Connect with us

Digital Assets 101

What is Staking in Cryptocurrency and How does it Work?

mm
Updated on

Blockchain technology has changed a lot in the last 13 years, since the launch of Bitcoin. Originally, it was developed by Satoshi Nakamoto to act as a digital ledger, meaning that it was only used for recording transactions. It wasn’t until 2015, and the launch of Ethereum (ETH), that the world realized that there is a lot more to blockchain than meets the eye.

Fast-forward several years, and Ethereum’s network has developed a lot of new trends thanks to the discovery that it can also record code. Thanks to Ethereum, blockchain can now run smart contracts, which means that you can use it to develop decentralized applications, launch different types of coins, and do a lot more than simply make payments.

This eventually led to the rise of decentralized finance (DeFi), which offers a wide variety of DeFi protocols — projects meant to provide regular people with decentralized banking services, such as lending & borrowing, yield farming, providing liquidity, staking, and more — all of which allows users to gain passive income in exchange for providing their tokens to the project’s use.

Out of all of these DeFi activities, staking has grown to be one of the most popular ones, so today, we decided to take a deeper look into it and see what it is all about.

What is Staking in Crypto?

Staking is a concept that you can run across pretty much wherever you go in crypto industry these days. It is a way that many blockchains are now using to verify transactions, but at the same time, it rewards those who engage in it with new coins. Using staking for transaction verification was made possible thanks to a process called Proof-of-Stake (PoS), which is a consensus algorithm that allows users to process transactions and store them on the blockchain.

Unlike the original algorithm that Bitcoin developed, called Proof-of-Work, PoS does not require massive amounts of electricity and computing power. It only requires for users to lock up a certain amount of their coins and tokens, varying from project to project, which allows them to become trustworthy enough to participate in powering the chain.

The more coins you stake, the more trustworthy the system considers you to be, and your chances of becoming a validator (as they are usually called) for the blockchain increase. In return, whenever you help validate and record a new block to the blockchain, a new amount of coins gets minted and distributed in the form of staking rewards. Typically, the rewards come in the same coin that you used to stake, although there are some projects that allow you to stake one coin and get the other as a reward.

In other words, staking is a fairly similar process to mining, only it is a lot more eco-friendly, it wastes a lot fewer resources, and you don’t need to invest thousands of dollars into equipment alone to start doing it.

Can I Stake All Coins?

Unfortunately, no. Staking is not an option with all types of coins, although the number of those that can be staked is rising all the time.

Earlier, we mentioned using the Proof-of-Stake model, which is a consensus mechanism that blockchain use to validate transactions. Well, while this is certainly a better version than PoW — not all blockchains use it. Bitcoin, Litecoin, and many others are still tied to Proof of Work. They were launched before Proof of Stake existed, and they are still sticking to it to this day.

Ethereum, on the other hand, is an example of a blockchain that used PoW when it was first launched, but it recognized its flaws, and since then, it started developing an upgrade that will switch it to the Proof of Stake. As you can imagine, this means that it has to overhaul the entire blockchain, so it is a lengthy process, but once it finally gets there, it will also be quite rewarding.

Am I giving up on my coins when I stake them?

Absolutely not. If you choose to stake your coins, you are simply locking them up inside of a staking pool that, in turn, grants you new benefits and privileges. However, your coins still remain yours. Depending on the project, there might be certain conditions, however.

Some projects require you to lock up your coins for a specific period of time, and if you try to withdraw them before that period runs out, you may face penalties. This is often encountered among young DeFi projects, whose prices are fairly easy to manipulate due to them still being fairly small.

This is a mechanism put into place to prevent price manipulation. You see, staking also serves as a way to prove that you have faith in the project. It is similar to HODLing in that way, and the more coins you have staked, the greater your support and faith in the project seem to be, which further encourages others to invest, and it keeps the price stable, or on the rise.

On the other hand, there are also projects that allow you to stake your coins and withdraw them unconditionally, at any time that you want, with no consequences.

Should I Stake Crypto?

Finally, we come to the biggest question — should you stake your coins or not? Just like most things related to crypto, the answer is not black and white, and it cannot be a simple yes or no. There are many things to consider before you make that decision, including which specific coin you wish to stake.

Does every project have its own specific condition, such as whether you can withdraw your coins without a penalty or not? What are the benefits of locking up your coins? How big is the reward, or how much do you get when it comes to passive income that the project will provide you with? Is the coin volatile? Is the project transparent enough for you to be sure that it is legit?

These and other concerns are still out there, and they vary from project to project. However, there are also pros and cons of staking that are fairly universal, so let’s take a look at those.

What are the Advantages of Staking?

Staking crypto does have its benefits, with the leading one being the fact that it is an easy way to earn interest on the coins that you own. If you were to simply buy coins and hold them locked up in your wallet, you could still make a profit over time, provided that their price goes up. Even then, you will likely have to wait for years for the next major crypto bull run to come and take your coin sky high.

If you stake them, you will still own them and be able to wait for the price increase, but at the same time, you would be receiving rewards for holding them, which is, in a way, a method of earning from your coins twice. It is not unlike buying shares of a company and receiving dividends, so it is definitely something that has existed for a long time, only now, you can do it in a decentralized way.

Another benefit is that you don’t need any equipment to engage in staking. We mentioned earlier that mining requires quite expensive gear, from top-notch GPUs to ASIC miners for Bitcoin which can cost thousands of dollars. Plus, there is the cost of electricity that you have to deal with. With staking, there is none of that. All you need to do is buy the coins, lock them up, and wait for the rewards to start coming.

Meanwhile, you are not the only one who benefits. By staking your coins, you are contributing to maintaining the security and efficiency of the blockchain whose coin you decided to stake. And, finally, staking is a lot more environmentally-friendly than mining.

What are the Risks and Flaws of Staking?

While staking does have a lengthy list of benefits, there are also flaws that you should keep in mind. These are not meant to turn you away from staking, but you should still keep them in mind and be careful, as doing it is not without risk. Of course, staking is still a lot safer than trading, but it has its own issues.

One example is price volatility. This is something that investors, in general, always have to keep in mind. Yes, you invested in an asset expecting its price to skyrocket, but the crypto industry is extremely volatile, and prices go up and down all the time. That means that your investment could be devalued in a matter of hours if something particularly bad ends up throwing the entire industry into the bearish mode. If you are not aware or present for it, you might not even know that your coins saw a massive value loss until it is too late.

So, if your staked assets suffer a major price drop, your losses could outweigh any interest that you managed to earn from staking.

Then, there is the possibility of staking coins of a project that has a minimum staking amount. That would mean that your coins are essentially trapped, and you can’t get them out without triggering a penalty. If you stake the coins of a project like that, and a price starts to drop, you will have to either wait out the bears and hope that the price will recover eventually, or quickly calculate what is worse — to suffer a penalty or have the coins lose their value.

And, finally, there is another possibility when it comes to unstaking your coins, and that is that there is a lengthy waiting period. For example, some projects allow you to unstake your coins, but they won’t be back in your possession for days, or maybe even an entire week, or even longer.

So, should I stake crypto or not?

Now that you are aware of the benefits and flaws of staking, we go back to the question of whether or not you should do it.

Staking can be extremely profitable if you choose the right project with high rewards, no minimum waiting period (or at least a short one), and during the period when the market prospers.

Overall, we believe that staking is a good thing, despite the risks. At least, if you have coins that you do not plan to use for a foreseeable period anyway. If you plan to buy coins and hold them for a time, you may as well stake them because you will get extra profits either way and even if the market price drops, all you need to do is wait out the storm.

If the project that you selected is good and strong, its price will definitely get back up eventually, and all you need to do is be patient and wait. Meanwhile, you will be getting more and more of the coin through the staking rewards system. In the end, it all comes down to which project you choose, and whether you have the money that you can live without, potentially for years, before the opportunity to cash out and enjoy it arrives. In that sense, staking is a more profitable version of investing, which definitely makes it worth it.

Ali is a freelance writer covering the cryptocurrency markets and the blockchain industry. He has 8 years of experience writing about cryptocurrencies, technology, and trading. His work can be found in various high-profile investment sites including CCN, Capital.com, Bitcoinist, and NewsBTC.

Advertiser Disclosure: Securities.io is committed to rigorous editorial standards to provide our readers with accurate reviews and ratings. We may receive compensation when you click on links to products we reviewed.

ESMA: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Investment advice disclaimer: The information contained on this website is provided for educational purposes, and does not constitute investment advice.

Trading Risk Disclaimer: There is a very high degree of risk involved in trading securities. Trading in any type of financial product including forex, CFDs, stocks, and cryptocurrencies.

This risk is higher with Cryptocurrencies due to markets being decentralized and non-regulated. You should be aware that you may lose a significant portion of your portfolio.

Securities.io is not a registered broker, analyst, or investment advisor.