What is staking?
Staked cryptocurrencies are locked up in a project. The project then uses these staked coins to maintain its operations, such as validating transactions. And just like a bank pays interest on deposits, the crypto project gives rewards for staking cryptocurrencies. So, both banks and crypto networks use the assets they are given (money or crypto) to operate (create loans or validate transactions), and both offer incentives (interest or staking rewards) to encourage people to provide these assets.
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The History of Cryptocurrency Staking
The original definition of staking describes a process of maintaining the operation of a blockchain network. People participate in the validation of transactions on a blockchain network by holding and locking up a certain quantity of that blockchain's cryptocurrency in a wallet. In exchange for this, they receive a reward. Over time, this narrow use case expanded into a more general definition to describe when people lock up a cryptocurrency or digital asset in return for a reward over time.
Cryptocurrency staking evolved as a response to the challenges faced by the original consensus mechanism, Proof of Work (PoW), which was introduced by Bitcoin. Let's walk through the historical progression that led to the concept of staking.
Proof of Work and its Challenges
The concept of cryptocurrencies was first brought to life by Bitcoin, envisioned by an entity (or individual) known as Satoshi Nakamoto. The Bitcoin network relies on a consensus mechanism called Proof of Work (PoW) to validate transactions and add new blocks to the blockchain. In PoW, miners compete against each other to solve complex mathematical problems, and the first one to solve the problem gets the opportunity to add the next block to the blockchain and receive a reward in Bitcoin.
However, PoW faces several challenges. It's energy-intensive, as it requires a lot of computational power to solve the puzzles. Additionally, PoW cannot handle many transactions per second, limiting the network’s throughput.
Introduction of Proof of Stake
In response to these issues, a new consensus mechanism, Proof of Stake (PoS), was proposed. The idea was first introduced in a 2011 forum post on Bitcointalk by a user named QuantumMechanic.
Unlike PoW, PoS selects validators to add new blocks to the blockchain based on the number of coins they hold and are willing to "stake" as collateral. This eliminates the need for computational power as a deciding factor, making it less energy-intensive and potentially more decentralized.
Evolution of Staking
The first cryptocurrency to implement PoS was Peercoin, launched in 2012. Peercoin's innovation was to use PoS for minting new coins, complementing its PoW mechanism, which was used for transaction processing. This hybrid system aimed to strike a balance between the security of PoW and the energy efficiency of PoS.
The idea of staking evolved with Ethereum's announcement in 2014 of its plans to switch from PoW to PoS via the Ethereum 2.0 upgrade, also known as Serenity. This brought the concept of staking into the limelight, as Ethereum is one of the largest cryptocurrency projects.
Other blockchains like Tezos, Cardano, and Polkadot also adopted PoS, further popularizing the idea of staking. These projects also introduced the concept of delegating stakes, allowing users to delegate their staking power to validators, making it easier for regular users to participate in staking without needing technical know-how or large amounts of cryptocurrency.
Modern Staking Practices
Today, staking has become a major part of the cryptocurrency industry. Centralized crypto exchanges have even gotten in on the action, offering centralized staking services to their users - a move that seems to undermine the decentralized nature of why staking was created in the first place. Furthermore, staking has become integral to Decentralized Finance (DeFi) protocols, where it's used to secure networks, validate transactions, vote on governance decisions, and grow new projects from the bottom up.
Why do people stake cryptocurrency?
- Passive income: Staking offers a way for crypto holders to earn passive income. By simply holding and staking their cryptoassets, participants can earn staking rewards, similar to earning interest on savings in a bank account.
- Increased security: For PoS blockchains, the more coins staked, the more secure the network becomes. Staking adds an extra layer of security to the network as malicious activities would require control of a majority of all staked tokens - a costly endeavour.
- Influence on network or protocol: Some cryptoassets allow users who stake tokens to have a say in the network or protocol‘s governance. This includes voting on proposals about updates or changes to the project. The more tokens a user stakes, the more voting power they have. Voters can, for example, help determine the reward rate for staking.
- Foster support for a project: When people lock up their tokens, they are providing grassroot support to a project. They give a show of confidence in the token and the project. The amount of tokens staked is a publicly available metric that individuals and businesses can use to gauge community support. Projects with more community support often attract more attention and investment.
What are Liquid Staking Tokens?
Liquid staking is a relatively new development in the world of cryptocurrencies that attempts to address one of the main drawbacks of staking, which is the illiquidity of staked assets.
When a user stakes their cryptocurrencies in a PoS network, the staked assets are often locked in a smart contract for a set period of time, during which the assets cannot be sold or traded. This can be inconvenient for stakers, especially in volatile market conditions.
Liquid staking addresses this problem by issuing tokens, often called staking derivatives or liquid staking tokens, that represent ownership of the staked assets. These tokens can be freely traded, sold, or used as collateral in other DeFi applications, while the underlying assets remain staked in the network.
Here is a basic overview of how the process typically works:
- A user stakes their cryptocurrency in a staking protocol that supports liquid staking.
- In return, the protocol mints a corresponding amount of liquid staking tokens. The rate at which these tokens are minted usually mirrors the value of the staked assets.
- These tokens represent the user's staked assets and any potential rewards from staking. They can be freely traded or used in other DeFi protocols, providing liquidity to the user.
- If the user wants to redeem their staked assets, they can return the liquid staking tokens to the protocol, which will then release the staked assets and any staking rewards.
Some examples of platforms that offer liquid staking services are Lido, which offers liquid staking for Ethereum 2.0, and Stafi, a dedicated platform for staking derivatives.
Advantages and Disadvantages to Staking Cryptocurrencies
Staking offers a number of distinct advantages but also comes with its share of drawbacks. Here are some key points to consider.
Advantages of Staking Crypto
- Passive income: One of the main advantages of staking is that it can generate a steady stream of passive income. By holding and staking their coins, users earn rewards, similar to how one earns interest on money deposited in a savings account.
- Energy efficiency: Staking is much more energy-efficient than mining, which requires substantial computational power and energy consumption. By contrast, staking requires little more than a stable internet connection and some staked coins.
- Increased security: In Proof of Stake systems, the more coins that are staked, the more secure the network becomes. This is because any attack on the network would require a majority of all staked coins, which would be prohibitively expensive.
- Participation in governance: In some blockchains, staking also gives users the right to participate in the governance of the network. This might include voting on proposed changes to the network's protocols or rules.
- Lock-up periods: Many staking programs require users to lock up their coins for a set period of time. During this period, staked coins cannot be sold or traded, which could be a disadvantage if the market price changes unfavorably.
Disadvantages of Staking Crypto
- Risk of loss: If a network is compromised or if a staking pool is poorly managed, users could potentially lose all the coins they have staked.
- Slashing: In some staking systems, if a validator node goes offline or fails to validate correctly, a portion of the staked coins (both the validator's own coins and those delegated to it) may be "slashed" or forfeited as a penalty.
- Inflation: While staking rewards can provide an attractive income, they also increase the supply of coins in circulation. This can potentially lead to inflation, which may devalue the coins over time.
- Complexity: For some users, the complexity of staking can be a deterrent. Some staking methods require a fair amount of technical knowledge, making them less accessible to less tech-savvy users.
How to Stake Crypto
The process for staking can vary between different projects, but the general steps usually involve the following:
- Acquire the token: Identify the project you wish to stake for, and buy or swap into the appropriate token for that project. You will need to put your tokens in a crypto wallet, preferably a self-custodial wallet like the Bitcoin.com Wallet app.
- Stake your tokens: Follow the project’s instructions on how to stake. Usually there will be an interface, sometimes as simple as clicking a “Stake” button.
- Earn rewards: After you've begun staking your tokens, all that's left is to wait and collect your rewards. The frequency and size of these rewards can depend on many factors, including the number of tokens you're staking and the overall staking rate on the network.
For a specific example, learn how to stake VERSE token using the Bitcoin.com Wallet app in the video below. You can learn all about staking VERSE here.
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