What is Staking? Earning Rewards and Minimising Risks of Staking
Staking refers to the way many cryptocurrencies and blockchain networks are operated. Network participants stake by committing their own crypto assets to help the network to verify all its transactions and in return, earn rewards proportional to their stake amounts.
What you'll learn about staking
- What staking is and why people stake cryptocurrency
- How staking works and the Proof-of-Stake consensus algorithm in crypto
- How to earn potential rewards from staking and using staking pools
- How some staking networks manage decision-making
- The risks of staking and what you can do to minimise them
What is the purpose of staking?
Chances are, you first heard about the concept of staking as a term related to earning money with cryptocurrency or simply, crypto. To get a better understanding of this concept, we look at the definitions and the purpose of staking crypto, before we go into the staking consensus mechanism, staking process and staking rewards. We then examine pooled staking as a way most people participate in the activity, before discussing some of the pros and cons of staking digital assets.
Staking coins isn’t just about passive income
While this is the current predominant concept in crypto staking, that is, to earn more money by staking in crypto, staking was also originally used to describe a way that many popular blockchain-based cryptocurrencies verify their transactions and secure their network.
It is worth noting that these two definitions of crypto staking are actually inter-related. This is because the process of staking to secure the network also rewards those who participate in this activity. Only today, many crypto investors who stake their crypto are motivated primarily by the potential rewards they can earn, and do not necessarily actively participate in the running of the network.
Staking to secure a network and earn rewards
To summarise, staking crypto involves committing your crypto assets to help secure a blockchain network and verify transactions. As the term “stake” suggests, stakers hope to share in the potential reward but they also share the associated risks with securing a blockchain network. We’ll discuss some of these risks in a latter section.
How Does Staking in Crypto Work?
It might help to understand stakes the way you would use the term in finance or investment, where your stake in a company reflects your share in the company’s performance and, therefore, its profit or loss. In crypto staking, the staking reward is distributed proportionately to your share of the total staked funds, just as company profits are distributed proportionally to shareholders. Any loss that may happen is also shared proportionally among stakers.
Of course, in many cases, especially when dealing with many staking apps and platforms out there, a lot of this is simplified for the user and returns are approximated.
You could even see staking from a gambling point of view, whereby a stake is an amount of money or something else of value placed on the outcome of a venture, with the desired outcome resulting in a profit. This gambling viewpoint might not seem like the appropriate metaphor but it actually makes sense from the perspective of how blockchain networks run.
Your stake is your commitment to the crypto network
Staking is only one of several ways that cryptocurrencies verify transactions and secure the network. In staking networks, the computers or people who run a network are actually randomly selected to validate transactions – the larger their stake, the higher their probability of getting chosen and earning the associated rewards. You might even consider crypto staking as a form of lottery sweepstakes in this case.
At the heart of it, when staking in crypto, you are committing your coins and hoping you get selected for staking rewards. To get a better understanding of how this process happens, we now take a look at cryptocurrencies that use staking mechanisms. These are called Proof-of-Stake crypto.
What is Proof of Stake?
Crypto staking is available with cryptocurrencies or blockchain networks that utilise the Proof-of-Stake model or system. You might sometimes see the model being referred to as the consensus mechanism or consensus algorithm. This is because the computers or people running a crypto network must collectively agree on which transactions should be validated and verified. Only with consensus is a set of transactions recorded to the blockchain ledger.
Proof-of-stake blockchains were developed as an alternative model to the Proof-of-Work model originally used by Bitcoin. The Proof-of-Work model requires the use of specialised mining devices that use intensive computing power to solve highly complex mathematical equations. This then requires participants or miners to operate sophisticated and expensive equipment that cost a lot of money to maintain. Proof-of-Stake does away with these crypto mining rigs so that people can participate in the network’s maintenance simply by committing their digital assets.
Staking rewards
As we discussed earlier in how staking works, by committing funds in the shape of crypto, digital assets, or tokens, network participants – called stakers, nodes or validators – must work honestly in the network, validating and verifying transactions correctly, while rejecting malicious or invalid transactions.
Validators risk losing their stake if they were to behave dishonestly. For instance, by accepting malicious or invalid transactions, these dishonest validators would be found out by other honest stakers, and they would lose their rewards. In extreme cases, they could even be disqualified from future rewards or forfeit their stakes.
In return for this committed stakes, stakers typically receive a certain amount of reward in the same crypto that they have staked. Every network has a different process to determine what this reward entails.
Typically, there is a fixed amount of reward for every time a Validator is chosen to validate transactions. When this happens, the validator actually records them as a new set of transaction into the ledger (or the blockchain), generating or “finding” a new “block” to be added to the blockchain. As such, this reward is usually referred to as a block reward.
In addition, the selected Validator also gets to keep any transaction fees or miner fees paid by those submitting transactions to the network. In the case of Ethereum, there are also miner “tips” included in the rewards.
Calculating staking rewards
In the Proof-of-Stake model, the chance of a staker getting a staking reward is estimated to be proportional to their stake’s share in the entire total of staked assets in the network. The bigger the staker’s share, the bigger the estimated reward.
Example: Ali decides to stake 1 ACoin into the ACoin Proof-of-Stake network. The total staked funds in the ACoin network is now 10 ACoin. This means that Ali’s stake is worth 10% (1/10) of the staked funds. Ali should expect an approximate 10% chance of getting selected to be a Validator for every block.
Winning staking rewards can be like a lottery
Remember the part when we discussed how staking could be viewed as playing the lottery?
Recall that the crypto network chooses randomly who among the stakers will become validators, thus earning the reward for validating and creating a new entry into the blockchain ledger. Technically, they are adding another block containing all the validated transactions to the existing blockchain.
It is important to point out that this entire sum of staked coins consists of many other stakes from other stakers. In fact, the more popular or the bigger the network, the higher the number of participants.
Some Proof-of-Stake networks, like Ethereum, are so big that some 375,000 validators are staking over 12.5 million ETH (Ethereum.org as of April 2022). This means that even if you were to stake 125 ETH (worth approximately $288,000, April 2022), your share of the staked funds would only represent 0.001% of the total staked funds. That equates to you only getting a 0.001% chance of being selected as a validator and earn rewards.
Furthermore, many networks have their own set of rules for Validators. Some cap the number of validators and others enforce a minimum stake amount. Ethereum, for example, has a minimum amount of 32 ETH (approximately $80,000, April 2022) to start staking.
Fortunately, regular users who want to stake don’t have to face such daunting odds or such high financial entry barriers on their own.
Many larger validators run what is called a Staking Pool that individuals can join, adding their stakes to those of the validators. In this way, ordinary users can still participate in Staking without meeting the actual individual requirements of the network.
What is a Staking Pool?
As the term suggests, a Staking Pool is simply the pooled total of all the staked funds contributed by multiple stakeholders to unify their staking power. This gives the Staking Pool operator a better probability of getting selected by the network in validating transactions and thus, earning the associated rewards.
These pool operators then perform all of the technical work of validating transactions and finding blocks. Once they earn the rewards for doing this, they then distribute the rewards to Pool participants’ crypto wallets, minus a small fee or commission. The distribution here is directly proportional to the share of the Pool.
Example: Lee decides to stake 1 ACoin into the ValidatorOne ACoin Staking Pool. The total staked funds in the ValidatorOne pool is now 10 ACoin. This means that Lee’s share of the pool 10% (1/10). Lee should expect to get exactly 10% chance of all the rewards earned by ValidatorOne, minus fees or commissions.
When you participate in a staking pool, you lock your assets there and can’t use them until you unstake them – much like directly staking into the network. However, because you aren’t directly staking it, you are delegating your stakes to the Validator operating the Staking Pool. You may come across the term “Delegated” staking to reference this activity. In a latter section, we will also briefly discuss how delegation of stakes can also result in the Validator gaining more decision-making power in staking networks that implement governance measures.
Most Pools also incentivize more frequent and longer staking periods, or the possibility to lock stakes (imposing a penalty on unstaking before the lock duration ends). This helps the Validator sustain their probability of earning rewards, or helps them attract more stakers to delegate funds to them.
The basic motivation is simple: the longer you keep your assets staked, the higher your share of earning rewards, or the more your share of any eventual rewards will be.
Staking or Savings on Exchanges
Many popular exchanges also offer a way for their users to directly stake tokens via their platform. These aren’t set up as conventional pools on a particular digital asset network but simply hosted accounts on the exchange as one of their financial products.
You may find that these pools are sometimes called Savings, which more appropriately reflect their purpose as a sort of exchange bank. The APYs offered on these types of Savings do tend to be slightly lower than that of actual staking activities or most staking pools, but they can be slightly more flexible in terms of unstaking during periods of extreme price swings.
DeFi Savings Pools
In decentralized finance (DeFi) protocols and platforms, staking pools (sometimes also called savings) work very much along the same concept, but generally make use of their native token for their protocol. For instance, Binance Smart Chain (BSC) protocols like PancakeSwap would have CAKE (its native token) savings pools, but it also hosts multiple pools for other protocols and projects launched on the same BSC network.
A secondary purpose of these pools is to lock liquidity (assets) into the protocols, ensuring that there are enough resources in terms of assets to meet the trading needs of people interacting with these protocols.
Rewards in these savings pools also include a share of revenue generated from the different protocol services (like fees and commissions), which is why APY percentages in DeFi savings pools can be higher than regular Proof-of-Stake pools.
Governance: Staking is voting, pools are not
Networks that use the staking mechanism sometimes also have a governance aspect to manage the way decisions are taken in decentralised networks with no central authority.
Decision-making is directly linked to the amount of assets committed to securing the network. In some networks, a separate and particular digital asset, sometimes called a “governance token”, is also issued to stakers along with rewards.
Being able to vote in the future development direction of a network can be important to Validators who want to ensure the right decisions are made to ensure the future value of the network (and thus, their crypto staked on the network).
Hence, staking power can sometimes also be voting power. Naturally, delegating your stakes to a Staking Pool also delegates your votes to the operator of that pool.
The Risks of Staking Crypto
There are undeniable benefits to putting money into staking work in the crypto scene, not least the opportunity to earn passive income and grow cryptocurrency holdings easily. Proof-of-Stake itself is also friendlier to the environment as a consensus mechanism. Using Proof-of-Stake also makes it far easier for newcomers to participate in the actual process of running a blockchain network, compared to Proof-of-Work crypto like Bitcoin.
However, like any other form crypto investment, there are also inherent risks that you should be aware of before you decide to stake coins.
Challenges to staking crypto
1. Complex technical knowledge required
To directly participate in staking as a Validator actually requires a high level of technical knowledge, since you will need to process transactions and add blocks to the blockchain network. Mistakes won’t go unpunished and networks tend to be unforgiving. The costs incurred in terms of penalties, loss of stakes or even reputational damage from making the wrong calls can take their toll on your income.
2. Stakes can be exposed to cyberattacks
Needless to say, there are always people looking to exploit security flaws or loopholes in cryptocurrency. Some staking mechanisms and some staking pools could unknowingly be vulnerable and if you happen to have your crypto staked there when a hack occurs, you could very well lose your funds.
3. Crypto volatility can nullify rewards
It is not uncommon in crypto to see staking APYs that far outstrip traditional savings interest rates. However, crypto prices by nature are highly volatile and you could easily lose out in sharp price movement in your staked assets. So, while a 30% APY might sound highly attractive, if the crypto loses 40% of its value over the year, then your crypto holdings would still end up in the red. The risk is even higher if you’ve committed to lock-up periods, since you won’t be able to unstake in periods of high volatility without incurring costly penalties.
Minimising the risks of staking crypto
1. Use a staking pool
Stake into an appropriate pool and simply earn rewards even more passively than if you were to stake directly. You do give up some of the income as fees or commission, but at least you won’t have to deal with the technical complexities of processing transactions and creating new blocks.
2. Use cold staking
Choosing the right crypto wallet for staking is important as you want to minimise the ways your coins could get hacked or stolen. Cold staking is a term used when you stake funds from a cold wallet or hardware wallet, that is, a wallet that is offline or not connected to the internet. The idea here is simple – if your wallet isn’t online, no hacker can access it electronically.
Not all Staking Pools are created equal
As discussed in a previous section, Staking Pools offer different incentives to try and attract more individuals to join them. Earnings are also far more predictable than solo staking, and stakers find they can more easily determine the Annual Yield Percentage (APY).
For the pools themselves, there is the obvious economic incentive, as larger stakes give these operators a higher probability of getting selected by the network to validate. They also stand to gain from more fees and commissions levied on the individuals staking crypto in their pools. However, they can also benefit in terms of their say in the network development.
In the Proof-of-Stake consensus mechanism where Validator stakes also represent their governance power or voting rights, there is a danger that one or more pools are too powerful as a result of delegated voting rights, granted when individuals commit their stakes to the Validator’s pool. In a decentralised system that works hard to prevent giving a single entity too much power, this can be an unhealthy situation.
Imagine a situation where a Validator creates the most lucrative pool to attract the most stakes in the network, rising to become the single most powerful voter. Since that validator has the majority vote (by having the majority stake), they would be able to determine development decisions like network upgrades that otherwise the majority of individual participants would be against. Worse, Validators that are negligent or irresponsible
Simply put, you should always do your best to examine each pool operator individually, not merely to maximise your earnings but also to ensure that their track record and past behaviour align with your principles.