Key Points
- Staking is emerging as a popular approach for cryptocurrency investors to generate passive income, as specific blockchains are known for rewarding their investors with high interest rates.
- Cryptocurrency staking is a procedure whereby investors may commit a portion of their cryptocurrencies to support a blockchain as well as validate transactions on the network.
- Staking is currently offered by blockchain networks that employ the proof-of-stake consensus mechanism in their payment processing method.
Staking may sound like an incredibly complicated jargon for certain crypto investors and traders to swallow, as many are only familiar with staking being a method for one to earn monetary rewards by holding specific cryptocurrencies over an extended duration. Nonetheless, should you be someone looking to build an income stream through staking rewards, it will always be helpful to understand how this concept works and why the system has been designed in such a way.
Meanwhile, VALK’s Smart DeFi Portfolio Tracker, Merlin, has been designed to offer an in-depth overview of your crypto investments, which can be vital to help investors enhance their investment strategies.
What is Staking?
In the cryptocurrency scene, staking involves an individual locking up (i.e., staking) their crypto assets with the goal of obtaining even more assets as their reward.
To better illustrate this concept, you could technically equate staking as the crypto equivalent of depositing your funds into a high-yield savings account. In particular, when an individual places their money into such an account, the bank will lend the fund to others needing capital. Consequently, the individual will be eligible for a portion of the interest earned from lending, even though the percentage interest is extremely low.
The critical objective of staking is ensuring that only legitimate transactions and data are introduced to a specific blockchain. With that, investors looking to validate new transactions could offer to have exact amounts of their cryptocurrencies staked in the system as a type of insurance. As a result, whenever a person stakes their digital assets, they are essentially locking up their cryptocurrencies to take part in maintaining the security and effective operation of the blockchain. Thus, in exchange for authenticating correct data and transactions via staking, the individual will earn monetary rewards determined by calculating their respective percentage yields. In the case of cryptocurrencies, these returns are usually far higher (circa 10% to 20%) than those offered by financial institutions.
However, it is also crucial to take note that if the investor were to validate fraudulent or false data improperly, they would risk facing a penalty of losing some of their cryptocurrencies. In the worst-case scenario, their entire stake may be lost due to a punishment known as “slashing”, which is known to occur on the Polkadot and Ethereum blockchains (albeit a rare situation).
How Does Staking Work?
All in all, there are various consensus mechanisms that cryptocurrencies employ. On that note, the whole notion of staking is made possible by introducing the proof-of-stake consensus mechanism, which was first introduced by Peercoin (CRYPTO: PPC) in 2012.
This is an approach adopted by various blockchains to choose investors deemed reliable for verifying new transactions and/or sets of data documented within the network. In particular, all network participants, termed “validators” or “stakers”, need to buy and lock away a specific number of tokens. Hence, should the blockchain become corrupted due to any forms of malicious activity (classic examples typically include validators going offline for prolonged periods), the price of the native token linked with it will fall, and the validators will risk losing their cryptocurrencies. With that, the proof-of-stake mechanism is widespread for its high efficiency and interest rates. These factors, in turn, attracted plenty of participants to the blockchain network.
The stake, in this case, thereby serves as the validators’ “skin in the game” so that they are sufficiently incentivised to act with the utmost integrity and in the best interest of the blockchain network. Put simply, the more significant the stake, the greater their chances of amassing bigger rewards in the form of the native cryptocurrency.
Besides, the stake does not necessarily need to be exclusively a person’s own coins. In the majority of cases, validators tend to operate staking pools in order to raise funds from several token holders. This essentially helps to lower the entry barrier so that more individuals will be eligible for staking. In addition, the validator can also choose to delegate their coins to the operators of the stake pool to perform all of the heavy work associated with validating data and transactions on the blockchain. On that note, validators must comply with each blockchain’s unique set of rules. For instance, the Terra network limited the number of validators to a maximum of 130. Furthermore, Ethereum’s proof-of-stake (formerly recognised as Ethereum 2.0) mandates every validator to stake a minimum of 32 ether, which is equivalent to over US$100,000 at press time.
Which Cryptocurrencies Can Investors Stake?
As previously stated, staking is only plausible when the validator uses cryptocurrencies associated with blockchains employing the proof-of-stake consensus mechanism. On that note, some of the popular cryptocurrencies used for staking would include:
- Ethereum (CRYPTO: ETH) – The first-ever cryptocurrency possessing a blockchain that developers could programme to develop apps.
- Solana (CRYPTO: SOL) – A blockchain created to enable scalability as it provides quick transactions in exchange for inexpensive fees.
- Cardano (CRYPTO: ADA) – A cryptocurrency known for its eco-friendly objectives. It was designed via evidence-based protocols coupled with peer-reviewed research materials.
- Avalanche (CRYPTO: AVAX) – A cryptocurrency that uses mining, peer-to-peer transactions, and other technological features to power its scalability and speed of transaction.
- Polkadot (CRYPTO: DOT) – A protocol permitting various forms of blockchains to connect and collaborate with each other.
Why Would Someone Consider Staking?
Staking is a standard method to incentivise token holders to preserve their crypto assets. As opposed to selling their portion to make a realised profit, investors can instead stand a chance to claim staking rewards that typically achieve double- or even triple-digit figures in annual percentage yields (APY). Thus, the crypto community often view staking as a much more attractive investment vehicle in comparison to those offered by centralised financial institutions. Not to mention, staking is a passive investment strategy whereby token holders will not be required to do anything besides staking their digital assets in a staking pool, followed by reaping the monetary rewards. However, it is also entirely possible for one to manage their own staking pool, though this would require greater attention, expertise, and capital to ensure successful execution.
Aside from the benefits mentioned above, other noteworthy advantages of cryptocurrency staking include the absence of equipment required by the investor to perform staking. The process is generally known to be more environmentally friendly than crypto mining.
How Can You Begin Staking Cryptocurrencies?
1. Purchase the relevant cryptocurrencies and store them in a blockchain wallet.
Prospective investors will first need to own cryptocurrencies that can be staked before they can start staking. Once they have already bought a few, they will have to transfer the coins from the app they have purchased to a blockchain wallet (a.k.a. crypto wallet) that permits staking. In general, wallets are deemed the optimal solution to store cryptocurrencies securely, and the quickest way for anyone to set up a wallet would be to download a free software version. Nevertheless, there are also hardware crypto wallets that crypto enthusiasts could consider purchasing.
Alternatively, staking opportunities are often provided on most large cryptocurrency exchange sites like Binance, Coinbase, and Kraken. As a result of this convenience, these sites are usually a popular go-to option among many investors. Other than that, if you seek to maximise your financial rewards, there are platforms specialising in searching for crypto exchanges offering the highest interest rates for the coins you own. These platforms, known as staking-as-a-service, would include sites such as Figment, BlockDaemon, EverStake, and MyContainer.
To assist investors who have committed digital assets to DeFi protocols and liquid staking services such as Lido, VALK has created a dashboard called Merlin. Merlin provides detailed analysis of an investor’s positions and calculates PNL related to selected protocols such as Lido, Compound, Uniswap V3, and Aave.
2. Take part in a staking pool.
Once everything has been set up, investors will need to conduct in-depth research into the staking pools available for their cryptocurrencies. Overall, there are several areas worth evaluating before making a decision:
Reliability
Every investor should remember that they will not be able to earn rewards if the staking pool servers are down. Hence, one needs to select a staking pool with a near-100% uptime as much as possible.
Size of the staking pool
Investors will usually need to balance out the risk-to-reward ratio associated with the staking pool size. To elaborate, smaller staking pools are generally less likely to be selected to perform transaction validations, but they may offer more significant rewards if they were to be chosen. Meanwhile, larger staking pools may have a cap on their reward size as they may be oversaturated with investors. With that, mid-sized pools would usually be the best option for the majority of crypto investors.
Staking fees
Investors can expect to pay a small portion of their staking rewards as a fee for participating in a specific staking pool. Reasonable amounts would have to depend on the cryptocurrency itself, but the regular fee percentage ranges between 2% and 5%. Once the investor has determined a staking pool that they like, all they would need to do is to connect their cryptocurrency with it via their blockchain wallet. Once that is completed, they can begin earning monetary rewards.
The Risks Associated with Staking Crypto
As with investing in other assets, there is no doubt that investors will need to bear certain risks associated with cryptocurrency staking. Firstly, cryptocurrency prices are notoriously volatile, so sudden declines in price may easily outweigh the profits or interests they could realise. On top of that, a counterparty risk associated with the staking pool validators is present. Investors are prone to miss out on large rewards if the validators fail to perform their job honestly. Moreover, staking pools are vulnerable to hacking, which may result in the total loss of funds amongst all affected investors. Not to mention, since crypto assets are currently still not protected by insurance, this implies that the probability for victims to be compensated for this loss is close to zero. Besides that, certain cryptocurrencies have a mandatory lock-up period in which investors will not be able to withdraw their assets. Also, investors need to bear in mind that there might be an unstaking period lasting at least one week.
Regardless, there are still various ways for one to minimise or mitigate such risks. To begin with, investors who are considering crypto staking are recommended to hold their digital assets over the long term in order to hedge themselves against unwelcome price swings. Alternatively, those who prefer lower-risk crypto investments might like to opt for cryptocurrency stocks in replacement for staking pools.
Concluding Remarks
In a nutshell, staking is an excellent option for investors looking to generate above-average yields on their long-term investments. However, it is highly advised for one to carefully consider the terms associated with the staking period to evaluate the duration of time required to get returns on investment back. In particular, investors ought to meticulously assess the terms and conditions associated with their staking pool of interest as well as understand the length of the staking period and the expected payback period. As a general rule of thumb, the higher the staking interest rates, the more likely it is too good to be true. With that, practising cautious optimism in cryptocurrency staking is key to maximising one’s probability of realising enormous profits.
On that note, VALK is developing a comprehensive ecosystem of decentralised tools to help crypto enthusiasts with their investment processes. For example, our Smart DeFi portfolio tracker, Merlin, can instantly calculate the effectiveness of one’s investment strategies by measuring the total yield and profit/loss gained from an investor’s portfolio in United States dollars (USD).
Frequently Asked Questions (FAQs)
What is crypto staking?
Cryptocurrency staking is a way for crypto enthusiasts to earn financial rewards by making their digital assets work for them. The procedure involves investors locking up their cryptocurrencies with a blockchain network to support its validity through the authentication of the blockchain’s data and transactions. At the point of writing, staking is only available for cryptocurrencies utilising the “proof-of-stake” consensus mechanism to process payments.
What are the benefits of staking crypto?
Cryptocurrency staking is an innovative approach for investors to earn passive income, as certain cryptocurrency staking pools offer above-average interest rates (i.e., far exceeding those provided by centralised financial institutions). Meanwhile, it is a more environmentally friendly investment in comparison to cryptocurrency mining.
What are the downsides of staking crypto?
Cryptocurrency staking mandates all investors to lock up their crypto assets for a minimum period, so they cannot withdraw the funds for any reason. On top of that, cryptocurrency prices are infamous for their high volatility. Thus, if an investor’s staked crypto assets experienced a significant price decline, this may potentially outweigh any interests they earned from staking them.