What Is Staking?

The contemporary financial landscape is an ever-evolving environment. Over the past decade, the proliferation of blockchain technology has given rise to the cryptocurrency asset class. One of the newer, foundational aspects of the blockchain is a process known as staking.

Staking Explained

Staking is the act of pledging crypto assets to facilitate blockchain operations in exchange for a paid premium. According to Nicole DeCicco, founder of CryptoConsultz, "Staking is a term used to refer to the delegating of a certain number of tokens to the governance model of the blockchain and thus locking them out of circulation for a specified length of time."[1]

Much like the interest paid on a bond or investment, coins that are staked to the blockchain earn a financial return. This comes in the form of value realised from newly minted coins awarded to the staker. Essentially, the staker of crypto assets is compensated for contributing to the validation of individual transaction blocks on a given blockchain.

Similar To Crypto Mining

Ultimately, crypto staking is similar to crypto mining because it allows network participants to earn cryptocurrency in exchange for adding batches of transactions to the blockchain.[2] As a result, individuals involved in staking can earn various sums of select, "stakable" crypto assets.

How Does Staking Work?

The technological infrastructure driving crypto staking is complex. It helps to first understand a few of the key terms involved before moving onto the process itself.

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Proof-of-Stake (POS)

Proof-of-stake is a means by which the integrity of a cryptocurrency is maintained. POS is a consensus mechanism which ensures that coins aren't spent more than once and eliminates "double spending."[3] The POS validation architecture is thought by many to be superior to older proof-of-work (POW) consensus algorithms. In order to be staked, a coin must exist on a POS blockchain. For instance, Bitcoin (BTC) adheres to a POW consensus algorithm, thus holders aren't able to stake their BTC.[2]

Validator

A validator is a person responsible for verifying transactions on a blockchain.[4] On POS systems, validators are given rewards for staking the local cryptocurrency. For instance, on Avalanche, validators are compensated for staking the local blockchain network token AVAX.[4]

Lockup Period

For stakers, a lockup period is the period of time that the pledged digital assets are unable to be accessed. Lockup timeframes do vary, but can extend for months and years.

In simplest terms, stakers and miners serve as blockchain validators. On the POS consensus mechanism, staking cryptocurrency is encouraged because it increases value in the blockchain. Thus, given the validator's pledged value, participation in consensus decisions is encouraged.[4] This helps to preserve the speed and integrity of transactions conducted on the blockchain network.

Staking Process

In the cryptosphere, there are two basic ways that people stake coins:[5]

  • Validator: As a validator, the staker runs an independent node on the blockchain. Being a validator requires having a technological framework in place and crypto expertise. Also, staking minimums are substantial. For instance, an ETH validator is required to stake a minimum of 32 ETH.[6] At the time of this writing, the market value of 32 ETH exceeds US$100,000.[7]
  • Delegation: Delegation is a vastly less resource-intense way of staking crypto. With delegation, stakers pledge their coins to a validator, a practice common to the staking-as-a-service (SaaS) industry.

With a bit of cryptocurrency know-how, the delegation staking process for retail participants is fairly straightforward:

  1. Select an available cryptocurrency to stake
  2. Become familiar with minimums, lockup periods and fees
  3. Secure the appropriate cryptocurrency exchange access
  4. Begin staking

Also, many large exchanges offer automatic staking. With automatic staking, users can easily pledge coins to a wallet held locally by the exchange. For instance, Coinbase offers automatic staking for a variety of coins, including Cosmos (ATOM), Algorand (ALGO) and Tezos (XTZ).[8] Other coins, such as Solana (SOL), offer delegation staking alternatives.[9]

Staking Rewards

The reason why many crypto enthusiasts are enticed to stake their coins to a blockchain is simple: to earn rewards. Staking rewards are a form of passive income, similar to the interest paid on a savings account. When someone stakes crypto, they are compensated for the use of their digital assets, much as bank depositors are paid interest on their account balances. However, instead of earning a currency return, stakers are allocated newly minted coins.

Staking rewards are not constant and are impacted by several factors.

Block Reward

A block reward is the amount of cryptocurrency that is credited to a miner or staker's account upon a new transaction block being completed.[10] For instance, the block reward for Ethereum (ETH) is two ETH. That means for each completed block on the ETH network, validators are compensated two ETH.[11] Each cryptocurrency has a unique block reward and values are subject to change.[12]

Staking Pool

A staking pool combines the resources of multiple stakers in order to increase the chance of earning a reward by verifying new blocks. Staking pools are managed by a pool operator and stakeholders are required to lock their coins in a designated crypto wallet.[12] Staking pools are only available on POS networks, and the participants split the rewards. Realised staking rewards depend upon the pool's number of stakers and any associated fees.

Market Value

The value of awarded coins is subject to fluctuation according to evolving market conditions. As a result, staking rewards may unexpectedly appreciate or depreciate in value when awarded.

Ultimately, staking is widely viewed as a way for crypto investors to generate passive income, akin to stock dividends or bank interest payments. Accordingly, revenues depend upon the network's block reward, coin's market value and whether or not the staker was a part of a staking pool.

Staking Risks

As with all forms of capital investment, there are various risks of staking to know. Aside from the standard hacking and network security threats, four factors can undermine a staker's returns:

Lockup Periods

Providers of staking and staking pools assign various lockup periods to facilitate blockchain verifications. As a result, crypto assets are inaccessible for extended periods, which can cause customer illiquidity and opportunity cost scenarios.

Market Volatility

The cryptocurrency markets are famous for their pricing volatility. While volatility offers significant upside opportunity, there is a downside. In the case of staking, participants are subject to a lockup period on their coins. So, if crypto prices crash during the lockup period, it is possible that a substantial loss in value may occur.

Slashing

Slashing is a mechanism built into POS protocols to regulate validator behaviour and promote system efficiency.[13] In the event that a validator misbehaves, a portion of that validator's tokens are lost or "slashed." Slashing is of particular concern to autonomous stakers that operate outside of an exchange or staking pool. If the staked blockchain's POS verification guidelines aren't closely followed, coins can be lost.

Fees

Much like mutual funds or ETFs, staking pools and crypto exchanges charge fees for participation. Fees cut into profitability and vary by exchange or staking pool.

Stakers are well-advised to perform their due diligence before pledging coins to a blockchain. Although staking rewards may appear enticing, it's important to take all factors into account before entering a lockup period.

Summary

For DeFi (decentralised finance) newbies, the concept of staking can seem abstract. However, it is a discipline similar to traditional investment in dividend stocks or fixed income securities.

By definition, staking is the process of a cryptocurrency holder pledging coins to facilitate the efficiency of a specific blockchain. Coins are staked in two ways: as an independent validator or via delegation.

Once staked, allocated coins are subject to a lockup period during which time they are used to validate transactions on proof-of-stake networks. In return for pledged crypto assets, participants are compensated with staking rewards, which are freshly minted coins on the blockchain.

For crypto investors, staking is viewed as being a viable way of generating passive income. However, returns do vary in relation to the type of blockchain, use of staking pools, fees and market value. As with any mode of investment, staking poses a degree of risk. Two of the biggest risks are crypto market volatility and slashing.

While staking can potentially generate significant gains, it is up to the individual investor to determine whether or not it is a suitable financial avenue.

FXCM Research Team

FXCM Research Team consists of a number of FXCM's Market and Product Specialists.

Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.

References

1

Retrieved 09 Dec 2021 https://www.businessinsider.com/personal-finance/staking-crypto

2

Retrieved 09 Dec 2021 https://www.coinbase.com/learn/crypto-basics/what-is-staking

3

Retrieved 09 Dec 2021 https://www.coindesk.com/learn/2020/12/30/what-is-proof-of-stake/

4

Retrieved 09 Dec 2021 https://support.avax.network/en/articles/4064704-what-is-a-blockchain-validator

5

Retrieved 09 Dec 2021 https://decrypt.co/resources/how-do-you-stake-cryptocurrencies-earning-passive-income-with-crypto

6

Retrieved 09 Dec 2021 https://ethereum.org/en/staking/

7

Retrieved 09 Dec 2021 https://coinmarketcap.com/

8

Retrieved 09 Dec 2021 https://help.coinbase.com/en/coinbase/trading-and-funding/staking-rewards/staking-inflation#eligible-cryptocurrencies-for-staking

9

Retrieved 09 Dec 2021 https://docs.solana.com/staking

10

Retrieved 09 Dec 2021 https://www.pcmag.com/encyclopedia/term/block-reward

11

Retrieved 09 Dec 2021 https://media.consensys.net/the-thirdening-what-you-need-to-know-df96599ad857

12

Retrieved 09 Dec 2021 https://academy.binance.com/en/glossary/staking-pool

13

Retrieved 09 Dec 2021 https://www.coinbase.com/cloud

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