What is Staking?

30 Jul 2021

You have likely heard of staking by now as a way to earn passive income on your holdings, but you may be wondering what it exactly is? Put simply, staking is a way to earn interest on your crypto holdings by locking cryptoassets to help validate transactions on their underlying networks.

Staking is similar to mining on Proof-of-Work (PoW) networks with the advantage of being less resource-intensive. Staking coins directly on the blockchain may be complicated for some users, but several cryptocurrency exchanges and wallets now offer services simplifying the process.

Staking on-chain is only possible with cryptocurrencies using a Proof-of-Stake (PoS) consensus mechanism. PoS networks are often more energy-efficient than PoW networks and are able to maintain a certain degree of decentralization. Some use a modified version called Delegated Proof-of-Stake (DPoS).

What Is Proof-of-Stake (PoS)?

To understand a Proof-of-Stake mechanism, we believe it’s easier to understand a Proof-of-Work mechanism first. PoW consensus algorithms gather transactions into blocks and link them together to create a blockchain.

Miners commit computational energy to solve complex mathematical puzzles to add new blocks to the blockchain, and that energy is used to keep the network secure. Miners compete with each other for the base reward associated with each block - known as the coinbase reward - and the transaction fees within them. This competition incentivizes more miners to join the network and improves decentralization.

The more resources committed, the safer a network is.  The more miners a network has, the more decentralized it is. The carbon footprint associated with PoW has drawn criticism, with Tesla at one point dropping bitcoin payments over environmental concerns.

A solution is Proof-of-Stake. Under a PoS consensus mechanism, network participants lock coins – their stake in the network – and at particular intervals the network assigns them the right to validate the next block.

The probability of being chosen is typically linked to the amount of coins locked. Network participants contribute to a network based on their holdings and not on their computational resources, reducing a network’s carbon footprint and, to some, enabling more scalability.

Ethereum, for example, is moving from a PoW to a PoS consensus algorithm both in a bid to scale and to reduce its environmental impact. The Binance Smart Chain (BSC) uses a hybrid between Proof of authority (PoA) and Delegated Proof of Stake.

A Delegated Proof of Stake consensus algorithm, first used as part of the BitShares network, allows users to commit their tokens as votes. Their voting power is proportional to their stake in the network – the amount of coins they hold. These votes are used to elect a number of validators that manage the blockchain. In these cases, staking rewards are distributed to the validators, who then send the funds to their electors.

How Does Staking Work?

Proof-of-Stake blockchains produce and validate new blocks through the staking process. Staking, essentially, sees token holders lock up their funds to become network validators, which are randomly selected by the protocol to validate new blocks.

Each blockchain differs slightly in the staking process, as each network adopts its own system to distribute rewards. Users looking to stake funds don’t need any specialized mining hardware such as Application Specific Integrated Circuits (ASICs).

Validators’ “stake” on the network – the amount of tokens they hold –represents their investment in it and incentivizes them to keep the network secure. Users with a larger stake in the network are more often chosen to validate transactions, which may lead to higher compensation.

Some wallets make it easy for users to stake funds and become validators through a user interface that makes it as simple as sending a transaction. However, in some cases, users need to set up their own nodes on the cryptocurrency’s blockchain to stake their funds.

These two factors – ease-of-use and whale advantages – have seen staking pools become extremely popular.

What Are Staking Pools?

Staking pools are somewhat similar to mining pools. A staking pool is created when a group of network participants combine their funds in a bid to increase their chances of being rewarded. Setting up and maintaining a staking pool is a lot of work and requires technical expertise.

Their purpose is similar to that of mining pools, as they allow participants with fewer resources to earn rewards while securing the network. While in mining pools miners pool their hashrate to increase their chances of finding a block and share the rewards, in staking pools, participants pool together their funds with the same purpose.

Staking pools often require participants to lock their coins in a specific address on the blockchain, and operators often charge a fee from the staking rewards distributed to participants in order to cover operating costs. These costs can be, for example, related to the hardware used to set up a node.

Most pools have low minimum balance requirements and charge no withdrawal fees. There may, however, be fixed lock-in periods set by the network the pools aren’t able to get around.

Cold Staking

More often than not, staking involves being connected to the internet and, in some cases, trusting third parties. On the other hand, cold staking is the process of staking through a wallet that is not connected to the internet – a cold wallet.

While it isn’t possible to cold stake on every Proof-of-Stake network, it’s advisable to do so in those that support it, as cold wallets are seen as more secure than hot wallets . Some hardware wallets such as the Ledger Nano X support cold staking.

Decentralized Finance Staking

Decentralized finance (DeFi) staking often refers to taking advantage of opportunities in the DeFi space to earn interest on your holdings. It’s worth noting that while the term staking is very common here, what actually happens could be lending or farming.

Some DeFi protocols allow users to lend funds to borrowers on their platform to earn interest on their holdings. These platforms let users keep custody of their assets and interest rates vary a lot. In some cases, protocols distribute their tokens to users who interact with the protocol, in a process called farming.

DeFi staking can be offered as a service by centralized trading platforms, wherein yields are often made up of lending and farming income. Users can also interact with platforms like Compound and Aave directly to earn interest.

Lending allows users to earn interest on cryptoassets that rely on PoW consensus algorithms, as the funds are being lent out and the income comes from borrowers’ payments. In a bid to ensure lenders are safe, most platforms require borrowers to overcollateralize their loans.

Choosing a Staking Platform

Staking can be rather complex, and as a result users often choose staking platforms to bypass creating their own nodes, choosing staking pools, or even managing their own private keys. Choosing the right staking platform is extremely important as the wrong choice could lead to a loss of capital and rewards.

While there are no right answers, it’s important to prioritize safety. It’s always important to try and see if a project is legitimate before committing any funds – first look at its founding team, user reviews, how long it’s been around, whether it’s regulated or not, and whether it has been hacked in the past.

Sticking to reputable platforms is likely going to be the best strategy over the long term, even if your APY is smaller than on riskier competitors. When looking at decentralized finance platforms, look past triple-digit APYs, and instead try to find out if the protocol has been audited and has an authentic and active community.

Before investing, make sure you read the platform’s terms and conditions to know what to expect. It may charge hefty withdrawal commissions, or it may lock up your funds for a period longer than what you’re comfortable with.

Risks of Staking

Staking doesn’t lead to risk-free earnings. When staking your cryptoassets, you may be incurring more risk than you realize, especially if you rely on a centralized platform to do so. Security incidents aren’t unheard of in the cryptocurrency space, which means platforms may fail to secure your funds.

There are also liquidity risks worth considering. Lockup periods are common when it comes to staking and while your funds may be safe, their value can shift dramatically during that period. While you may have more tokens when the lockup period ends, their value could be substantially smaller.

Running a validator node also involves technical know-how to avoid disruption in the staking process. Nodes need to have 100% uptime to ensure returns are maximized, so a poor setup could diminish your returns. In some cases, validators are penalized and completely lose their rewards.

Boiling it all down, you need to be aware of:

  • Cybersecurity risks
  • Third-party risks
  • Liquidity risks
  • Validator risks
  • Market risks

All of this means that if you invest in a cryptocurrency specifically to stake it, you may lose money on your investment. It’s important to do your own research and thoroughly understand what you are doing before committing your money.

Is Staking Worth It?

There is no clear answer here. In some cases, staking can be extremely profitable, while it can be a waste of time in other cases. Each blockchain network offers different rewards to users, so there are a plethora of factors to consider.

Staking returns are not just affected by the price of a cryptocurrency. They can be affected by factors including:

  • Node costs
  • Lockup periods
  • Inflation rates
  • Third-party fees
  • Transaction fees

 To determine if staking is worth it, consider every cost you’ll incur and how long you plan on holding the cryptocurrency for, while factoring in the risks mentioned above.

Cryptocurrencies That Can Be Staked

It’s estimated there are over 10,000 cryptocurrencies out there, and many use Proof-of-Stake consensus algorithms or some variation of it. This means there are numerous possibilities, so the best way to find out what you can stake is to do your research on platforms built specifically to track these cryptoassets such as StakingRewards.

Some large-cap cryptocurrencies you can stake include:

  • Cardano (ADA)
  • Polkadot (DOT)
  • Ethereum 2.0 (ETH)*
  • Solana (SOL)
  • Algorand (ALGO)
  • Binance Coin (BNB)

*Ethereum is set to undergo a massive upgrade in the near future as it transitions from a Proof-of-Work to a Proof-of-Stake blockchain. Users can lock up their funds in an Ethereum 2.0 staking contract if they have a minimum of 32 ETH to become validators on the network. These funds will remain locked until the launch of ETH 2.0.

Closing Thoughts

Cryptocurrency staking can be an attractive way to earn on your cryptocurrency holdings, but it should not be the only factor behind your investment decision. It allows token holders to participate in a network’s consensus and the returns coming from it should be seen as a bonus.

As centralized platforms make it easier for users to stake their funds, it’s essential to consider every risk associated with doing so before committing your funds. It’s important to always do your own research to ensure you know what you are doing.


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