Generally, when most people think about cryptocurrency investing, they think of crypto trading, buying and holding, or mining. However, the cryptocurrency sector has grown exponentially over the past decade and opened up various financial opportunities that investors can leverage to grow their assets—one of which is crypto staking.
While crypto staking might be relatively new in the crypto space, it has quickly become one of the most popular investment vehicles. As such, investors need to understand what crypto staking is and how it works.
Crypto staking might feel like a step beyond buying bitcoin or trading an exchange. However, learning about crypto staking can help you diversify your crypto portfolio. In this article, we will look at what crypto staking is and how it works.
The need for Cryptocurrency Staking and the Proof of Stake
Before diving into staking, it’s reasonable to think about why the crypto space might need it. During the first few years after the inception of bitcoin, Proof of Work (PoW) was the popular consensus mechanism used by nearly all blockchain projects. Even the second-largest cryptocurrency by market cap, Ethereum, was launched on the PoW mechanism.
PoW generally depends on computational power to validate transactions on a network and later append the newly generated block to the blockchain. Although highly secure and effective, PoW was not scalable, and it required an immense amount of computational power. With the growth of decentralized finance (DeFi) and increased transactions, PoW became seen as a slow and inefficient consensus mechanism.
Moreover, many people regard PoW as an environmental hazard due to the carbon footprint it generates from the power plants, commonly known as mining farms, that provide its mining hardware with power.
As an alternative, Sunny King and Scott Nadal suggested the proof of stake (PoS) consensus mechanism in 2012 to solve PoW’s high energy consumption.
What is Proof of Stake?
According to The Ethereum Organization, proof of stake is a consensus mechanism that requires users to stake (lockup) some of their cryptocurrency tokens like ETH to become a validator in the network. A validator is responsible for the same thing as miners in the proof of work network — ordering transactions, creating new blocks that all nodes have agreed upon and appending them to the blockchain.
Like the PoW mechanism, PoS also aims to maintain a decentralized and distributed network by allowing anyone to join the governance process through staking. However, unlike PoW, which does require users to deposit crypto coins to get started, users have to purchase the native coins of the staking project.
The difference between staking and mining
1. Consensus mechanism
The primary difference between staking and mining is the underlying consensus mechanism used to validate transactions. Mining operates on PoW while staking operates on PoS.Â
2. Validating transactions
In the case of mining, PoW solves complex mathematical problems to append transactions to the blockchain, while users in a PoS blockchain validate and append new blocks by locking up their assets.
3. Focus
Mining focuses on specialized mining hardware while staking focuses on the number of crypto tokens locked up, thereby saving almost 99% of the energy used in mining.
4. Choosing a validator
With mining, the first miner to solve the complex puzzle gets the privilege to append the block to the blockchain. With staking, the network selects the validator according to:
- How many coins you have staked – the more coins a user has staked, the higher the chances of being chosen as validators. Additionally, the more tokens you stake, the more rewards you will receive.
- The period you have staked your coins. Generally, users who have staked their coins longer are considered more trustworthy and, hence, highly likely to be chosen as a validator.
- Randomness – for some crypto projects, the validator is chosen randomly. Even a user with a few coins staked also stands a chance to be selected.
- All the above – more advanced PoS crypto projects implement all the above factors when selecting a validator.
What is crypto staking?
In simple terms, staking is the process through which crypto owners lock their crypto assets in a cryptocurrency wallet in order to participate in the maintenance of a proof of stake blockchain network. Staking gets its name because it only operates with cryptocurrencies that run on proof of stake blockchains. Staking crypto is quite similar to depositing your fiat currencies in the bank to earn interest or receive any rewards associated with deposits. Like the PoW mechanism, staking also involves some rewards.
From a more technical perspective, users who delegate/stake their tokens are incorporated into the governance model of a PoS-based cryptocurrency. They can vote on updates or changes to a project’s ecosystem, the reward model, or even vote for a validator.
Another critical aspect of staking is the economic implications. Staking tokens take them out of circulation through a process known as burning — permanently removing them from circulation. This limits the token supply, and following the law of supply and demand, the demand inherently increases. This means that stakers might get their tokens back at a point where their value has greatly increased. Additionally, the network rewards users who stake their tokens. For instance, according to Staking Rewards, users stand a chance to earn an APY of an estimated 6.06% when staking solana with Everstake, 8.91% with Binance Chain on ANKR or 10.1% for staking ether on Ethereum. Compared to conventional financial investment, crypto staking offers higher interests.Â
The different types of staking mechanism
Although the primary aim of staking remains the same — a decentralized and distrusted network – there are various staking mechanisms. It is crucial to understand these different mechanisms, since each affect the incentive model of a crypto staking platform or project.
Regular proof of stake
In a regular proof of stake, the validator is chosen in a random process containing various combinations of the number of tokens staked or the staking period and not by computing power. This is the most basic staking mechanism. As a user, you stake your crypto tokens, and if you are selected or your pool is selected (discussed below), the network rewards you with the crypto project’s native coins.
Delegated proof of stake (DPoS)
Within the blockchain space, it is challenging to develop a decentralized, scalable and secure blockchain protocol, often referred to as the blockchain trilemma. For instance, bitcoin focuses on security and decentralization, but its scalability in transaction speed is limited. PoS projects like cordano provide high security, high transaction speed and scalability, but are considered more centralized than decentralized.
With a clear impression of the blockchain trilemma, developers launched DPoS to raise the transaction speed and block creation without compromising on decentralization. DPoS was founded in 2014 by Daniel Larimer, the founder of EOS. The DPoS protocol democratically maintains decentralization by creating a reputation-based voting system. If users perform dishonestly, they are expelled and replaced by another node.
Additionally, dishonest nodes are at the risk of slashing. This refers to a process where the protocol deducts a portion of the user’s staked coins each time a node behaves dishonestly. This ensures that all validators are performing honestly.
DPoS is currently implemented on the Bitshare, Steemit and EOS blockchain protocols.
Leased proof of stake (LPoS)
Launched in 2017, LPoS is essentially similar to the regular proof of stake, but users have the option to lease out their staking ability. If you do not want to keep track of your staked tokens, then you can issue your coins to another user who will, in turn, stake them. This type of user offers this feature at a fee, and you will receive a percentage of the payout as a reward. LPoS is currently implemented on the Waves blockchain protocol.
Bounded proof of stake (BPoS)
BPoS is similar to the leased proof of stake, except that for BPoS there is a pre-defined number of users that can stake (bond) their tokens with a single validator. BPoS is currently implemented on the Cosmos blockchain protocol.
Masternode proof of stake (MPoS)
Unlike the regular proof of stake mechanism, where all stakers are considered similar, in the MPoS mechanism, users who stake a considerable amount of tokens obtain special privileges.
In this mechanism, a Masternode is a well-connected node that is materially invested and is considered more trustworthy. It provides valuable services to the network by maintaining an up-to-date blockchain record.
According to Blockchair.com, the size of a PoS blockchain ledger, in this case, cordano, is roughly 43GB and increasing. Since this is a relatively large storage space for an average user, the Masternode is rewarded with up to 43% of the block reward.
DASH is one of the popular blockchain protocols that implement MPoS.
Zerocoin staking
Zerocoin staking is similar to the regular proof of stake mechanism, except that users are allowed to stake anonymously. Currently, Zerocoin staking is specific to the PIVX cryptocurrency.
Where and how can you stake your crypto assets?
There are many ways to get involved with staking coins, from complex methods like running your validator node or more straightforward ways like staking on a crypto exchange, crypto wallet, or simply joining a pool.
1. Running a validator node.Â
Running a validator node in a PoS network requires users to stake a relatively large amount of tokens and download and run the network’s software. Running your node allows users to directly participate in the PoS consensus mechanism by broadcasting votes that contain their cryptographic signatures to the network. If the network deems the transactions valid, the validator will append the block to the blockchain. In return, the node will be rewarded with a native token of the blockchain.
While PoS consumes less computing power, hardware requirements might force users to purchase above-average hardware to gain a competitive advantage in validating transactions. On the plus side, running a node gives users higher returns.
2. Join a staking pool
A staking pool allows various users to combine their tokens to increase their chances of being selected to validate transactions and receive rewards. Staking pools often follow a two-tier model. An administrator who ensures the pools are run smoothly by overseeing the work of the validators and delegators who bring together their resources. When a pool earns rewards, they are shared among the operators and the pool.
It’s crucial to note that some staking pools like Cordano have a minimum staking amount. The minimum fixed ADA staking fee across the cordano network is 340 ADA. The blockchain protocol sets this amount and it can’t be any lower.
3. Cryptocurrency exchanges
Staking via cryptocurrency exchange or wallet is perhaps the easiest way to stake your tokens. In essence, users are required to deposit a “stakeable” token in their crypto wallet and send it from their regular exchange account to a staking account. In this approach, users deposit funds, and the exchange handles the technical aspects of the staking. An excellent example is the Binance Staking service.
What are the benefits of staking cryptocurrencies?
Higher returns
The primary advantage of staking is the opportunity to earn higher returns compared to mining. Staking interest rates can range anywhere from 8% to 20% annually. For long-term investors (holders), staking their crypto assets is an effective way to grow their coins as the value of their assets rally.
Ease of entry
Unlike mining in PoW, users don’t need to invest in expensive hardware. All you need is a digital wallet and some fiat currency to buy a “stakeable” cryptocurrency. Also, the software and hardware required to run your node are profoundly cheaper than those needed in the PoW mechanism.
Environmentally friendly
With the second-largest cryptocurrency by market cap shifting to PoS, there will be a considerable reduction in energy consumption and carbon print emissions. Staking presents a better case for crypto adoption and an environmentally-friendly alternative to mining.
Direct participation in the network
Since staking gives users the privilege to participate in the voting process and governance of the network, users can air out their ideas to ensure the network runs efficiently. Moreover, staking allows users to play a crucial role in maintaining the security and decentralization of the underlying blockchain network.
The risks involved with cryptocurrency staking
Market risk
When staking, the most significant risk that investors face is price volatility. If, for instance, you are earning a 12% APY for staking an asset, but the crypto market crashes and your asset’s value fall by 50%, you’ll still have made a loss. As such, investors need to choose an asset carefully. You can choose to stake stable coins like USDT, USDC or DAI as they are pegged to fiat currencies.
Liquidity risk
While micro-cap, which are crypto projects with small market caps mostly below $1 billion, have higher yields, some are illiquid. Even though your asset is earning you high interest, you cannot resell it. The demand for it is very low.Â
Lockup periods
Some “stakeable” coins, such as cosmos and tron, come with lockup periods where you cannot withdraw your assets until your staking period ends. If the price of your ATOM, cosmos native token, drops substantially, you cannot unstake it. This will affect your overall returns and principal.
Reward duration
Like lockup periods, some staking platforms do not pay out rewards daily. As a result, stakers have to wait to receive their rewards. While this might not affect your annual returns, it will prevent you from re-investing the daily rewards.
Validator risks
Running a validator node requires users to have the technical know-how to set up and operate the node. Moreover, the node needs to have 100% uptime to receive maximum returns. What’s more, if a validator node misbehaves, the user incurs a penalty that affects the returns. In extreme cases, a validator might be expelled from the network, rendering their hardware and software useless.
Factors to consider when choosing a staking platform
The interest rates offered by staking your cryptocurrency assets give a conclusive answer as to why staking is worth it. Moreover, various large crypto coins support staking. For instance, avalanche (AVA), solana (SOL), cordano (ADA) and event ethereum are shifting from PoW to PoS blockchain ecosystems.
As such, it is easy for the novice investor to put their funds in the first platform they come across. However, such decisions turn south quite fast in most cases because the reputable staking platforms are few. So before staking your crypto coins, you can rely on the following factors:
- Always ensure that you research a platform’s reviews and feedback from social media platforms or crypto forums. Don’t blindly trust their websites.
- Try to go for more reputable platforms like MakerDAO, Aave, and Crypto.com, to mention a few. While high interest might seem appealing, your asset’s security is more crucial.
- To understand how the blockchain protocol around a crypto coin works, always ensure you go through its whitepaper. This will give an idea of how the staking rewards are calculated, the staking period and how they are distributed.
- Lastly, you should leverage analytics platforms on PoS-based blockchain like Staking rewards to dive deeper into the details of a staking platform.
Final thoughts
Within the cryptocurrency space, staking is among the top services and features taking decentralized finance to the next level. Staking allows you to earn interest on your deposits. It provides an effective alternative to earning cryptocurrencies with crypto trading. You can lock up your assets and watch them grow in value. Moreover, staking through the proof of stake mechanism allows users to be more involved with cryptocurrency projects. You can vote on what changes you support on a network or disprove those you do not want. This dramatically improves decentralization and supports the shift from centralized financial ecosystems to decentralized autonomous financial organizations that govern themselves.
With the attractive interest rates, staking is opening up the crypto space to more investors. However, it’s essential to evaluate the risk and rewards you can get with staking your cryptocurrency assets.
