What is Cryptocurrency Staking and How it Works? - FXLeaders

What is Cryptocurrency Staking?

Crypto staking refers to the act of delegating particular tokens to the blockchain and, in doing so, removing them from circulation for a specific period. Like interest earned on a bank deposit account, staking participants earn some crypto or tokens as a reward. 

How does staking work in cryptocurrency

Staking works by letting users add new transactions to the blockchain. Blockchain networks that use the Proof-of-Stake Consensus mechanism in verifying transactions allow users to stake their tokens and earn additional tokens. 

Unlike the Proof-of-Work consensus mechanism, where miners compete to solve cryptographic puzzles in validate transactions, PoS validate transactions with the staked tokens. The network selects validators randomly based on the amount they have staked and the length of time the funds have remained in the staking pool. Cosmos (ATOM) and Tezos (XTZ) are some of the cryptocurrencies that provide staking options. 

What are the risks of staking crypto?

Staked crypto-assets cannot be traded or accessed until the vesting period is over. The tokens also cannot be redeemed before the staking period lapses, which can be a disadvantage for investors looking to profit from a short-term up-trending market. If the price of crypto falls, users whose tokens are tied in the staking pools suffer losses. The Proof-of-Stake mechanism burns part of the staked tokens in a process called slashing event, if they validate an illegitimate transaction. The risk can be high if staking is done outside an exchange. Exchanges charge a percentage of the staked assets as fees. 

Auto compounding staking rewards

Exchanges that offer staking options like Binance, have an auto-subscription option that reinvests the staked tokens. The auto subscription feature allows investors to earn compound interest by reinvesting the daily interest sent to the crypto wallet. Investors can also reinvest their staked assets manually once the staking period is over. The compound interest on the staked tokens becomes significant over time.

How staking impact inflation

Staking in digital assets can be a store of value to hedge against inflation. The staked tokens allow investors to earn staking rewards as they promote network development. Investors can hedge against inflation by staking cryptocurrencies like ETH and Bitcoin while using stablecoins to make regular transactions. As users participate in the network through staking, inflation decreases, and additional ecosystem components can avail tokens for alternative use in the blockchain ecosystem. Inflation rate movements can occur algorithmically in a blockchain network. An adjustment algorithm moves the incentive for participation and enhances the activities of those who act in the best interest of the network.

Staking stablecoins vs. volatile coins

Crypto assets are volatile; if there is a drop in the digital asset’s value, losses could surpass the interest earned in staking. Staking stablecoins is ideal for holding digital assets in the current low-interest rates and avoiding high volatilities. USD Coin, Binance USD, and Tether are stablecoins that can be staked on Binance. Investors can earn around 3% APY, staking USDC and BUSD, while Tether can offer around 5% APY when staked on Binance. New projects with very high volatile prices often offer better returns than stablecoins, but the fluctuations can wipe returns.

Staking vs. providing liquidity

Liquidity mining is a smart contract that pools funds to allow users to lend, buy, borrow, and sell cryptocurrency. Liquidity providers use their deposited funds to power the DeFi ecosystem and earn an annual percentage yield, which has a compound effect. The protocol rewards users with governance tokens mined at each block as long as the tokens remain in the liquidity pool. The governance tokens can offer users the opportunity to exchange the tokens and get better crypto rewards. While staking presents volatility risks of the underlying crypto, liquidity providers could face impairment losses, project risks, or smart contract risks.

Popular Staking Options

Binance

Binance provides a large crypto exchange site to generate passive income via staking due to the large trading volume. On Binance, users can participate directly in staking digital assets like Eth 2.0 staking. Users can stake digital assets on Binance. The exchange insures users’ funds against cyber security losses with a feature called Secure Asset Fund for Users. The exchange provides multiple interest earnings for varying securities, with newer crypto assets having higher interests than the more established ones. Binance vets the DeFi staking partners on the platform to minimize risks, but the platform does not guarantee the issuers on smart contract securities.

Coinbase

Coinbase is the largest crypto exchange in the US; the exchange allows users to earn extra income through staking. Coinbase enables users to run nodes, synchronize with the blockchain and attain the volume margin for staking. Algorand, Cosmos, Ethereum, Dai, USDC, and Tezos are the crypto assets available for staking on the exchange. Ethereum and Cosmos have the highest APY at 5%. If the transaction validated in a blockchain network is illegitimate, the staked crypto is slashed. Coinbase may replace the slashed asset or they may not, depending on the cause of slashing.

Celsius

Celsius is a regulated network that allows users to earn interest on deposited crypto or borrow collateralized loans. The network has a native token CEL, used in borrowing, rewards, and payments. Celsius uses a proof of stake formula that calculates staking interest as a function of the deposited funds and the number of days in the network consensus mechanism. Celsius is a centralized platform and does not have a crypto exchange service, despite the robust DeFi services.

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