What is Cryptocurrency Staking and How it Works? - FXLeaders

What is Cryptocurrency Staking?

Crypto staking refers to a holder of a particular cryptocurrency locking away funds in order to maintain the function of a proof-of-stake (PoS) blockchain. In return for allowing the network to use their tokens to validate transactions, stakers are rewarded with an interest rate, which can be anywhere from 0.2% to 100%+ depending on the token.

How does staking work?

Older cryptocurrencies, like Bitcoin and Ethereum, use a system known as proof-of-work (PoW). This consensus mechanism relies on resource-intensive cryptographic puzzle solving to verify transactions.

In contrast, stakers lock away their funds in validator nodes. Generally speaking, an algorithm will randomly select a node and assign a block to it. With many PoS cryptocurrencies, the chances of being chosen increase in line with how many tokens a node stakes. The validator will review the block and check that everything is accurate (performed automatically). If it is, they’ll add it to the end of the chain and receive block rewards and transaction fees.

So instead of requiring expensive GPU equipment that requires massive electricity use, staking utilizes smart contracts to lock up funds, leading to claims that staking reduces energy consumption by over 99%.

Cardano (ADA), Solana (SOL), and Polkadot (DOT) all offer staking. Ethereum (ETH) is moving to a PoS system soon.

What are the risks of staking crypto?

While staking is an excellent method of boosting your returns, there’s a risk in staking volatile cryptocurrencies. As you’re often required to lock up your tokens for a specific period, usually a few months but sometimes longer, a decline in crypto prices could lead to an overall negative yield from your investment.

There’s also a liquidity risk. If you know that you may need to pull your money out of crypto at some point, maybe in an emergency, locked-up tokens can cause a bit of a liquidity problem. These lock-up periods can last a year and even more. If a catastrophic event devalues the entire crypto market, you’d be unable to withdraw your tokens as they decline rapidly.

Part of the incentive for validators to return accurate blocks is that they’re penalized for returning incorrect data. Your tokens may be lost or reduced in value through no fault of your own if there’s an error in the software or the computer goes offline. You can offset this risk by using a staking pool – a collection of holders that pool their tokens together, often facilitated by large companies, like Binance or Coinbase – but this reduces your overall yield. 

As a rule of thumb, the higher the yield, the higher your overall risk.

Auto compounding staking rewards

Some exchanges, like Binance, have an auto-compounding feature, where interest is reinvested to maximize yields. Kind of like reinvesting dividends, the interest that’s paid, usually daily or weekly, is put back into the pool of tokens, saving time and effort in re-staking your rewards. The best part about auto-compounding is realizing compound interest, which can boost your APY (Annual Percentage Yield) massively.

Staking and inflation

There’s another mechanism closely related to staking, known as inflation-earning. It operates very similarly to PoS yet requires no lockup periods. Algorand (ALGO), for example, has inflation built in and has a process where tokens are regularly added to the total supply. In 2022, ALGO has an inflation rate of 6%, but this decreases exponentially as time goes on. The new tokens are distributed to holders of ALGO, who are rewarded for simply holding their tokens and validating transactions on the network.

In a broader sense, staking can be used as a hedge against economic inflation because of the high interest rates. Of course, this is mitigated with volatile coins, but with stablecoins, staking can be an excellent way to protect your fiat cash.

Staking stablecoins

As mentioned, crypto assets are volatile; losses could surpass the interest earned in staking if there is a drop in the asset’s value. However, if you’re looking for a greater yield than what a bank will give you while maintaining your money’s fiat value, then staking stablecoins could be the answer.

Tokens like USDC, BUSD, and USDT are all pegged to the dollar. A platform like Binance offers up to 10% APY on stablecoins (although this value does drop with larger investments). If you’re concerned about inflation in 2022, then take a look at what rates you could get for staking stablecoins.

Staking vs. providing liquidity

Liquidity mining is a process in which cryptocurrency holders lend their tokens to a decentralized exchange for a reward. As decentralized exchanges often suffer from low liquidity, especially with niche tokens, liquidity mining is a way for both the holder and exchange to benefit from facilitating transactions.

While liquidity mining can provide excellent yields in the form of governance and native exchange tokens (like Uniswap’s UNI), there are risks that are typically associated with new, low liquidity coins. These are typically seen in the form of more volatile and more likely price decreases, failed projects, and even malicious rug pulls (a hyped token that sees its founders dump all of their tokens for a quick payday).

Popular Staking Options

Binance

Binance is the world’s largest crypto exchange and offers a full suite of staking options, with plenty of tokens to choose from, including a few Ethereum options and Ethereum 2.0 staking. Binance insures user funds against hacking with a feature called Secure Asset Fund for Users (SAFU), and offers up to 100% yields on some lesser-known tokens. It also has options for riskier yields, using something called dual investment, as well as liquidity mining.

Coinbase

Coinbase is the largest crypto exchange in the US and allows users to earn passive income through staking. Coinbase enables users to run nodes as well as participate in staking pools. It has ten different popular tokens, with yields up to 5.75%. 

The platform is known for its simple-to-use interface, which also applies to its staking platform. If a transaction validated is illegitimate and your staked crypto is slashed, Coinbase may replace the slashed asset depending on the cause of slashing. Overall, Coinbase is the easiest way to stake your crypto.

Kraken

Kraken is one of the oldest crypto exchanges still around today, and it’s an ideal platform for staking. It offers on-chain staking (regular staking) and off-chain staking, where you lend your assets to Kraken for them to use. This enables you to stake Bitcoin, USD, and EUR directly. Currently, Kraken has 17 assets you can stake, with competitive rewards reaching up to 23%. The exchange itself has never been hacked and is a favorite of seasoned crypto investors.

About the author

Eric Nkando // Financial Trader and Technical Analyst
Eric Nkando is a professional forex trader and financial analyst from Nairobi, Kenya. He has 3 years trading experience, with interests in Forex, cryptocurrencies, and commodities. He is a CPA(K) holder and a B.com degree (Finance) graduate. Eric’s market analysis and coverage have featured on leading financial websites including Wikifx and Seeking Alpha