What is staking in crypto?

Publish Date 28 Apr 2022
Blockchain / 6 Min Read
Alex Lielacher / Last Update 28 Apr 2022

Crypto staking is becoming popular among investors as it provides a way of earning interest on your existing crypto investment.

In the crypto world, there are a few different ways to make money. You can buy and hold coins in the hope that their value will go up over time, trade on price speculation using crypto CFDs, or you can participate in DeFi and stake your cryptocurrencies.

In this article, we'll explain what staking is and how you can get started staking coins.

Table of contents

What is staking in crypto?

Staking cryptocurrencies involves “locking up” funds to keep a cryptocurrency network secure and in turn, receiving newly minted tokens as rewards, earning passive income from the coins without having to sell them. Staking in crypto is similar to depositing your money into a high-yield savings account.

As opposed to spending computing power through high electricity consumption (like in proof of work), staking enables cryptocurrency networks to reach consensus on the state of transactions through a proof of stake model, relying on internal security derived from their native tokens.

This is evidenced in popular proof of stake cryptocurrencies in the crypto market like Cardano, Solana, and Polkadot. Through different forms of staking, these networks have been able to successfully handle a large number of transactions for minimal fees. This makes blockchain infrastructures more scalable, cheaper to use, and more environmentally friendly.

Beyond security, scalability, and cost reduction, staking also enables cryptocurrency owners to earn passive income

Many investors who plan to hold a coin for the long term are leveraging staking rewards to enable them to earn extra yields on their investments. However, staking comes with certain drawbacks like not being able to quickly sell your holdings during a market correction.

How does staking work?

Staking crypto involves locking up tokens in a proof of stake crypto network to ensure the network’s security and integrity are upheld.

Proof of stake employs a staking process, where nodes are required to invest in the blockchain by purchasing cryptocurrency, instead of computer hardware. 

Staking their cryptocurrencies gives them rights to validate transactions and add new blocks to the blockchain. Although the implementation of staking differs from protocol to protocol, they all follow a basic pattern.

Validators lock up the native cryptocurrency of a blockchain protocol to enable them to have a chance of being selected by the network to validate transactions and add new blocks to the blockchain. Every time a new block is added, the network rewards the chosen validator with newly minted tokens. However, if the validator acts dishonestly by compiling invalid transactions in a block, the network slashes a part of their staked tokens as punishment.

Validators are selected by the network based on the amount of their staked tokens and the length of time they've staked them - the more tokens you stake and the longer the time you've staked them, the higher your chance of being selected by the network.

Users with a smaller amount of tokens have a lower chance of participating in the security of the network and earning rewards. Hence, smaller users leverage staking pools to enable them to participate in the network.

Before the invention of staking, early cryptocurrency networks like Bitcoin, for example, employed a proof of work (PoW) model for validating transactions.

PoW method required nodes (miners) in the network to purchase energy-intensive computer hardware known as application-specific integrated circuits (ASICs) to solve complex cryptographic puzzles to enable them successfully validate new blocks of transactions and earn rewards. This concept is also referred to as cryptocurrency mining.

What is a staking pool?

Staking pools require users of a cryptocurrency network to pool funds together to have a higher chance of being selected to validate blocks and earn block rewards.

The block reward is split among stakeholders in the pool based on the share of the pool they contributed. This means the rewards from a staking pool are typically smaller compared to solo staking. However, the chances of even earning rewards with solo staking requires a large investment on the cryptocurrency network in question as opposed to the consistent and predictable rewards from staking pools.

Staking pools are operated and managed by pool operators - often crypto exchanges - who are responsible for keeping validator nodes up and running. Users of the pool are required to lock their funds in a specific blockchain address. The pool charges a small fee for providing this service to you.

Other alternatives allow participants to stake with pools directly from their wallets. An example is cold staking, which lets users join pools from a hardware wallet.

Through staking pools, users can easily participate in the security of a cryptocurrency network without having the technical knowledge of managing and running a node.

Choosing a staking pool in the Cardano Daedalus wallet

Cardano's Daedalus wallet stake pool selection screen   Source: Cardano

Which cryptocurrencies are eligible for staking?

Staking is only available for cryptocurrencies that use a proof of stake based consensus mechanism for validating transactions. The method of staking may differ from protocol to protocol but they generally enable users to earn rewards and keep the blockchain network secure.

Popular cryptocurrencies eligible for staking include:

  • Cardano (ADA)
  • Solana (SOL)
  • Ethereum (ETH)
  • Avalanche (AVAX)
  • Tezos (XTZ)
  • Tron (TRX)
  • Luna (LUNA)
  • Polkadot (DOT)

Why do only some cryptocurrencies have staking?

The consensus mechanism employed in a cryptocurrency network determines whether or not it will have staking. 

Bitcoin and Litecoin, for example, can't be staked because of the type of consensus mechanism they use. These consensus mechanisms are the reason cryptocurrency networks solve the double-spending problem encountered in earlier digital money experiments.

The sound economics applied in these consensus mechanisms is what enables them to flourish in hostile decentralised environments. In early cryptocurrency networks, the economics used involved nodes showing proof of work (PoW) by competing to solve cryptographic problems with computing power in a process known as mining. The first node to verify the correct set of transactions and solve the cryptographic problem receives rewards in transaction fees and newly minted coins. But the energy consumption involved in cryptocurrency mining attracted criticism.

The concept of staking was later introduced by the creator of Peercoin in 2012 to address the shortcomings of the proof of work consensus model. Instead of solving complex cryptographic problems, nodes show support for the correct set of transactions by putting their tokens on the line. It is only cryptocurrencies that support this type of consensus model that allows staking. 

Although, some cryptocurrencies combine both proof of stake and proof of work in reaching consensus. Ultimately, proof of work can comfortably work for simple cryptocurrency networks like Bitcoin and Litecoin. But for cryptocurrency networks like Ethereum, which performs complex smart contracts computations, proof of work tends to be extremely slow and more costly.

How to stake crypto?

In this section, we used Cardano as an example to explain how you can stake cryptocurrencies. You can either stake Cardano directly from your wallet or delegate your stake to a staking pool.

Below is a step-by-step guide to getting started on staking with pools in exchanges:

  1. Create an account with a crypto exchange that supports Cardano and runs a staking pool.
  2. Deposit ADA tokens into your exchange wallet by transferring from another wallet or making a purchase directly on the exchange with your debit cards.
  3. Navigate to the staking page of the exchange and choose Cardano.
  4. Choose the staking duration.
  5. Enter the amount of tokens you want to stake and proceed.
  6. After the staking period, you can claim your ADA tokens and additional interest to your wallet.

How are crypto staking rewards calculated?

Staking rewards are calculated using crypto staking calculators. These calculators reveal the interest you are likely to earn after the staking duration.

The calculators take into account the amount of tokens staked, the APY, and the staking duration. Before staking, ensure you calculate the staking rewards to enable you to choose the best option that suits your intentions.

Using Cardano as an example, try their staking rewards calculator to find out what rewards you could get with ADA tokens.

What is Annual Percentage Yield (APY) and how is it calculated?

Annual Percentage Yield (APY) is the amount of interest rate earned on an investment over a year while taking account of the effect of compound interest. 

APY is calculated using the formula:

APY = (1 + r/n )n – 1

Where r is the stated interest rate and n is the number of compounding periods.

A more frequent compounding period will lead to an increased APY, which is more profitable for users. APY shouldn't be confused with APR (annual interest rate), which only takes account of the interest rate earned based on simple interest.

Through the APY of staking pools and cryptocurrencies, users will be able to make a more informed decision and compare which pool or coin is best for them. And also, consider pool fees as APY doesn't take staking pool fees into account in its calculation. Additionally, users ought not to make the mistake of thinking they will earn more from staking more valuable coins as APY generally decreases when the value of a coin increases as more investors start to stake it.

What are the advantages of staking crypto?

As with all types of investing, there are risks but also advantages. Discover the advantages of staking crypto below:

  • Uses minimal energy to validate transactions.
  • Provides internal security for a cryptocurrency network without relying on external hardware.
  • Enables users to earn passive income on their cryptocurrencies.
  • It helps cryptocurrency networks to be more scalable.
  • Encourages users to participate in the security of blockchains by lowering the barrier of entry to just their tokens.

Is staking crypto safe?

While staking is an innovative and fairly straightforward way to earn passive income on your crypto assets, it's not risk-free. There are some risks that investors should be aware of before staking their coins:

Low liquidity - Staking smaller cap cryptocurrencies often comes with the risk of users not being able to sell their tokens after a staking period is completed. To mitigate this risk, opt for a highly liquid cryptocurrency that allows staking.

Lockup periods - Some staking protocols come with lockup periods that prevent users from accessing their tokens during the staking period. In case of a personal financial emergency or if the price of the staked token is dropping substantially, you won't be able to sell and mitigate losses. Alternatively, you may end up accessing your tokens at a cost that will see your staked tokens slashed. A solution to this is to stake tokens that do not have lockup periods.

Validator limitation - Some protocols require validators to maintain a 100% uptime in running their nodes to increase their chances of validating blocks. Also, validators need to be meticulous when running a node. If validators default by going offline or mistakenly include the invalid transactions, they may have their staked tokens slashed (which may include the tokens of users under that node). To mitigate this risk, learn the technical know-how of running a node to be a validator or stake your tokens with a reputable staking pool.

Crypto staking

FAQ


Can I trade or send funds while they’re being staked?

It is impossible to trade or transfer your tokens while they're being staked. Typically, your coins are locked up in a blockchain protocol when you stake them and they can't be accessed for any other use.

Depending on the cryptocurrency or staking pool, you can typically withdraw after a certain predefined time period.


Is receiving rewards a taxable event?

The regulations governing cryptocurrency usage in a country determine whether staking rewards are taxable or not. 

In the US, for example, the IRS doesn't give any guidance on whether staking rewards are included in taxable income. Same for many other countries.

It's important you seek legal advice on this issue to enable you to gain clarity.

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Alex Lielacher

Cryptocurrency Content Contributor

Alex Lielacher is a ‘banker-turned-bitcoiner’ who exchanged the bond trading desk for a laptop in a co-working space to provide engaging and educational content for leading companies in the blockchain technology space.

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

Cryptocurrencies (such as Bitcoin) are extremely volatile and can move or jump in price with no apparent reason due to lack of liquidity and ad hoc news. There is little or no fundamental reasoning behind its pricing and as such trading CFDs in cryptocurrencies poses a significant risk to clients. For any Cryptocurrency CFDs that we limit to Monday – Friday trading, it is important to note that the underlying market will continue to trade over the weekend, meaning there could be a significant price change between Close of Business on Friday and open for business on Monday. Therefore, these symbols should be traded by clients with sufficient experience to  understand that, subject to negative balance protection (where available), they risk losing all their investment, or more, in a  short period of  time, and only a very  small part of their portfolio should be allocated.


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