Introduction
While most crypto investors begin their journey by purchasing and trading coins on a centralized exchange, more advanced users and investors quickly learn that crypto staking is one of the most consistent methods of accumulating cryptocurrencies.
Crypto staking, often referred to simply as “staking”, is a method of earning passive income using cryptocurrencies. Although it can be intimidating to dive into a new concept in crypto, staking is an essential piece of knowledge to fully understand your crypto investments and the potential to leverage them to generate passive gains over time.
At a high level, crypto staking uses your digital assets to earn returns (similar to interest or dividends) over time. Typically, these returns can outweigh those found in traditional finance. However, the returns are almost always denominated in highly volatile crypto assets, and there is risk involved to consider before locking up assets in a high-interest staking pool.
What Exactly is Staking?
The act of staking most often refers to locking up a specific crypto asset to assist with running and validating the blockchain. As a reward for staking coins, there is a regular payment or reward given back to the users (referred to as “stakers”). There are other forms of staking associated with DeFi platform fee sharing, but this form of staking is not discussed here.
By committing tokens to stake, staked tokens are being used to ensure the validity of transactions. Since blockchains are decentralized, there needs to be a method of confirming the legitimacy of transactions. If there is no centralized authority to confirm the validity of each transaction, how do blockchains create a trustless ledger? While the exact approaches vary, each blockchain needs to use a “consensus mechanism” to validate and confirm transactions.
What are Consensus Mechanisms?
To better understand the reason for staking rewards, you should first understand the consensus mechanisms. Consensus mechanisms are the processes used by blockchains to allow a decentralized ledger to maintain its integrity without using a centralized authority. There are two primary ways blockchains validate transactions and ensure security: Proof-of-Work (PoW) and Proof-of-Stake (PoS).
Proof-of-Work
Proof-of-Work blockchains (such as Bitcoin and Ethereum 1.0) validate blocks of transactions by using miners to submit hashes until a hash is submitted below the network difficulty rate – a process of submitting thousands of numbers which requires significant computing power. Upon submitting a valid hash, the “winner” of a given block submits the record of transactions and is paid a reward. PoW has received criticism due to the high levels of energy used by the computers submitting hashes.
Proof-of-Stake
On the other hand, a Proof-of-Stake blockchain (such as Ethereum 2.0, Solana, or Tezos) allows validation based on having tokens staked by the validators. In PoS, the validation responsibility is randomly assigned among validators who have staked assets. Typically, the size of the staked assets will influence their chances of being selected. Then, after the transactions and activity is reviewed, a reward is paid to the validators.
The requirements to be a validator vary by chain. In many cases, investors can group or pool their tokens to participate. These groups are known as “staking pools” and are a common way for individual investors to stake crypto and receive rewards over time.
PoS has gained momentum for two primary reasons: energy usage and scalability.
One significant critique against cryptocurrencies is the immense amount of energy used to secure the blockchain. By using the Proof-of-Stake consensus mechanism, the computing power necessary is drastically reduced (no brute force submission of massive amounts of hashes to validate) and this energy efficiency allows broader adoption of ‘greener’ chains.
Secondarily, early blockchains were relatively simple compared to today’s chains which run smart contracts powering innovations such as DeFi and NFTs in addition to common financial transactions. With Proof-of-Work, fees and processing time to validate can grow to create bottlenecks and increased fees or gas prices. Anyone who transacted on Ethereum 1.0 during the recent NFT cycle can attest to high fees and how these limit the growth and adoption of cryptocurrencies.
What are the Benefits of Staking?
By staking coins, investors are participating in the decentralized and trustless process that enables cryptocurrency blockchains to function. Of course, the benefits are not simply participating and learning more about the inner workings of blockchains. Rewards, typically paid in the blockchain’s native token, are accumulated for each staker over time.
Long-term investors tend to favor staking tokens since the alternative is simply holding them in a wallet or on an exchange. By ‘putting your money to work,’ these assets are earning interest during the hold period.
How are Staking Rewards Calculated?
As investors consider staking, there will commonly be a rate of return (APR or APY) or reward percentage shown to give an estimate of the returns over time. These values give a sense of the expected rate of return, however, investors should investigate the return time frame, lock-up periods, total token supply, reward plans or changes, auto-compounding, and other token-specific plans that may influence returns. The best place to review is the blockchain’s website for a whitepaper or discord group that can answer questions and provide clarity.
Keep in mind the fiat value of the token is not considered in most staking reward systems. While a stable or growing value token may offer extremely appealing rewards (token appreciation + staking rewards), the loss of value in fiat can easily wipe out any gains from staking. As with traditional finance, the largest promised returns often have a higher risk associated with them. A token with a large APY is probably more volatile in fiat value than a more established coin with moderate staking returns.
As of the writing of this article, the average rate of return on staking tokens is 9.6% annually with returns ranging from low-single-digits to 18%, 20%, or more depending on the type of token and the chain on which it is staked.
Risks of Staking
While staking can be an excellent way to build up a crypto portfolio, it is not without risks. As discussed briefly in this article, the primary staking risks are fiat value, lock-up or vesting periods, and counterparty risk with either the pool operator, the project team, or the chain itself.
Fiat Value
Any investor in crypto markets understands the volatile nature of these assets. Crypto prices in USD (or any native currency) can change at a rapid pace which may enhance or wipe out gains from staking. Even a 20% staking return can quickly evaporate in fiat value when the market shifts. On the other hand, upward price movements compound staking gains.
Lock-up Periods
Lock-ups or vesting is another consideration for an investor prior to choosing to stake tokens. For most coins, when you stake, you are committing to locking up your tokens for a set period of time. Sometimes, this is as short as a few hours, but is often a week, a month, or longer.
If you are actively seeking to trade or would like the freedom to react quickly to market conditions, then staking coins that require a lock-up may not be the best option. Keep in mind investment time frames. With compounding rewards and small, regular payments over time, staking is often a better choice for a long-term investor and a personal investment time frame is a key consideration.
Counterparty Risk
One additional risk consideration with cryptocurrency staking is called “counterparty risk.” Counterparty risk is traditionally defined as the likelihood that the party with which you trust your assets may not uphold their side of the deal.
In terms of staking, if you are working through a staking pool that relies upon a pool operator to run the validator, there is a risk of fees or penalties assessed to the pool. These fees are typically assessed if the pool operator has downtime or dishonest actions.
Finally, blockchains are new technologies and there is always an outside risk of a catastrophic chain failure that could put locked or staked funds at risk.
How to Get Started
So now that you have a basic understanding of staking, the big question is “how do I get started?”
The process is not necessarily as complex or daunting as it may seem at first. Everyday users can get started with most large crypto exchanges (such as Coinbase) or on the respective project’s website. Keep in mind that the process below is the simplest starting point. To become a full validator would require additional investment and technical knowledge beyond the scope of this article.
A quick overview of the simple process is as follows:
- Determine the token to stake
- Purchase tokens
- Commit tokens to a staking pool
Let’s walk through a quick example:
Determine the Token to Stake
As discussed previously, types of cryptocurrency available to stake must use the Proof-of-Stake consensus mechanism. Additionally, we would like to compare fiat value over time, staking payout rates, and research the token as an investment.
Nansen’s analytics platform is a great way to conduct this due diligence, using tools like analyzing various forms of staked Ether, such as Lido’s stETH.
Want to start analyzing staked tokens? Sign up for a Nansen plan today!
Purchase Tokens
This step is completed easily on your preferred crypto exchange. Popular cryptocurrency exchanges such as Coinbase are often set up to buy and stake in a few easy clicks. Depending on the token, you may be able to use a decentralized exchange such as Uniswap.
Keep in mind if you are purchasing the token outside of a centralized exchange, you will likely need a crypto wallet that supports the token. Popular crypto wallets vary depending on the coin, but links to reputable software wallets are commonly found on the official website of the project. Hardware wallets can be used for staking, but may need additional software such as Ledger.
Commit Tokens to a Staking Pool
Staking through a crypto exchange like Coinbase is as simple as selecting an option to “Buy & Stake” or after purchasing, going to the “Interest” section to commit tokens to staking. When using a centralized exchange, the process is simplified which comes at a cost of a reduced APR. Using an exchange may even help mitigate concerns around validator select and counterparty risk.
Other options may vary depending on where you purchase and hold your crypto. Wallets often offer staking and may require you to create a staking-specific account and then select a validator to join a staking pool. Be sure to investigate the validator prior to delegating tokens, to ensure you are reducing counterparty risk.
Conclusion
Staking, and Proof-of-Stake consensus mechanisms, are essential to the functioning of a trustless, decentralized blockchain. Not only are stakers and validators participating in the process, but using crypto as reward-generating assets to earn passive income (similar to a savings account at a bank or a stock paying dividends). As crypto users and investors, understanding the basics of how staking functions is an important element of becoming an educated investor making smart decisions within a portfolio.
As with any decision in a complex and rapidly evolving ecosystem, proper research and understanding are key to success. Using research tools, such as Nansen, combined with direct research on project websites and official Discords, is the best method of setting an investor ahead of the curve, leading to long-term sustainable results.
