Staking is one of the common ways cryptocurrency holders use to earn crypto passive income from their idle digital assets. Staking involves earning rewards for committing certain types of crypto assets that support a blockchain network and help in transaction confirmation. However, this is a more simplified definition. It is important to understand a little bit more about how staking works and why it works the way it does.
To lay the ground for understanding staking, we will review some of the basic principles of blockchain, how transactions are validated on a blockchain network, and the problem, that staking is trying to solve.
Blockchain and Transaction Validation
Blockchain is a distributed ledger that manages data without the need for centralized authority. Every blockchain network needs a consistent method for validating the data that is stored in that network.
Initially, the solution to managing blockchain was done through mining. Mining is how a new unit of digital currency is created (“minted”) and added to the blockchain network. Unlike centralized financial systems such as Banks, cryptocurrencies act as decentralized banking ledgers. The transaction records involving these digital tokens are kept in multiple computer nodes that together form the distributed network. This network is updated by adding new data blocks to the existing chain of blocks.
Mining requires users to solve complex mathematical equations that the system generates. A miner who completes the process first is awarded through a set of rules written into the protocol’s code, for example, Bitcoin’s code.
The mining process is highly competitive since only the first miner to find the solution is awarded. As a result, miners use expensive and highly powerful computers to win. The faster a miner’s computer is, the more guesses they can make, and the higher the chance of finding the required solution.
The technical term for mining is “proof-of-work” since miners prove they have put in a lot of work by displaying the correct solution. Proof-of-work (PoW) is a consensus mechanism because it creates an agreement as to who updates the ledger amongst a group of people in a trustless environment.
The PoW consensus mechanism is a reliable and secure solution to managing a decentralized ledger. However, it is resources intensive. It requires a lot of money to buy and run supercomputers required for mining. Additionally, mining consumes a lot of energy to run, thus directly affecting the environment.
Due to the challenges with mining, alternative consensus mechanisms have been suggested. One of the popular alternatives is Proof-of-stake (PoS). PoS is less energy-intensive and involves locking coins to get the chance to to validate transactions. Users lock their coins at a particular interval on an everyday computer connected to the network. The computers for such users are called nodes, and their locked funds are known as stake. Participants who have staked their tokens enter the contest of which node will be selected to validate the next block. Winners are chosen based on multiple factors, including the amount of token staked and the period for which the coins have been locked. The selection is made randomly to prevent a single node from gaining a monopoly over validation. Generally, the chance of being chosen as a validator is directly proportional to the amount of coin staked.
Apart from being less resource-intensive, some also argue that staking enables higher scalability for blockchains. For example, Ethereum Network is in the process of migrating from PoW to PoS in a set of technical upgrades collectively called ETH 2.0. This move aims to solve multiple problems that the network currently faces, scalability is one of them.
How does Staking Work?
The staked assets are put to work by the protocol to validate transactions hence securing the network. In return, the participants are rewarded with passive staking profits.
To take part in crypto staking, you must own a cryptocurrency that uses the PoS model. Each PoS blockchain has its particular staking currency. However, some networks may adopt a two-token system, which involves rewards being paid in a second token.
Typically, staking involves keeping funds in a suitable wallet. Depending on their preferences, participants may use hot or cold wallets to lock the coins. Staking using a hot wallet involves using wallets connected to the internet, such as exchange wallets. Such wallets are non-custodial, meaning the wallet owners trust third parties to manage and protect their wallets and only give permissions to send and receive tokens. Alternatively, participants can use cold wallets to hold their cryptocurrency – cold staking. Cold staking is mostly done with hardware wallets; however, air-gapped software wallets may also be used. It is important to consider a secure crypto wallet to ensure the safety of your coins.
Networks supporting cold wallet allows users to stake tokens while securely holding them offline. Stakeholders stop receiving rewards when they move their coins out of the cold wallet. Large stakeholders prefer cold staking since it offers maximum protection of the locked funds.
Staking is rewarding hence competitive. Out of the many people who would want to earn from their idle coins, only one person is selected at a time to validate the transaction and earn the reward. Therefore, staking protocols seek a way of reducing the number of participants to a manageable one. The most common way of achieving this goal is to set a minimum of coins required to participate in staking. For example, Ethereum requires a minimum of 32 ETH to participate in staking.
This minimum requirement may be a barrier to many people willing to participate in staking. For example, 32 ETH translates to over $100,000, which is quite a lot of money, especially for beginner investors.
Staking pool is a strategy that coin holders use to break the financial barrier to staking and even increase the chances of validating blocks to receive rewards. It involves a group of coin holders merging their coins in a pool and sharing the generated reward proportional to their contributions.
Trading requires a lot of time and expertise to set up and maintain. Additionally, they have proven the most effective way of breaking the barrier of entry both technically and financially. Therefore, many staking pool providers charge some fees from the staking rewards that are distributed to stakeholders.
Staking pools can provide additional flexibility for individual coin holders. Stakes are usually locked for a specific period, with a preset withdrawal or “unbinding” time.
Calculating Staking Reward
Each blockchain network may use a different method of calculating staking rewards. In some cases, the rewards are even adjusted on a block-by-block basis, considering many factors. Some of these factors are:
- The number of coins the validators is holding at stake
- The period that the validator has been actively staking
- The total number of staked tokens on the network
- The rate of inflation
Some blockchain networks determine staking rewards as a fixed percentage, which are distributed to validators as compensation for inflation. Normally, inflation encourages users to spend their coins instead of holding them, hence increasing the usage of digital coins. However, with a fixed percentage reward model, users can calculate the staking reward they can expect and determine if it is worth their investment. Some stakers prefer a predictable reward scheme rather than a probabilistic chance of receiving a block reward.
Interest in staking is often measured in Annual Percentage Rate (APR), which presents how much interest a user will receive for the staked asset in one year. Some staking schemes also support compounded interest, which is measured in Annual Percentage Yield (APY).
Soft staking enables users to receive staking rewards without locking their funds. It does not restrict coin holders from moving their assets from custody. Instead, investors can withdraw assets whenever they want. Another unique feature of soft staking is that it has no minimum staking period, and investors can receive interest income daily. It can allow for quicker and more efficient compounding and flexibility with portfolio management. Soft staking often attracts lower interests compared to other staking schemes. However, some investors believe that lower interest is a small price to pay for freedom and more protection from the severe market volatility that the staking mechanism offers.
Soft staking was pioneered by KuCoin in 2019 and has since attracted many cryptocurrency networks as well as users. Currently, some protocols offer soft staking at higher interest rates – close to those of other staking schemes. For example, Hi.com, a relatively new protocol, is offering staking without locking funds at 11% for Ethereum and 11% for USDT.
Risks of Staking
Staking may come with some risks that the coin holder should consider when deciding to commit their funds into a scheme.
First, cryptocurrency prices can be very volatile and can drop drastically leading. Sometimes a large price drop that outweighs the interest can occur. In that case, stakeholders may record huge losses. The level of these risks depends on the type of digital assets. Popular and liquid assets may present lower volatility than small cryptocurrency projects. Investors must be careful with small projects that offer extremely high staking reward rates; some of them entice investors yet are highly risky.
Second, smart contracts that manage locked cryptocurrencies may be prone to bugs. Any failure of a smart contract or a successful attack on it may lead to loss of assets. Investors need to do their own research in trying to find the most secure schemes and wallets. Using a quality wallet such as hi.com can neutralize this risk.
Staking is a popular way of earning a passive income out of idle tokens. Many protocols offer decent interest through different staking mechanisms, including soft staking. However, coin holders must do their own research and ensure that they are locking their funds in a safe smart contract to avoid losing their funds. It is essential to use a secure wallet that can offer maximum security for digital tokens.