What is staking and how to stake cryptocurrencies?
25 July 2022 by Marlo Pluto
Reading time 5 min
Staking can help investors earn interest on their crypto assets without additional equipment. Simply put, it's a well-known way to get passive income.
What is Proof of Stake (PoS)?
Proof of Stake (PoS) is a consensus mechanism in blockchains. It is involved in creation of the new blocks and processing transactions. Proof of Stake (and its variations) implies selecting validators in proportion to how much cryptocurrency they hold (stake).
Proof of Stake is not the original consensus mechanism. The first one is called Proof of Work (PoW) and the way it works includes using computational power (the required amount of which is gradually growing) for solving various mathematical algorithms in the process known as mining. This is how the new blocks are validated. This method is used in the Bitcoin blockchain.
In the Proof of Stake mechanism, each next block is selected randomly but nodes with higher stake positions have larger chances to be chosen as validators and get rewards. In the result, the blockchain is secured, while the stakeholders are incentivized to get rewards.
Blockchains that use Proof of Stake
Avalanche, Cardano, Cosmos and Polkadot are actively used blockchains that utilize the Proof of Stake consensus mechanism. Chainlink (LINK) is a project that uses a non-standard approach to the Proof of Stake mechanism, and also allows staking.
Some other cryptocurrencies are in the process of going from the Proof of Work to the Proof of Stake mechanism. For example, Ethereum has been in preparation for the change for a long time, with the release of Ethereum 2.0 (this is how the version of this blockchain that will use the Proof of Stake solution is called) scheduled in 2023. But the users can already stake ETH even during this transition period.
Advantages and Disadvantages of Proof of Stake
- No special equipment is required. Unlike Proof of Work, there is no need to solve complex algorithms and mine coins using significant amounts of computational power and spending money on expensive hardware.
- Energy efficiency. Since it does not require powerful computers, less energy is used, making the solution a “greener” and more environmentally sustainable one among the two.
- Superior potential for scalability. The technology is designed in such a way that it will be easier to scale up the blockchain if needed. The Proof of Stake mechanism allows for better latency with less computation during processing. It also gives access to superior scaling solutions such as shard chains.
- Transaction processing is efficient and fast, low transaction fees. These are the results of a superior validation method.
- Less proven security-wise than the Proof of Work. While the Proof of Stake mechanism is designed to be quite secure, the Proof of Work is an excessively researched tried-and-true solution that is more than a decade old. It is also worth mentioning that the Proof of Stake solutions are better equipped against the so-called “51% attack” (a hypothetical attack, where the miners/stakeholders controlling more than 50% of assets disrupt the process of block creation)..
- Stakeholders with large amounts of tokens can be excessively prioritized. This is a part of the design of the Proof of Stake consensus mechanism. The stakeholders who possess larger amounts will always be prioritized.
- Smaller rewards for those who stake compared to miners
How does staking work?
Putting is simply: staking means earning rewards for holding some amount of certain currencies. The currencies one decides to stake are used for the process of verification and securing transactions: this is how the Proof of Stake consensus mechanism operates by design.
What is a staking pool?
Staking pools consist of several stakeholders united together and moderated by a pool operator. It is especially useful for the situations when the minimum amount of tokens required to start staking is too large for a regular user. This also offers a chance of higher block rewards (but they will be split between the participants). It is worth noting that many pools charge fees.
- What are the advantages of staking?
- Staking is a way to get lucrative rewards without needing any equipment. Even the stakeholders without powerful systems can get their rewards, assuring lower barriers to entry This also makes this method more environmentally friendly;
- Staking is possible without Internet access. Such a method is called a “cold staking”, it utilizes locking assets in a smart contract;
- Another thing to consider is that staking can be a great way to support the project directly, which is important for many enthusiasts;
- There is a huge range of yields, so staking can attract people with different risk-assessment approaches.
- What are some staking risks?
- All of the currencies utilize the “lock-up” method for staking to a certain degree. This means that a stakeholder will not be able to access them for a certain amount of time, which can be risky;
- Cryptocurrency is volatile which in turn can result in diminishing rewards;
- Malicious activity within the system will be punished. For example, the validator nodes can be penalized if they do not meet 100% uptime requirement for processing;
- Stakeholder’s returns are dependent on both the success of the project and the behavior of the staking operator (if the pool gets hacked, etc.);
- Many platforms rely on smart contracts that can sometimes malfunction. This will result in the loss of funds.
How can I start staking?
To start staking, one should research the projects they are interested in. After that, there is a need to meet the minimum requirements to start staking. These include the minimum amount of a coin one is planning to stake.
- There are five main ways to stake:
- Using a private wallet. Providing direct interaction with a blockchain, this gives a stakeholder the maximum possible level of control and decentralization. But the requirements can be high. A stakeholder must not move the coins to another address, since this will break the lock-up period and result in lost rewards;
- Using a hardware wallet. The same principle as above, but the data is stored on a hardware wallet (a special encrypted device);
- Using cryptocurrency exchanges. Many exchanges offer such capabilities: this can be a great way to diversify one’s portfolio, and one can use their preferred exchange to base their choice on the platform’s reputation;
- Staking platforms that offer Staking-as-a-Service (SaaS) solutions. This is also known as “soft staking”;
- DeFi projects that offer staking capabilities. This is also known as liquidity mining or yield farming.
Research on the services is strongly recommended. Thankfully, there is a lot of reliable data online, covering the reputation of various companies, exchanges and services.
Did you know that you are able to extract data from API into Microsoft Excel using the in-built Power Query feature?
Top Cryptocurrencies You Can Stake
How to find the best token to stake
There are various factors that will play a role in how successful and profitable staking a certain token will be.
Large market cap means that the coin is popular and has all the foundations needed for its further growth. It also means that the coin is in active circulation and will likely continue to be used: a lot of value is already held, so there is an incentive to continue accumulating such holdings. The coins with smaller market caps have a larger opportunity for growth, but the risks are bigger, since they are not as popular. In some cases, a smaller market cap might mean that the token is a new one, so there are many unknown things about the project.
Ease of staking
This depends on several factors: from the number of offered services (and wallets) that provide the ability to stake a certain coin to ease of use of such solutions.
Average rate of return
This is one of the most important factors (among others) to keep in mind, since it shows the possible profits. Annual Percentage Yield (APY) is how many percent of the original investment will be earned by a stakeholder in a year.
As was mentioned above, not all cryptocurrencies support Proof of Stake. But there are options to stake even the Proof of Work ones by using third-party services or via solutions similar to staking.
Bitcoin does not support Proof of Stake and operates on the Proof of Work consensus mechanism. Nevertheless, since it is the most popular cryptocurrency, and the vast majority of crypto assets are held in Bitcoin (BTC), there are various solutions allowing to stake it. Those are mainly the Decentralized Finance (DeFi) services that make it possible to deposit BTC and earn rewards.
Chainlink (LINK) is a cryptocurrency and DeFi project operating on the Ethereum blockchain. It utilizes a mechanism similar to the Proof of Stake one. Providing Decentralized Oracle Networks and using hybrid smart contracts, the technology behind the project seems to have a great future. It is already widely used and has several opportunities for further growth. The project itself provides a wide network of decentralized oracles. To become an oracle (a node) one has to stake LINK tokens. A penalty mechanism is also in place for underperforming nodes.
Stablecoins (USDC/USDT/DAI/BUSD and others)
Stablecoins are the cryptocurrencies with a fixed market price. It is mainly set at $1 (USDT). This removes any volatility and the risks associated with it. With a good rate of return, they provide a very balanced and safe solution. The rates of return are relatively low, but this approach is a very low-risk one.
The Ethereum blockchain is currently in the process of upgrading from the Proof of Work mechanism to the Proof of State one. This will be called Ethereum 2.0 (after everything is complete). Staking is already possible but the blockchain is not yet fully converted to the Proof of State one.