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What is staking and how does it work?
Staking is one of the most popular ways to earn an income with cryptocurrency – here's what's involved.
Staking is the process of temporarily locking up cryptocurrency in order to help secure a blockchain network in return for financial reward – in the form of more cryptocurrency.
Similar to mining, staking is a way to earn revenue by participating in the operation of a blockchain, but it only requires capital in the form of coins or tokens rather than investing in mining hardware. As a result, staking has become one of the most prominent ways to earn an income from cryptocurrency.
Staking is the process of depositing cryptocurrency into a smart contract on a network to receive tokens as a reward. These staked coins act as a form of collateral to enable various functions, which range from validating transactions on the network to providing financial collateral in order to mint new tokens. Exactly how staking works, and the rewards paid for doing so, varies between each blockchain and dapp.
Staking originated as part of a consensus mechanism known as proof of stake (PoS). Proof of stake enables stakers to validate blocks by depositing their tokens as collateral as a means of ensuring honesty when validating transactions. If the validator were to submit false transactions to the network, they would be punished by missing out on block rewards or even losing a portion of their staked tokens. Inversely, validators are rewarded with newly minted tokens for doing the right thing.
Typically, a validator’s chance of validating a block (and earning rewards) is proportional to the number of tokens the holder has compared to the total amount staked across the network.
This is compared to proof-of-work (PoW) blockchains like Bitcoin and Ethereum, where miners add new blocks to the blockchain using advanced computational algorithms and high processing power using mining hardware like application-specific integrated circuits (ASICs) and graphics processing units (GPUs).
Staking has played an essential role in the success of decentralised finance (DeFi), with many decentralised apps (dapps) requiring tokens to be staked in order for the service to work. Because staking occurs at the dapp level, there is more flexibility in how tokens are staked and how rewards may be earned as opposed to the more rigid process of PoS to secure the underlying blockchain.
For example, Uniswap users provide liquidity to the market by staking coins in return for liquidity provider tokens (LPT). The staked coins then create a pool of collateral for users to trade in and out of, which eliminates the need for a counterparty on each trade. In return for staking tokens, depositors receive a cut of the trading fees for the pool, and their LPT essentially works as an IOU coupon enabling the holder to redeem their deposit later on.
How does proof of stake work?
Staking can be achieved in a number of ways, but typically it involves four key aspects:
- It requires token holders to lock in a minimum number of tokens into the blockchain network as a stake similar to security deposits in the tangible world.
- The stake is like buying a lottery ticket to earn the opportunity to create the next block in the blockchain network. The larger the stake, the higher chance of the node being chosen for the next block.
- Once the node has created a block, the staker, who is also the validator, gets a reward in the blockchain’s native currency.
- The stake incentivises the holder to contribute positively to the blockchain since a part of their stake is lost in the case that they double sign or try to attack the network.
Staking can be done directly from compatible cryptocurrency wallets. Some cryptocurrency exchanges such as Binance, Kraken and KuCoin even offer staking services to the users of their platform, which provides a convenient way to earn money while keeping coins ready to trade. Some blockchains also entitle stakers to voting rights on protocol changes to the blockchain, which means that these rights are instead awarded to the exchange if that’s where you’re storing your coins – something to think about.
To overcome the minimum threshold of tokens that participants need to own to become a part of the staking process, there is an innovation known as staking pools, which allow multiple holders to combine their computational resources in the blockchain to increase the chances of earning block rewards.
The funds of all the stakeholders in the staking pool are collected and locked in one blockchain or wallet address. The pool is managed by a pool operator and the stakeholders. Any voting powers are directly proportional to the number of tokens a stakeholder has locked within that particular pool.
When compared to individual staking, staking pools generally offer smaller rewards as the reward is split between all the stakeholders in the pool, and there are often staking pool fees involved as well. On the flipside, staking pools are a good option for consistent passive income for stakers who aren’t willing to get technically involved in maintaining and running a node for validation.
How to stake coins?
The token holder can stake their coins either through their own cryptocurrency wallet or through cryptocurrency exchanges, such as Binance or Coinbase, that offer staking services to users that register on their platform. There are several cryptocurrency wallets through which users can stake their cryptocurrency funds. You can find a list of these wallets below.
There are several centralised and decentralised exchanges that offer staking services on various tokens. Here is a list of a few of the major exchanges that offer these services:
What coins can you stake?
Most of the native tokens of PoS blockchains can be used as a tool for staking. Here is a non-exhaustive list of cryptocurrency tokens that can be staked on their blockchain either through wallets or cryptocurrency exchanges:
What rewards can you earn through staking?
Each blockchain or smart contract may use a different method of assigning and calculating staking rewards. The profitability of the rewards is highly dependent on the structure and conditions of the staking rewards of that particular network. A few blockchains offer a fixed percentage of the funds as a staking reward, while many others base the rewards on various factors. Some of these factors are listed below:
- The inflation rate prevailing in the economy.
- The number of coins staked in the network in total.
- The duration for which a particular staker has been involved in the staking process.
- The number of tokens staked by the holder.
Wallets for staking
Here is a non-exhaustive list of cryptocurrency wallets that allow users to stake digital tokens directly from their own wallets where they hold their cryptocurrencies:
Is staking safe?
Even though staking is mostly safe, there are some risks attached to staking funds in a blockchain network or dapp:
- Market risk: Staking doesn’t rid the token owner of the market risks involved in the cryptocurrency markets. If the price of the token falls in the market, the value of the token decreases as well and so do the attached rewards that come with it.
- Lock-up period: There may be a minimum lock-up period for how long the tokens need to be deposited. The period varies on the type of blockchain or dapp used for staking. During the lock-up period, the funds cannot be shifted or traded and obviously can’t be withdrawn. Fortunately, not all staking systems have a lock-up period.
- Proof of stake: PoS validators get a higher share of the rewards when compared to passive stakers. These higher rewards are meant to compensate the validators for the higher operating costs they bear to validate blocks and transactions on the blockchain actively. Since this requires high computational power, it is not something the average staker can be a part of.
- Penalties: Stakers can lose portions of their stake for failing to meet the specific requirements of the protocol. Penalising stakers for such activities is known as slashing. Essentially, it is a process that the network and its governance use to disincentivise irregular and unethical behaviour in the blockchain network.
- Exchanges: Stakers using cryptocurrency exchanges to stake their funds are vulnerable to hacks and exploits that are often seen in cryptocurrency markets.
- Voting: By staking through an exchange, the staker essentially gives up his/her voting privileges in the network by handing it over to the exchange, thus leading to a certain degree of centralisation.
- Impermanent loss: When staking coins to provide liquidity to a decentralised exchange that uses an Automated Market Maker (AMM) model, the staker must be aware of the potential for impermanent loss, which is a risk unique to dual-token AMM pools. Explained briefly, impermanent loss is due to changes in the market value of staked tokens that causes the ratio between the staked tokens to change, resulting in a potential loss for the depositor when they withdraw their portion of the pool.
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