Staking crypto has grown to become a popular way to participate in blockchain networks. Most major exchanges have implemented staking products as adoption has risen. At the same time, more developers have built on the infrastructure that enables it.
How to Make Money With Cryptocurrency?
Staking is simple to understand on the surface level; it’s a way of earning passive yield on crypto holdings. In many cases, the yield generated from staking exceeds the interest offered by traditional financial outlets.
This has contributed to the roaring adoption of crypto staking. Although it is not widely understood by those outside of crypto, understanding the source of the yield and the factors that impact it is critical for holders who choose to stake.
Ethereum is in the process of migrating from proof-of-work to proof-of-stake; this will permit staking for rewards on the network. The migration is part of the ETH 2.0 upgrade (also known as Serenity).
What is proof-of-stake?
Each mechanism achieves the exact outcome of confirming transactions on a blockchain network, but they take different avenues to do so. Proof-of-work requires energy input and computational power to solve complex math problems to validate transactions.
This process is commonly known as mining. On the other hand, proof-of-stake outlines that validators (nodes) are selected to confirm transactions in proportion to their amount of holdings in a network’s native unit. The proportion is expressed as a percentage of supply.
Thus, proof-of-stake uses a leaner process to validate transactions by avoiding the computational costs associated with proof-of-work.
Proof-of-stake was designed to increase transaction confirmation speed and efficiency to achieve higher throughput and lower fees.
These goals are achieved by cutting out the energy and computational power requirements of proof-of-work. Under proof-of-stake, the coins held by users are what powers consensus. This only requires some investment into a network itself.
How does staking work?
In simple terms, staking works by placing coins into special accounts that allow them to earn yield. Coins cannot be accessed as long as they are in these accounts or wallets. This can be a risk for many holders.
Reclaiming staked coins (undelegating) can take up to three weeks, depending on the network or platform a holder is staking on. But what happens when coins are locked in these accounts or wallets?
When a user stakes cryptocurrency, they elect to allocate (delegate) their coins to a node. Nodes are the vehicles that validate transactions on a proof-of-stake network. Under the hood of each node is a pool of coins held by a network’s users and/or the node itself (also known as “self delegating”).
The size of the pool underpinning a node determines the likelihood of it being selected to validate blocks. They are given crypto staking rewards for their work after being chosen randomly and successfully stamping new blocks onto the blockchain. This reward is the source of the yield users receive when staking their coins.
Running a node can be capital intensive and requires extensive technical knowledge. On top of operating costs, such as hardware and network costs, some networks have lofty requirements for how many coins a node must hold in order to be an active validator. The financial requirement is a barrier for most network users.
A user must also have the technical knowledge to operate a node in the event they need to cover the monetary costs. Failure to understand how to operate a node properly can lead to slashing, which occurs when a node improperly does its job.
Slashing is a mechanism designed to prevent behavior that threatens the functions and security of a network (i.e., double signing and downtime). The penalty for slashing ranges from monetary penalties, resulting in losses to users’ delegated coins, to the revocation of a node’s operational status on a network.
That’s why it’s essential to research a validator before choosing to stake it properly.
How is staking yield calculated?
Staking yield is the ratio between supply inflation and the staked coins or the number of coins being staked on a network. The equation determining nominal yield is (Inflation X (1 – Community Tax) ) / Staked Tokens Ratio. In a perfect world, this is the rate stakers would actually realize.
Inflation is the growth in the supply of a coin from year to year. 20 coins added to a network with a supply of 100 coins over a year equates to an inflation rate of 20%. The community tax is taken out of the rewards distributed to stakers and is given to the community to be used for building and holding up the ecosystem.
This fee is often marginal but plays an important role in ecosystem development. Lastly, the staked tokens ratio is the percentage of a coin’s supply that is being staked. It is calculated as Staked Coins / Supply.
At times stakers will notice that the nominal yield they were planning on receiving isn’t the same as what they are realizing. This is due to fluctuations in validators’ capabilities to confirm transactions at the assumed rate. The actual yield will be below the nominal yield if validators take longer than the assumed rate to add blocks to the chain.
The opposite is true when they confirm transactions quicker. The time it takes for transactions to be confirmed is called “block time” or “block interval.” Changes in a network’s block interval impact new supply issuance and, by extension, annual inflation.
The actual yield is calculated as Nominal Rate X (Actual Inflation / Assumed Inflation). This function considers any imperfections in the block interval and offers an accurate representation of the yield earned by stakers.
Finally, stakers must consider the commission they pay to validators for staking their coins. Some validators charge no commission, while others charge 5% or more.
The function Actual Yield X (1 – Validator Commission) depicts the final yield stakers earn if the validator they delegate to charges a commission.
Beyond the user
Staking offers users an outlet to passively earn a yield on their holdings and even opens them up to other potential benefits. However, it doesn’t just benefit users. It also serves a critical role in the most important characteristic of any blockchain: security.
The cornerstone of a network’s security rests on its staking composition. This is due to its relationship with validating transactions and reaching consensus. There is a direct relationship between the number of coins allocated to staking (staked value) and the network’s security.
Networks with a higher staked value have higher security, and vice versa. In more technical terms, this means the cost to manipulate or attack a network rises as the amount of value delegated to nodes increases in proportion to the amount of value locked in a network.
Staked value, expressed as a percentage of market cap and the percentage of eligible tokens being staked (participation), quantifies how secure a network is. A network is more secure the higher these values are.
The future of staking
Staking is a quickly evolving component of the blockchain ecosystem. Strides are being made to strengthen its user experience and its impact on the networks that support it (as well as their underlying ecosystems).
The inaccessibility of coins that are being staked renders their value illiquid when it could otherwise be deployed elsewhere in an ecosystem. This has a negative impact on ecosystem growth as it limits the extent to which value locked can be stationed.
Liquid staking is an emerging concept that makes staked value more liquid. It does so by creating alternative representations of staked coins.
These derivatives hold similar utility to the underlying staked coin and can be deployed alternatively in other areas of a network’s ecosystem.
Although it is still a work in progress, liquid staking can reduce opportunity costs for networks choosing to benefit from high security and staked values.
Some networks are looking for new ways to incentive users to stake. Liquid staking is among these incentives, as it lessens the opportunity costs associated with staking. Another incentive networks offer is governance token rewards. Governance tokens are akin to votes and voting power.
They give their holders a voice in the future of a network or application by acting as votes on new proposals. This structure is attractive for users who strongly believe in a network’s capabilities or those who want to shape the future of a network’s landscape.
Another incentive that has grown in popularity is airdrops. Airdrops are free rewards to stakers, unrelated to the rewards earned from staking, distributed by developers to promote their projects.
Airdrops became popular over the last few years and have effectively promoted staking.
Start staking today
Staking poses opportunities for investors that are unique to the crypto-sphere. Understanding the risks and factors that influence staking gives users an edge in developing yield-based strategies.
Coinciding with the technology’s core pillar of inclusivity, CEX.IO’s staking product has low minimum requirements. This allows users to stake any amount they are most comfortable with and opens the door for users of any background to benefit from the growth of the space.