acts as an incentive to the community to secure the network. The reward varies from network to network but among the top ten most staked assets, that reward ranges between 4% and 15%.
It’s worth noting that some other staking networks do not introduce new tokens as rewards for staking but instead use transaction fees to pay up the stakers for their efforts.
There is no change to the circulating supply in this scenario since the transaction fees are paid out from users who have liquid assets already in circulation.
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Is high circulating supply good?
Let’s borrow the age-old economics principle of demand and supply, which states that a rising supply leads to depressed prices and vice versa. So if we are considering the price of an asset, then an increased supply in the market may not be a good thing.
Interestingly, an increasing supply that corresponds to increasing demand may not lead to falling prices. In crypto, this phenomenon has been very evident in some big assets such as Bitcoin.
The flagship cryptocurrency is considered an inflationary asset meaning that its circulating supply is rising. The rising supply has not led to a fall in the price because demand has also kept abreast if not surpassed the rising supply.
How does staking work?
Staking exists in various versions within the cryptocurrency space, with different projects implementing a version of their preference. The most common of these implementations are the Proof of Stake (PoS) and Delegated Proof of Stake (DPoS).
PoS is the simpler of the two in which interested transaction validators have to stake their assets in a locked wallet for the period they will participate in transaction validation and network governance.
DPoS is a version of the PoS implementation in which token holders delegate their rights to a third party through a voting system, and the delegates are tasked with verifying transactions.
The stake is used as an incentive for good behavior because malicious actors lose their staked assets in a process called slashing.
What is the downside of staking?
Staking as an economic activity and consensus mechanism has some drawbacks that are essential to pay attention to if anyone considers engaging. Some of the risks include:
Network centralization: this drawback is not automatic, but there is a possibility that large investors may lock a bulk of the coins in circulation, leading to the centralization of the network.
Market risk: stake assets are typically locked away in an escrow smart contract meaning that the coins are inaccessible for a given period within which the asset price will fluctuate. A steep negative price movement could lead to deep losses.
Price volatility: closely related to the previous point is that reduced circulating supply leads to an increase in price volatility, which may not be ideal for an asset seeking to become digital money.
Opportunity cost: locking an asset for a period makes it illiquid, meaning that it cannot be used for a variety of other uses, and in a buzzing economic scene such as the one being witnessed currently within the blockchain space, there could be a lot of investment opportunities one has to forgo when they opt to stake their assets.
What will happen if the circulating supply reaches max supply?
As we have defined earlier, circulating supply is the number of coins available in the market, while max supply is the total amount of coins within a network, and no new coins past this figure can be introduced.
Suppose the circulating supply rises to match the max supply. In that case, typically, the networks revert to using transaction fees as compensation to the validators and token holders who participate in network governance.
In Bitcoin, for example, the miners currently get compensated for their efforts with newly issued BTC coins and transaction fees.
However, the rate of issuing new coins keeps falling while the value of transaction fees rises. The end goal is to completely replace the new-coin issuance mechanism with transaction fees when the circulating supply matches the max supply of 21 million coins.
Staking is an innovative blockchain consensus mechanism that also comes with some drawbacks. It exists in several forms, including PoS and DPoS, which are a few ways that some blockchain projects have chosen to implement it.
Staking has both positive and negative effects on circulating supply, and it all depends on how the particular network has implemented it. To get the maximum benefits of staking, one has to stake for a long period and do so within a highly promising project.