What is Staking?
Staking is one method for securing a cryptocurrency network (meanwhile earning passive income) in which the participant holds a certain quantity of coins to participate in the network and in turn receives rewards. By placing a stake with the minimum balance required by a given coin, the crypto is temporarily pledged—akin to a security deposit that guarantees renter’s intent—and the node has a chance to create a new block that is directly proportional to the quantity staked.
Definition of Staking
Staking is the function that secures a Proof-of-Stake network. Proof-of-Stake is a consensus mechanism where participants on the network validate blocks on the Proof-of-Stake blockchain.
Proof-of-Stake, via Staking, was developed as an eco-friendly, less resource intensive alternative to Proof-of-Work, but it still provides a method of reaching distributed consensus and validation on the blockchain network like Proof-of-Work. In practice, a holder locks his or her coins/tokens in a cryptocurrency wallet, which in turn earns passive income in the form of additional crypto.
Below are some popular cryptocurrencies; the following table indicates whether a cryptocurrency uses Proof-of-Stake or Proof-of-Work:
How Does the Process Work?
Because blockchain is decentralized, consensus protocols must be developed to ensure that all nodes—the computers that create the network —are synchronized and properly maintaining the immutable record. Such a consensus mechanism differs with the blockchain underlying the cryptocurrency. The two most common, as mentioned above, are Proof-of-Work and Proof-of-Stake.
With Proof-of-Work, mining is the consensus protocol that verifies transactions. Miners are individuals or entities that maintain the centralized network by using computational energy to solve complex mathematical problems. The first miner to solve the mathematical problem earns the right to add the next block to the growing blockchain. Successfully mining a block earns a reward.
With Proof-of-Stake, staking is the consensus protocol that verifies transactions. Validators either “stake” or “attest” in order to receive rewards, as discussed below. The decision of who creates the next block depends upon random selection of users that have staked their own cryptocurrency and the protocol acts at specific intervals to create a block. In other words, a person that is using their own cryptocurrency can lock or stake their own coins — personally committing capital. Thus, the activity has the essence of a lottery in which the number of tickets each participant may receive depends on how much cryptocurrency he or she has staked and the length of time that he or she has staked.
Additional validators then “attest” the block and when there are adequate attestations, the block is added to the blockchain. Validators receive rewards for triumphantly proposing blocks and for making attestations. There are multiple Proof-of-Stake mechanisms, including Delegated Proof-of-Stake, and each mechanism affects the procedure for its underlying currency.
Proof-of-Stake has been praised as a more equitable approach than mining, given that block confirmation rights are not simply assigned to miners with greater computational power than others. It also saves significant amounts of energy. Some argue that because it relies upon less energy and does not rely upon the ability to solve complex mathematical problems, it is more likely that it will have adoption due to the lower barrier for entry.
How to Stake Cryptocurrency
The good news is that if you want to stake, you don’t have to buy expensive hardware, use a lot of electricity, and solve complex mathematical problems, which is why some believe that Proof-of-Stake will do better than Proof-of-Work. Proof-of-Stake consensus allows regular crypto owners to assist in the maintenance of the blockchain from the comfort of their own home and with minimum preparation!
Prior to using any method, it is important to understand the risks associated with doing so. To commence the process of staking, follow the following three steps:
- Obtain a Compatible Wallet.
One must own a wallet in order to participate in staking. Generally, a user may stake directly from their digital wallet. If this feature is unavailable, certain exchanges allow users to stake on their platforms. If a user has an offline wallet, cold staking is still available as described below.
2. Choose the Cryptocurrency.
Each currency varies in its application of the Proof-of-Stake consensus mechanism and thus has different requirements as well as varying rewards. It is critical to understand the differences in each cryptocurrency, therefore more research (i.e., how to stake Ethereum versus TRON) may be required depending on that which the user has chosen. More information on these differences is available below.
3. Choose a method.
Depending on the user’s goals, it may be more lucrative to stake individually or via pooling. If you have a small quantity of coins, it may be more favorable to pool your assets with others in order to receive returns at all, depending on the odds of winning the “lottery” for the given coin.
4. Earn rewards!
Holding cryptocurrency offline via cold storage does not prohibit users from staking. Cold staking allows these individuals to stake without transferring their funds to an online wallet. This permits users to simultaneously earn passive income and maintain the extra security of cold storage.
Rather than stake individually, staking pools allow multiple users to party together and stake as if alone. A user has a greater chance for selection as the validator when pooling together. The greater chance for selection increases the opportunity to thus earn rewards than doing so unaccompanied. The reward is, however, spread evenly across all participants. There is less risk assumed by the participant, however the reward is similarly reduced.
Rewards & Reward Calculation
The winner of the “lottery” receives additional currency, akin to the bitcoin that miners receive on Proof-of-Work blockchain. Few cryptocurrencies offer rewards based on fixed percentages and others are calculate their rewards based on a selection of factors, some of which include:
- number of coins staked;
- number of coins staked on the network;
- duration of time spent staking; and
- inflation rate.
Rewards are generally credited directly to the coin holder’s wallet. If cryptocurrency must be removed from the stake, a failure to meet the minimum balance will render the participant ineligible to receive rewards.
Popular Cryptocurrencies to Stake
Holders of any currency using a Proof-of-Stake protocol may stake coins. The means of doing so and the rewards earned, however, vary by network.
Depending on the currency, the minimum number of units required for staking (i.e., Dash runs on a smart contract, or masternode, that necessitates 1,000 coins) and the percentage of return will differ. For example, NEO offers new coins at 5.5% of coins staked annually and Tezos’ rewards are up to 6%, while OkCash is nearly double at 10%.
Ethereum was originally designed to use the Proof-of-Work protocol, but will transition to Proof-of-Stake. At the moment, staking is not available—it is expected to be offered soon. Once it is released, the procedure for how to stake Ethereum will be the same as presently available cryptocurrencies.
There are many advantages to staking. Some of these include:
- Passive income
- Opportunity to participate in a blockchain project
Staking gives individuals who would be holding cryptocurrency regardless an opportunity to earn income without much active engagement. Unlike a mining operation, this does not require expensive equipment that uses significant measures of energy; it is an environmentally friendly and much more accessible method of verification. Staking therefore gives users the ability to participate in blockchain projects that they previously would not have been able to support.
Despite its many advantages, staking coins has its fair share of risks, including:
- Market Volatility
- Potential Slashing Risk (if network supports this)
It is important to exercise caution and only stake what one is willing to maintain within their possession. A participating user is required to hold the currency for a defined period while it is being staked and thus may not be able to sell until the defined “lock-in” period concludes. Cryptocurrencies are notoriously unpredictable—generally more so than stocks and bonds. In the event that the asset being staked loses its value, the reward–which is determined by network participation, as defined above–may be worth less than the decrease in the staked assets’ price. Lastly, there is a risk of punishment from the network when a validator breaks the rules designed for the protocol. This may include the potential loss of a portion of a user’s stake.
CrossTower Inc. provides this content for general information purposes, to better inform you on your digital asset investment journey. We do not provide investment recommendations or provide tax advice. Please consult your investment professional or tax advisor if you require assistance in these areas.