If you’ve spent time researching cryptocurrencies or hanging around in the crypto space, you’re sure to have come across the term “staking.” Staking is the mechanism some blockchains use to secure their network while incentivizing participants to honestly report transactions that occur on the chain. Most people have heard of bitcoin mining and how the rewards for finding the next block are paid out in bitcoin to the miner. Staking is another form of those rewards. To be able to understand staking, you first need to know about Proof-of-Stake and Proof-of-Work. I’ve provided a brief explanation of both below.
Proof-of-Work (PoW) is a consensus mechanism used to decide which blockchain network users are eligible to create a new block, the most famous of which is bitcoin. For someone to be selected and able to choose the next block, they’ll have to solve a particular mathematical problem and then broadcast the answer to be verified. There is no efficient way of finding the answer other than pure guessing, and a lot of energy is used to guess those random numbers.
Proof-of-Stake (PoS) is another type of consensus mechanism for creating new blocks on the blockchain. In PoS, you don’t need to solve a mathematical problem. Instead, new block creators are selected by the amount of coins they have locked-up in the network. This removes the need for excessive computing power and energy, while also allowing access to rewards for those without the technical know how of setting up a mining node. Notably, it is not always the validator with the most at stake chosen, as that would centralize things pretty quickly.
Security is a major reason why a blockchain chooses a particular consensus mechanism, and there has been healthy debate as to whether PoW or PoS is more secure. Even though every blockchain network is different and has its level of risk, the most frequently cited issue with blockchain security is the 51% attack; a situation in which malicious actors with more than 50% of the computational power or wealth staked in the blockchains would be able to manipulate the blockchain for their own interests and thus be able to change transactions and have the possibility to double-spend cryptocurrencies. That’s not something anyone would want to happen since this destroys the fundamentals of the blockchain. Luckily, it’s an issue that nearly everyone in the space is aware of, and metrics on decentralization are readily available for most blockchains. Though that’s not to say it’s impossible; for example, in August 2020, privacy coin Grin suffered one of these attacks.
For PoW systems, for such an attack to occur, miners would need to have more than 50% of computational power (and a lot of hardware) focused on mining the coin. For the major cryptocurrencies that use proof of work, such as Bitcoin and Monero, this is widely considered impossible as mining is sufficiently decentralized. For a 51% attack to happen on PoS systems, someone would need to own over 50% of all available tokens. With most popular networks having large market capitalizations in the millions, we could also say that this is near impossible. Furthermore, buying assets from a network inflates the price of the token. If you’d to try and buy half a network worth of a single coin, it would eventually just become too expensive. Plus, once you’d own most of the network, you don’t have the interest to attack it since your ownership would lose value as well. And so, in this aspect, PoS could be considered more secure. To this point, it should be noted that Ethereum is currently in the process of transitioning from proof-of-work to proof-of-stake.
So, why would you participate in staking your crypto assets? Staking cryptocurrencies offers several advantages. First, staking your assets through PoS avoids being diluted by inflation by offering attractive rewards. Currently, through Kraken, you can get 12% APY staking DOT and up to 17% through their ETH staking program, providing a quasi-guaranteed return and a somewhat predictable source of income. Nonetheless, the value of your staked tokens can be affected by fluctuations in the currency price, and it’s also important to note any lock-up periods. Polkadot has a 28-day “un-bonding” period, you must wait to remove them from staking, and Ether is locked up for at least the next two years as Ethereum 2.0 rolls out. While these lockups serve to help stabilize the price, it can be maddening when short-term market volatility is ripe for trading.
Furthermore, a significant benefit of staking digital assets is that it doesn’t require expensive hardware, which makes it more accessible to a broad public. Also, it is more environmentally friendly to invest in PoS because it doesn’t require high amounts of energy, like with mining in PoW networks.
As with any investment, staking cryptocurrencies isn’t risk-free. First, there is the possibility of “slashing,” which means the validator you are staking through can receive punishment for a fault conducted. This mechanism is designed to discourage abnormal behavior such as dishonest behavior or even an excessive amount of time offline. The second, and probably most crucial risk, is asset volatility. It’s no secret at all that the price of cryptocurrencies can be extremely volatile, with 20% changes in price being considered normal. If the price action moves for the better, this can make crypto investing and staking very profitable. However, the downside is that it can depreciate the price of your tokens too much, leaving you empty-handed while your coins are locked up.
Ultimately, staking is just another example of cryptocurrencies and blockchain technology innovating to create value and attract outside attention. To investors who have already used to the heart-pounding volatility of crypto, the rewards available to the average person greatly outweigh the risks. If you’re a long-term holder who believes in the technology and that the price of crypto will be higher five years or even ten years from now, it’s time to make sure you understand staking.
Cheers, and thanks for reading,
Disclaimer: I am not a financial advisor and nothing written in the above post should be considered financial advice. Among the cryptos mentioned in this article I hold BTC, ETH and DOT.