The world of cryptocurrencies has come a long way since the inception of Bitcoin. While at the beginning everything was connected to Bitcoin due to the invention of Proof-of-Work consensus mechanism, a few years later, different consensus mechanism protocols were created.
One of them, and probably the most famous one right after the Proof-of-Work is called Proof-of-Stake. This consensus mechanism allows for staking of cryptocurrencies and varies from Proof-of-Work in several aspects, which will be talked about about more in the next few paragraphs.
What is proof of stake?
Proof-of-Stake, unlike Proof-of-Work consensus mechanism, does not need mining or extensive computational power to run the network. The PoS was designed in such a way that the holders of the coins, the stakers, are able to use their holdings to help secure the network solely by locking them in specialised pools in a process known as staking (Becker, 2021).
This is allowed for thanks to staking pools, where the participants can pledge their coins. Once they do that, the protocol uses those coins to validate and confirm transactions, which helps with the overall security of the network. The protocol chooses validators from the pools , which are then rewarded new minted coins or tokens for their staking. This means that the more you as a holder pledge to the protocol, the more likely you are to be selected, and hence to receive the staking rewards.
This makes sense from the logical standpoint as well. The higher the number of staked coins in any protocol, the higher the chance that the owner is not trying any malicious activity as that would deteriorate their wealth. Thus, the more skin in the game the owner has, the higher the chance of them being honest, and the higher the crypto staking rewards they should earn (Granahan, 2022).
This means that crypto staking can be thought of as a savings account. The depositor (holder) earns some yield/interest on the money they put in when it is in the bank as the rewards from the bank, which uses it as money for other purposes, for instance lending. The crypto staking rewards can be then thought of as the interest earned (Sandor, 2022) .
Obviously, the amount staked is solely based on the decision of the holder. While the higher the number of staked coins, the higher the probability of earning more crypto staking rewards, the holders of the coins also need to take into account the lockup staking periods.
These are essentially time periods during which the coins cannot be moved from the wallet because they are locked in. Thus, while still belonging completely to the original owner, the coins cannot be moved at any time.
PoS vs PoW
Determining the difference between Proof-of-Stake and Proof-of-Work can take up a whole lot more than just a few paragraphs in an article. That is why this comparison will be very short, but will try to highlight the biggest differences, without going too much into details (Daly, 2022).
Proof-of-Work and Proof-of-Stake are two of the most used consensus mechanism protocols in the cryptocurrency world. While PoW is associated with mining, which is how transactions are validated and new coins are issued, PoS is a protocol that allows users to stake their coins and get rewards for doing so.
Both of these processes thus provide an incentive for verifying and validating the transactions. PoW needs energy, which many view as a negative, while PoS solely needs lockup periods. Yet, both of these consensus mechanisms serve the same purpose, no matter what their differences are — and that is to help the blockchain work smoothly.
How to start staking
Does staking sound interesting to you, but you do not know where to start? Here is a very simple guide of what exactly you should do. First of all, you need to select which cryptocurrency you want to stake, as there are currently countless cryptocurrencies offering this service, since they are running at Proof-of-Stake protocol. To name just a few, staking is available with Cardano (ADA), Polkadot (DOT), Solana (SOL), Tezos (XTZ) or Avalanche (AVAX).
Interestingly enough, Ethereum (ETH) also offers staking rewards in anticipation of a merge to Ethereum 2.0. Ethereum is now at a unique state where the participants in the network can both mine the cryptocurrency as well as stake it, prior the switch to Proof-of-Stake that was promised to be delivered by the end of the year 2022.
After you have selected the cryptocurrency you want to stake, and have hopefully done proper research on it, you need to transfer the tokens to the wallet that would allow you to join the staking pool. This can either be a wallet of some exchange that offers those services, or a different platform that allows for staking.
You would also need to make sure that you are staking the minimum amount required. For Ethereum it is 32 ETH, for instance, however, there are pools out there that allow for joining with smaller amounts.
Next, you would need to join a staking pool, which allows staking of the given cryptocurrency. Here it is very important to check for reliability of the staking pool, since if the pool is down often, it can cut your potential losses quite significantly. Also, the size of the pool matters as a very small pool is likely to fail more often than a big one.
In this step you would also want to check the fees that the pool is taking as their cut of the profits. If their fees are reasonable, which traditionally would be somewhere between 2–5% that is appropriate, but if they charge more than that, it might not be the best pool out there.
Is staking crypto safe?
As was already mentioned, there are several aspects and information that everyone needs to check before they start staking themselves. Thorough research and in-depth analysis are very important, as any form of staking will need an upfront investment, which means that everyone should make sure they know where they are putting their money.
What is the history of the cryptocurrency, what rewards it is generally offering to its clients, how does it work and how does the pool that the user is about to select work? Answering all of those questions and many others, will determine how successful the crypto staking will be.
Generally, staking with any of the biggest cryptocurrencies is quite reliable. While the Luna debacle showed us that nothing is 100 % safe in the cryptoworld, cases such as these are rather rare, at least with the biggest altcoins. With smaller coins and tokens, implosions can come more rapidly. This means that they often want to offset the higher risk with higher reward, which should be immediately a red flag.
It, however, still needs to be stated that the cryptocurrencies that are locked in any contract or in any staking pool, still belong to the owner. They might be locked for a few days, which means that the owner might not be able to sell them or move them immediately after they decide to do so, but the ownership is theirs. So, unless the protocol completely goes to zero, no matter what happens, the tokens should hold some value to the user, even with big price swings. Volatility in this case is nothing more than just a noise.
Disadvantages of staking cryptocurrencies
Nevertheless, the noise can still be a distracting force for many, which may then lead to suboptimal decisions. That is probably the biggest risk of staking the cryptocurrencies. Once the stakers see that the price of their cryptocurrency is getting lower, they might be prone to taking it out and selling, which can take days. While this is not the best decision, by far, it is still common, since fear has the ability to influence the decisions of people in the markets.
As the Luna/Terra debacle showed, one can never be too sure about their tokens. But this is a risk that is shared amongst all the altcoins and some even say, Bitcoin itself. This asset class is still very young and will definitely have a lot of bubble bursts before it matures. However, while still being a disadvantage of staking, this is more a problem of the whole sector, rather than just the subsector of Proof-of-Stake cryptocurrencies.
Some of the other problems suggest that hacks can be very dangerous for the staking pools. While true, this also applies to other liquidity pools or different bridges, which are more prone to hacks. The security element will, without any doubt, need to improve, if the investors want to have a good night sleep.
Other than that, investors in these products and services need to make sure that they understand what they are doing. Research is definitely key as it can help from making bad decisions connected to choosing the cryptocurrency that will be staked.
Staking is one of the most intriguing parts of the cryptocurrency world. It definitely has the ability to provide a very easy way to earn passive income, but this needs to be based on solid research and analysis. If that does not happen, the investors can be very quickly surprised by how ruthless the cryptocurrency world can be. Yet, if the due diligence is proper, crypto staking rewards can increase the size of the portfolio of any cryptocurrency trader or hodler.
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