What is Staking and How Does it Work?
In decentralized finance, staking is a way for participants to earn rewards by holding and using their tokens to validate transactions on a blockchain network.
This is often done through a process called “Proof-of-Stake,” where those holding the most tokens have the most significant influence over the network and can earn the most rewards.
To stake their tokens, participants must first deposit them into a cryptocurrency wallet that is designed for staking. They can then use this wallet to participate in the network’s consensus mechanism, which involves validating transactions and adding them to the blockchain.
In return for their participation, stakers are rewarded with a share of the network’s transaction fees and/or new tokens that are created through the process of block production. The rewards that stakers receive will depend on the specific blockchain network and the number of tokens they have deposited.
When a user stakes their funds in a decentralized finance network, they are essentially committing those funds to support the network and help to secure it against malicious attacks. This is done through a process known as “consensus.”
In order to add a new block of transactions to the blockchain, a group of users, known as “validators,” must come to a consensus on the validity of the transactions in that block. If a transaction is deemed invalid, it will not be added to the blockchain, helping to maintain the integrity of the network. This is done through a process called Proof-of-Stake (PoS), where the users who have staked the most funds on the network are given the most influence over the decision-making process. Because the validators have a financial stake in the network, they have the incentive to act in the network’s best interests and ensure its security.
What types of staking are there?
In decentralized finance (DeFi), several types of staking can be used. Some of the most common types include:
- Validator staking: This is a process in which an individual or entity stakes a certain amount of a platform’s native token as collateral to become a validator and verify transactions on the platform.
In a decentralized finance (DeFi) platform that uses a Proof-of-Stake consensus algorithm, the validators are the ones who verify transactions and add them to the blockchain. Here’s a more in-depth explanation of how it works:
To become a validator on the DeFi platform, an individual or entity must stake a certain amount of the platform’s native token (e.g., XYZ) as collateral. This is known as “validator staking.”
The amount of XYZ that must be staked to become a validator will vary depending on the specific rules and requirements of the DeFi platform.
Once the individual or entity has staked tokens, they can begin validating transactions on the platform.
For every transaction they successfully validate, they will earn a reward in the form of more XYZ.
The number of tokens that a validator earns as a reward will depend on a few factors, such as the amount that they have staked, the overall level of activity on the platform, and the inflation rate of XYZ.
Validator staking allows for a decentralized and transparent way of verifying transactions on a blockchain. It also provides an opportunity for individuals and entities to earn a return on their investment in the platform.
- Delegated staking: Delegated Proof-of-Stake (DPoS) is a consensus mechanism used by some blockchain networks. It is an improvement on the traditional Proof-of-Stake (PoS) consensus algorithm, which allows token holders to “stake” their tokens as collateral to validate transactions and maintain the network.
In a DPoS system, token holders can delegate their staked tokens to a validator, also known as a “witness” or a “delegate.” These delegates are responsible for validating transactions and maintaining the network, and the token holders typically elect them.
The advantage of DPoS over traditional PoS is that it allows for a more efficient and decentralized decision-making process. In traditional PoS systems, all token holders can validate transactions and participate in block production. This can lead to network congestion and low transaction throughput.
In a DPoS system, only a limited number of delegates are responsible for block production, allowing faster transaction times and higher scalability. Additionally, because the token holders elect the delegates, the decision-making process is more decentralized and democratic.
One disadvantage of DPoS is that it relies on token holders to actively participate in the election of delegates. If token holders do not engage in the process, it could lead to a small group of delegates having too much control over the network. This can potentially centralize power and undermine the network’s decentralization.
One example of a blockchain network that uses Delegated Proof-of-Stake is EOS. In the EOS network, token holders can delegate their staked tokens to a validator, also known as a “block producer.” These block producers are responsible for maintaining the network, and the token holders elect them.
Here’s an example of delegated staking:
Imagine that Alice has some Ether (ETH) and wants to use it to earn rewards by participating in a staking pool on a DeFi platform. However, Alice intends to avoid managing the staking process herself, so she decides to delegate her staking to Bob.
To do this, Alice sends her ETH to a smart contract on the DeFi platform that manages the staking process. This smart contract holds the tokens on Alice’s behalf and allows Bob to manage the staking process for her.
Bob then uses his expertise to select the best staking opportunities and manages the staking process for Alice’s ETH. This includes choosing suitable staking pools, monitoring the staking process, and making necessary adjustments.
As a result, Alice can earn staking rewards without having to manage the process herself. The dividends are paid to the smart contract, which is then distributed to Alice and Bob according to their agreed-upon terms.
- Liquidity staking: This is the process of providing liquidity to a pool of assets to earn rewards. This is typically done by depositing holdings into a “liquidity pool” on a decentralized exchange (DEX) and then earning a share of the transaction fees generated.
Liquidity staking is a crucial concept in DeFi because it allows users to earn rewards for helping to improve the liquidity of the assets in the pool, making it easier for users to buy and sell them. In addition, stakers often have the ability to earn a portion of the assets in the pool as a reward for their contribution.
To participate, users typically need to have a wallet that supports the DEX, where the liquidity pool is located. They can then deposit their assets and start earning rewards. The number of rewards earned will depend on the specific terms of the liquidity pool, such as the types of assets it holds and the fees charged for transactions.
Here is an example of liquidity staking in action:
Imagine that Alice wants to participate in liquidity staking on a decentralized exchange (DEX) called “DEXX.” She has some Ether (ETH) and some Wrapped Bitcoin (WBTC) in her wallet, and she wants to use them to provide liquidity to a pool on DEXX.
First, Alice must deposit her ETH and WBTC into the liquidity pool on DEXX. She can send the assets from her wallet to the DEXX liquidity pool contract on the Ethereum blockchain.
Once her assets are deposited, Alice will start earning rewards through transaction fees generated by the pool. These fees are paid in the form of the DEXX token, the native token of the DEXX decentralized exchange.
Over time, as more users trade on DEXX, the liquidity pool will generate more transaction fees, and Alice’s rewards will increase. She can then withdraw her share of the rewards and her original deposit at any time.
This is just one possible example of liquidity staking. The details may vary depending on the DEX and the liquidity pool.
Staking in Ethereum
After Ethereum transitioned to Proof-of-Stake, transactions are confirmed by the validators on the network who have staked a certain amount of the platform’s native token (ETH) as collateral.
As we discussed, a validator must stake a certain amount of tokens to start confirming transactions.
When a user sends a transaction on the Ethereum network, it is broadcast to all of the nodes on the network. The validators on the network then compete to validate the transaction and add it to the blockchain.
In order to validate a transaction, a validator must perform complex computational tasks, such as solving cryptographic puzzles and verifying the transaction’s authenticity. If a validator successfully completes these tasks and adds the transaction to the blockchain, they earn a reward for additional ETH.
What is gas?
Gas plays a vital role in paying for the computational resources needed to execute the transaction or contract.
When a user sends a transaction or interacts with a smart contract on the Ethereum network, they must include a certain amount of gas with their trade. This gas is used to pay for the computational resources needed to execute the transaction or contract.
The validators on the network use the gas from the transaction to pay for the computational resources needed to validate the transaction and add it to the blockchain. If the amount is insufficient to cover the computational costs, the transaction will not be executed, and the gas will be refunded to the user.
Some downsides
There are a few potential downsides to the system of confirming transactions on the Ethereum network through Proof-of-Stake and gas. These include:
- High transaction costs: Because users must include gas with their transactions to pay for the computational resources needed to execute them, the cost of executing transactions on the Ethereum network can be pretty high. This can make it difficult for small transactions or contracts with a low value to be executed on the network.
- Centralization of staking: Because the amount of tokens that must be staked to become a validator on the network is quite high, the majority of staking is done by large, well-funded entities. This can lead to a certain degree of centralization in the staking process, which can reduce the decentralization and transparency of the network.
- Inflation: The Ethereum network uses an inflationary model for its native token (ETH), which means that the total supply of ETH will increase over time. This can lead to a decrease in the value of ETH over time, reducing the rewards earned by validators and decreasing the return on investment for stakers.
Impermanent loss – A considerable risk
No system is perfect, and staking is no exception. It is important to note these problems as many participants flock to this mechanism hoping for easy gains, not knowing the risks it may carry.
In decentralized finance (DeFi) staking, an impermanent loss is a potential loss in value that can occur when an individual or entity is staking their tokens in a liquidity pool.
Because the value of the tokens in a liquidity pool can fluctuate over time, there is a risk that the value of the staked tokens may decrease relative to the value of the rewards earned. This is known as impermanent loss.
For example, let’s say that Alice stakes 100 XYZ tokens in a liquidity pool that generates 1% in fees per day. If the value of XYZ increases by 1% per day, Alice will earn 1 XYZ token per day as a reward, and the importance of her staked tokens will also increase by 1%. In this case, Alice will not experience any impermanent loss.
However, if the value of XYZ decreases by 1% per day, Alice will still earn 1 XYZ token per day as a reward, but the value of her staked tokens will reduce by 1%. In this case, Alice will experience impermanent loss, as the value of her staked tokens will be less than the value of the rewards that she has earned.
To elaborate on this:
Let’s say that the value of XYZ starts at $1 per token. On the first day, Alice earns 1 XYZ token as a reward, and the value of her staked tokens remains at 100 XYZ x $1 = $100. However, on the second day, the value of XYZ decreases by 1% to $0.99 per token, and the value of Alice’s staked tokens also decreases to 100 XYZ x $0.99 = $99. In this case, Alice has experienced an impermanent loss of $1 ($100 – $99). This loss is impermanent as only the dollar value has dropped, and the number of tokens earned has not.
Is staking crypto a good opportunity?
Staking is a good option for investors interested in earning passive income on their long-term investments and isn’t bothered by the short-termed price volatility. Like any cryptocurrency investment, staking also carries a high risk of losses.
Only stake money you can afford to lose. Always do your thorough research and choose companies with good reputations and high-security standards. Note that when you see interest rates that seem too high to be true – you are probably right, and that should be considered a red flag.
