Cryptocurrencies have opened up previously unheard-of avenues for making money. Everyone is probably now aware of trading CFDs, mining, and the traditional buy-and-hold strategies for investing in this market.
Another prominent feature is staking, which forms part of yield farming in decentralized finance or DeFi. Along with lending and saving, staking is a mechanism for crypto holders to earn a yield from locking up their holdings for a specific period.
What is staking?
The term ‘staking’ comes from proof-of-stake. Therefore, we need to understand what proof-of-stake is first. At the core of every digital currency is a chain of computers responsible for providing security and validating the issuance of new coins.
We refer to a consensus mechanism, a complex system for these computers to agree or come to a consensus over specific data values within a blockchain.
Presently, the two most commonly utilized consensus mechanisms are proof-of-work and proof-of-stake. Proof-of-work, which is essentially mining, refers to the process of a computer proving to other computers in a network a certain computational amount of work.
More specifically, mining requires these computers to compete by being the first to solve highly complex cryptographic hashes, resulting in new coins being ‘minted.’ Whichever miner is the quickest to solve these puzzles has the privilege of adding the block along with receiving the new token.
The amazing thing is proof-of-stake entirely eradicates miners where the blockchain assigns new blocks to users based on their existing stake of the cryptocurrency itself.
Effectively, staking means locking up or ‘freezing coins’ to become a passive block validator and earn extra tokens on a predictable basis. The bigger the holding, the more rewards one can receive overtime.
How does staking work?
While experts consider proof-of-stake slightly less secure than proof-of-work, it still does an incredible job of maintaining security, efficiency, and decentralization. Proof-of-stake shines above its counterpart for scalability, allowing for astronomically more transactions to be confirmed quickly.
So, how does staking work? People who stake their coins are typically referred to as validators or forgers. Each project will state the minimum of crypto someone must own before being eligible for staking.
A proof-of-stake blockchain algorithmically confirms transactions, not through any computational work like mining but rather on the stake size. The network will randomly select the next validator based on how many coins they’ve locked up.
Investors have a higher probability of being consistently selected with the more tokens they’ve staked. Depending on the cryptocurrency, validators might need to stake for a defined period without withdrawing. They may further have an ‘unbonding period’ when they decide to withdraw.
Many cryptocurrencies use ‘soft staking’ to alleviate these problems, where investors can withdraw their stake anytime and receive their interest daily without being bound to a specific period. By receiving recurring tokens, holders are incentivized to hold their coins.
The calculation of the extra tokens validators earn is not universal and will vary widely from coin to coin. As a basic guideline, each project will typically regard the following:
- The size of the investor’s stake
- How long the investor is staking for
- The number of total coins in the network
- Inflation rate
- Other aspects
Any act of maliciousness in the network runs the risk of them losing their entire stake. Numerous exchanges and external providers offer staking to customers.
Why is staking a good way to invest in cryptocurrencies?
Let’s first observe the environmental impacts of cryptocurrencies. Experts have criticized proof-of-work projects like Bitcoin for consuming astronomical amounts of energy. Proof-of-stake is nowhere near as power-intensive as the former.
Secondly, acquiring adequate mining equipment has become increasingly expensive, further exacerbated by accounting for electricity and maintenance costs. However, these considerations with staking are mostly absent.
Although many projects do require a sizable minimum to stake, the process is much simpler. Many investors prefer neither mining nor staking, opting to buy a particular coin outright and hold it for the long term. While this is also simple, the investor can only profit when the asset increases in value, but the number of coins they have remains the same.
In contrast, by staking, the trader grows their holdings gradually over time. When they decide to sell at a profit in the future, their total investment has grown considerably with the extra tokens they would have accumulated.
We could liken staking to receiving some form of stock dividends or interest yield. Essentially, staking is like a ‘two for one sale’; investors receive extra tokens without allocating additional funds and potentially profit from the token’s natural value increase.
Lastly, staking as an investment often generates better returns than a savings account or other known financial securities. Projects in this field yield anywhere from a few percent for more established cryptocurrencies up to 300% yearly for lesser-known coins.
Staking is becoming an increasingly popular method for anyone with idle cryptocurrencies to earn passive income. As with any outlay, it takes knowledge and experience to choose the right asset along with the technical requirements and market risks affecting the expected returns.
One critical observation is never choosing a project wholly based on a high ROI or return on investment. A key issue within the industry is the flurry of new cryptocurrencies, some of which do not last long.
The inherent value and use case for any coin is far more important and makes it likely to exist years down the line. Lastly, like any financially speculative endeavor, investors should never invest more than they can realistically afford to lose. Cryptocurrencies remain one of the most volatile instruments globally.