Cryptocurrency staking is a way to earn rewards for verifying transactions on a blockchain network without having to sell your assets. This process can be compared to earning interest on a savings account, but the mechanics of staking fundamentally differ from traditional lending. Like many other things in the cryptocurrency ecosystem, staking has its peculiarities and nuances that are better understood in advance.
How Staking Works
Staking performs two main functions: it ensures the accuracy of new information added to the blockchain and protects the network from 51% attacks – when someone tries to seize control over the majority of the system. Cryptocurrency staking allows owners to earn rewards for helping verify blocks of transaction data on the blockchain network.
The system operates based on rewards and penalties that are automatically controlled by computer rules. Stakers who honestly follow protocol rules receive rewards for their work. Those who violate the rules can lose their cryptocurrency.
Staking rewards are typically paid in the same cryptocurrency you locked up (usually proportional to that amount). In some blockchain networks, the more assets you deposit into a staking smart contract, the higher your chance of being selected to verify blocks. Participants with larger stakes are incentivized to act honestly, since violations would result in losing more money and having their assets confiscated by the network.
But to avoid giving advantages only to wealthy participants, some protocols add an element of randomness so that everyone who invested a small amount has a chance to earn rewards. Some networks also use the principle of “coin age” – stakers can increase their chances by holding tokens in staking for longer periods. Coin age is calculated by multiplying the number of coins by the number of days in staking. The longer tokens are locked, the greater the probability that the validator will be selected. When a node successfully validates a block of transactions, the coin age resets to zero.
Benefits of Staking
It gives owners of certain cryptocurrencies the opportunity to actively participate in blockchain network operations and receive rewards for their crypto assets over time. This is an example of stable passive income and can become part of a long-term investment strategy that encourages holding cryptocurrency in the network.
Staking doesn’t require large initial investments in expensive mining equipment – PoS protocols run on ordinary computers, and PoS blockchain networks consume significantly less energy compared to PoW, reducing their environmental impact.
Staking potentially protects against inflation, as it allows you to grow your assets faster than the overall rate of currency depreciation. Additionally, many cryptocurrency holders view staking as a way to support projects they believe in by helping secure their network. In some cases, staking provides voting rights in governance decisions, allowing you to influence the project’s development.
Types of Cryptocurrency Staking
- Direct staking: when participants lock their tokens directly in the blockchain network during the consensus process.
- Staking pools: cryptocurrency owners combine their assets, creating a shared staking node to increase chances of earning rewards and gain access to networks with high minimum requirements. Rewards are distributed among participants proportionally to their contribution.
- Delegated staking: stakers transfer their rights to a validator node operated by another party. Rewards are split between validators and delegators.
- Exchange staking: when cryptocurrency exchanges manage all processes and then distribute rewards – they provide staking services to users who can lock their assets directly on the platform.
- Liquid staking: for assets locked in staking, users receive special fungible tokens (not frozen) that can be used in other DeFi protocols to earn additional rewards there. This means your original assets continue earning staking rewards while you essentially earn twice from the same amount.
- Custodial or non-custodial: in the first option, you transfer your tokens to a platform; in the second, you store tokens in your own digital wallet.
What You Need to Know About Proof of Stake
Proof of Stake is a consensus mechanism in blockchain that allows owners of certain cryptocurrencies to validate transactions and earn rewards when they lock their tokens in staking (deposit them into a special staking smart contract).
PoS protocols require validators to purchase and “freeze” a certain amount of tokens to participate in block verification. Each PoS blockchain has its own method of selecting validators, but most use an algorithm that determines who exactly will verify the accuracy of data in a new block. After selection, validators check the correctness of transactions and smart contract data, ensuring the security and integrity of the blockchain network. Many PoS protocols set a minimum token amount to run validator software. For example, the Ethereum blockchain requires a minimum of 32 ether (ETH) to start staking on the network.
What is Delegated Proof of Stake (DPoS)
Delegated Proof of Stake (DPoS) is an improved version of classic PoS, where validators can choose delegates who will maintain the staking node and validate blocks on their behalf. Delegated staking operators typically retain a commission or percentage of earned staking rewards. They compete with each other and offer stakers the most favorable fees to convince them to entrust their assets specifically to them.
By reducing the number of validator nodes, DPoS increases energy efficiency and speeds up transaction verification compared to standard PoS. However, critics note that DPoS blockchain networks are more centralized, as transaction verification is handled by a limited number of delegates.
A prime example of a DPoS blockchain is the TRON network, which functions as a platform for decentralized applications (DApps). Thanks to DPoS, the Tron project processes transactions faster and with lower fees than many other PoS-based blockchains. All verification in the Tron blockchain is carried out by only 27 delegated block producers called “super representatives.”
Penalties in Staking
When a block validator acts dishonestly, it can harm the entire network: users lose trust, and the cryptocurrency’s value may drop. To avoid this situation, proof-of-stake blockchains use a penalty system called “slashing.” Slashing means the protocol confiscates part or all of the tokens a validator locked in staking if it detects dishonest actions on their part.
The most common reasons for slashing in PoS protocols are validating incorrect blocks and prolonged validator inactivity on the network.
Staking Risks
Despite attractive rewards, staking has its risks that are important to consider before depositing cryptocurrency into a protocol.
Network problems (bugs or vulnerabilities) can threaten the security of your assets. If a validator or delegated staking operator behaves dishonestly, you may face penalties (slashing) and lose part or all of your locked assets. Market volatility – when cryptocurrency prices fluctuate significantly, even while earning rewards, the overall value of your assets may decline. When you add assets to staking, you surrender full control over them to the protocol, unlike secure storage in a personal wallet. New laws can also affect staking practices or its legality in your country. Assets locked in staking cannot be used for trading, participating in DeFi protocols, or purchasing NFTs.
Important information
The main risk is that your coins are locked for a certain period, and during this time you cannot sell, transfer, or withdraw them. If the price drops sharply, your losses may exceed earnings from staking. However, some platforms offer flexible terms with the ability to withdraw cryptocurrency at any time.
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