What is Crypto Staking?

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robertstevens

Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.

Crypto staking generally refers to “putting your money in something and expecting to get more money as a result.” For legal reasons, these are sometimes not called interest accounts, savings accounts, or investment funds, though on a functional level they resemble such products.

This article will cut through the crypto terminology and explain, in plain English, precisely what staking means and how to get started. Note that most staking activities are highly unregulated, and lots of funds turn out to be scams, hacked, or negligently run. Plus, returns are often paid out in cryptocurrencies, which themselves are sparsely unregulated and often highly volatile.

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Staking to secure networks

The most common type of staking is to stake (pledge or lock up) cryptocurrency to proof-of-stake blockchains networks. These networks grant stakers the right to validate transactions on the network, and reward the stakers in cryptocurrency for doing so. Popular proof-of-stake blockchains include Tezos, Algorand, and Solana, and, most prominently, Ethereum 2.0., the upcoming upgrade to the second largest blockchain.

Staking, also referred to as baking or validating, is an alternative way of verifying transactions to proof-of-work, the consensus mechanism that powers the Bitcoin blockchain and many others. Powerful computers called Bitcoin miners compete against other miners by expending computational power. The Bitcoin blockchain interprets computational power, which is expensive to produce in the amounts necessary to earn Bitcoin, as an indication that a miner is reputable enough to validate a transaction.

The point of mining or staking is to distribute the labour of verifying transactions across a distributed network of anonymous actors, rather than having a single company (or handful of companies) run the entire network. This makes it difficult for a government to shut down a blockchain.

It also makes blockchains tough to hack, since a hacker would have to control the majority of a proof-of-work network’s mining power to start influencing transactions (and therefore undermine its authority), or own more than 50% of all available tokens on a proof-of-stake network. This is practically impossible in networks like Bitcoin or Ethereum, each of which is worth hundreds of billions of dollars.

The disadvantage to proof-of-work mining is that this game is incredibly wasteful to play, both in terms of the electricity it requires, which often comes from fossil fuels, and the high-end computers that miners churn through. Proof-of-stake infers the reputation of a miner from the amount of coins they pledge. This opportunity cost suggests that rich stakers have a stake in the network’s success, and should therefore be rewarded for locking up their money. This doesn’t waste any electricity, although critics say it just makes the rich richer.

It is also a lot cheaper to stake crypto than mine it, since you don’t need to buy expensive computer equipment to get staking software up and running, like you do with the Bitcoin blockchain. This is good for the health of the network, since it means that more people are on hand to verify transactions rather than a select few.

There are lots of ways to stake crypto in proof-of-stake networks. It’s often expensive to do it alone—you’ll need 32 ETH (about $100,000 USD as of this writing) to become an Ethereum 2.0. validator—but you can team up with others. Popular ETH 2.0 staking pools include Ankr, Staked, and Rocket Pool, and centralized exchanges, like Binance, Kraken, and Coinbase also offer staking services.

As of this writing, Ethereum 2.0. has 219,915 validators, the greatest number of validators on any blockchain. The Ethereum Foundation, which develops the Ethereum network, expects to transition Ethereum to a proof-of-stake network by the end of 2021, although the upgrade will take a couple of years before it becomes fully implemented. Cardano has 2,076 validators, Avalanche has 1,034, and Tezos has 382.

Staking pools work in different ways and come with different risks. Binance, for instance, is centralized, meaning that there’s a chance that the company could fold, lose all your money, or misappropriate funds. Some pools are decentralized, meaning they’re run by algorithms rather than people. However, the code could contain bugs or be vulnerable to hackers.

Returns vary according to the amount of ETH staked in ETH 2.0, and some pools charge an administrative fee. Some pools, like Binance’s, issue you with equivalent versions of your locked up ETH tokens so that you can keep using your money while earning rewards.

Staking lets you earn an income from your crypto holdings while you wait for profits to arise from price speculation, which could take years. You can reinvest your income in staking networks or by buying other cryptocurrencies, analogous to compound interest in traditional markets.

Staking does, however, come with risks, and you might have to lock up your crypto for several months or years to benefit from these returns, by which time the value of your staked cryptocurrency could have collapsed.

Other kinds of staking

Proof-of-stake is far from the only type of staking, and other cryptocurrency companies have co-opted the term to market any practice of locking up crypto with the expectation of returns.

Some companies or protocols will pay you to lock up your crypto. This type of investment is sometimes referred to as a savings account, interest account, or staking opportunity.

In practice, it is a type of fractionalized reserve banking, similar to how banks lend out or invest your deposits to earn returns on them, then give you a small cut of the proceeds, all while keeping enough money on hand to ensure that deposits can be fulfilled.

Companies like BlockFi do this: BlockFi lends out customer deposits of Bitcoin and other cryptocurrencies and pays out a part of the yield to the customer. As of this writing, deposits of the stablecoin USDC can pay out up to 7.5% per year. This is very attractive when compared with bank interest rates, which are often less than a single percentage point.

However, depositing funds in companies like BlockFi carries several risks. Funds are often uninsured (although BlockFi promises that customers will get first rights in the case of insolvency).

The cryptocurrencies themselves could be banned in countries where BlockFi operates, and BlockFi itself has come under fire by several U.S. states, including its headquarters of New Jersey, for offering unregulated securities.

Cryptocurrencies are also volatile. A 4% annual percentage yield on Bitcoin deposits that are paid out in Bitcoin is useless if Bitcoin crashes to 0. These risks are applicable to similar companies—BlockFi happens to be the largest company that hasn’t folded.

DeFi protocols

You might also find the word staking in the marketing of decentralized finance protocols. Decentralized finance, or DeFi for short, is an umbrella term that refers to any non-custodial piece of financial technology. There are a few types of decentralized finance protocols that promise returns for staking funds.

The first is a DeFi lending protocol, like Compound or Aave. Deposits in crypto are lent out to other people on the network and earn interest. This interest is paid out to lenders periodically, and returns are calculated according to the scarcity of that crypto and the terms of the loan. These protocols might also offer you platform-specific cryptocurrency tokens in return for lending your crypto, each of which can be sold on cryptocurrency exchanges. You can also “stake” (pledge, or temporarily lock up) these governance tokens to vote on how to run the network.

The second is an automatic market maker protocol like Uniswap. Here, you stake pairs of tokens to provide liquidity for token swaps. You earn trading fees on the platform. Uniswap is very popular. As of late August 2021, $1.3 billion has traded on the latest version of Uniswap in the past 24 hours.

The third type of DeFi protocol is so-called yield farming, which is where you invest in a big pot of money that an algorithm shifts around to different decentralized finance protocols to earn you the biggest yield. These are crypto versions of asset managers. For these types of protocols, “stake” can be aptly replace with “invest.” However, securities laws frown upon crypto investment projects, which is one reason why “staked” is sometimes used instead.

All DeFi protocols carry smart contract risks, which means that the algorithms that power the protocols could be faulty or contain vulnerabilities. In August 2021, a hacker exploited a vulnerability on a DeFi protocol called Poly Network and took home $600 million. They’ve returned much of the money but, as of this writing, not everyone has gotten their money back.

DeFi projects are sometimes unwieldy to use and require an advanced understanding of the cryptocurrency market. Increasingly, major crypto exchanges, such as Binance and Coinbase, are beginning to integrate these complex products into their own offerings and insuring funds to negate risk.

Last Updated September 7, 2021

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