What Is Staking?
A Step-by-Step Guide to Using Tokens to Maintain Blockchains
By: Rahul Nambiampurath •DeFi Tutorials
One of the key benefits of blockchain technology is that it can offer banking services without banks.
Instead of banking clerks, there are smart contracts. Instead of offices and guards, there is a decentralized network secured by its consensus mechanism. This is the foundation for Finance 2.0, or Decentralized Finance (DeFi).
One of the most sought-after DeFi features is staking. Just as banks pay interest on deposits, smart contracts pay income to tokenholders who stake their assets.
Making Your Crypto Money Work for You
Since time immemorial, borrowing and lending has been the lifeblood of any economy. Borrowers need money to grow their businesses, or they may need cash to get out of temporary financial trouble.
In turn, lenders supply funds to meet borrowing demand. To make it worth their while and cover the risk if they don’t get paid back, they charge an interest rate, so that borrowers have to return more than they borrowed. Otherwise, why would lenders bother?
This process is now completely automated. Thanks to blockchain’s distributed and immutable database feeding smart contracts, the demand for borrowing is easier to meet than ever. In the crypto world, it is interchangeably used with different terms.
How Does Staking Work?
Staking is locking up digital assets into a smart contract platform such as Ethereum, Cardano, or Solana. These are all proof-of-stake blockchain networks. Meaning, instead of using specialized ASIC machines to run cryptographic hash functions, as is the case in Bitcoin’s proof-of-work blockchain, they use a different method to secure and verify transactions.
As their name suggests proof-of-stake blockchains use economic validators instead of miners. In this consensus mechanism, validators use their locked crypto funds as a replacement for energy-hungry ASIC miners. This is their stake in the network.
The key difference between proof-of-work and proof-of-stake is their foundation, physical-electricity vs. economic-crypto funds. Source: Etherplan.com
Some view the PoS consensus as a weakness because one would have to own 51% of the network to compromise it. In contrast, a PoW would need to be overcome with brute CPU power, which is at this point virtually impossible.
Whichever system proves itself in the future, validators receive small rewards when people use the network, just as Bitcoin miners do. In fact, when all 21 million bitcoins are mined, miners will also start receiving transaction fees instead of block rewards.
By the same staked token, if validators misbehave, they get slashed. This means their locked crypto funds are reduced.
In the case of the largest smart contract platform, Ethereum, which is soon to transition into a fully PoS blockchain, slashing is done for two reasons — attestation and proposal offenses.
By automating incentives and discouraging dishonesty, proof-of-stake (PoS) networks are secured without centralized institutions. The validators’ stake is the foundation for the network’s trustworthiness. However, staking can also mean something else.
Staking As Liquidity Mining
When people use the word “staking” in reference to cryptocurrency, it can either mean validator staking or liquidity mining. For instance, a crypto trader can say ‘I have staked X tokens into Y platform for a Z yield’. This means they have become a liquidity miner by locking up their tokens for other traders to use in exchange for a small cut.
Although centralized exchanges such as Coinbase or Binance provide token swaps the same way banks provide currency swaps, the same can be done with decentralized exchanges. For that to be possible, liquidity has to be provided, so the swaps can run smoothly without delay.
The measure of any market liquidity is the speed with which traders can sell/buy assets without a major price shift. Case in point, non-fungible tokens (NFTs) are inherently illiquid assets because their price is speculative and low in supply, just like in the real estate market.
For regular tokens, an exchange like Coinbase is the market maker that provides liquidity for token swaps. Without them, how can liquidity be achieved? Through the use of automated market makers (AMMs). For instance, a decentralized exchange Uniswap uses AMM protocol to make everyone into a liquidity provider.
Everyone with a crypto wallet can become a liquidity provider by staking their tokens into a liquidity pool, which is just another smart contract. Then, when a trader wants to exchange token A for token B, they tap into that pool, giving the liquidity provider a cut.
Likewise, the identical process occurs with lending protocols such as Compound, Aave, and others. At the end of the line, staking is a form of passive income utilizing crypto funds. This utilization commonly takes three forms:
- Staking crypto assets to secure the blockchain network itself
- Staking crypto assets to provide liquidity on decentralized exchanges
- Staking crypto assets to provide liquidity on lending platforms
The big question is, which form of staking utilization is the most profitable? The answer to this question is the main focus of yield famers who are always seeking the next highest APY (annual percentage yield).
Staking Size and Profitability
According to Staking Rewards aggregator, the total crypto assets staked across different blockchain platforms stands at about $280B.
Top six cryptocurrencies by staking marketcap: Staking Rewards
As you can see, the staking rewards completely outpace the banking sector’s national average savings account interest rate of 0.06%. Moreover, when we examine lending protocols themselves, the staking rewards are even higher.
This effectively nullifies the erosive effect of inflation on savings. Commonly, stablecoins offer the highest and most reliable staking yields for the simple reason their demand outmatches their supply. After all, stablecoins nullify inherent crypto volatility while also being a cryptocurrency. As such, stablecoins are a natural fit for a cheap and instantaneous global payment system.
How Can You Start Staking?
One of the more popular and easiest ways to start earning passive staking income is through MyContainer. This dApp relieves you of the manual labor of finding the right coin and the right blockchain to stake in.
Instead, all in one place, it offers over a hundred coins for staking. Once picked, MyContainer leverages those deposits in the background, delivering the staking yields back to you. Therefore, their business model is cut inception — cut from a cut.
Is Staking Worth It?
Staking is becoming increasingly popular in both the crypto world and traditional finance. After all, it is no secret that day-trading stocks delivers losses for the vast majority of investors. Case in point, an eToro study concluded that 80% of day traders lose money over a year, with an average loss of 36.3%.
Nonetheless, risks in staking should not be disregarded as well:
- Crypto volatility, if deciding to stake non-stablecoin tokens.
- Lock-up periods – while you retain the ownership, tokens are not available during.
- Hacks – few platforms have insurance. Nonetheless, even those that don’t tend to refund assets unless they suffer a reputational hit. For instance, in a recent $600m Axie Infinity hack, the team promised refunds.
With these caveats in mind, staking is a profitable venture compared to traditional finance by a significant, inflation-outpacing margin. Moreover, because it doesn’t rely on active engagement, staking is a low-anxiety, set-and-forget form of long-term investing.