Staking is becoming one of the hottest trends in crypto as investors seek a way to earn passive income on their idle cryptocurrency. But staking is more than just a way to make a quick buck. In this guide, we thoroughly explain the role of staking and the underlying proof of stake system.
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Table of contents
What does staking mean?
– Background
i. The role of blockchain: going back to basics
ii. Proof of Work versus Proof of Stake
– Different types of staking mechanisms
i. Regular Proof of Stake (PoS)
ii. Delegated Proof of Stake (DPoS)
iii. Leased Proof of Stake (LPoS)
iv. Bonded Proof of Stkae (BPoS).
v. Masternode Proof of Stake (MPoS)
vi. Zerocoin Staking
– The advantages of a proof-of-stake system
i. No expensive hardware requirements
ii. Solves scaling issues associated with Proof of Work
iii. More energy efficient than Proof of Work
iv. Staking rewards
v. Staking for participation
vi Disincentives for a 51% attack
– What are the risks of staking?
i. Loss of your cryptocurrency holdings
ii. Price volatility (and lock up periods)
iii. Changing staking rewards and/or staking rewards not being paid
iv. Project failure and counterparty risk
v. Minimum holding
vi. Exposure risk
vii. Slashing
viii. Network centralisation
Key takaways
Staking through an exchange
What does staking mean?
Put simply, staking is the process of keeping funds in a cryptocurrency wallet (or staking pool) to help the underlying proof-of-stake blockchain network (for a particular project) operate more efficiently and securely.
A stake represents a voting right in a particular project that is earned after purchasing a minimum amount of coins. This means the more coins we hold in a staking pool, the more voting rights we obtain. And since holding the coins helps the underlying proof-of-stake network operate more efficiently and securely, a reward is paid out.
Comparing and contrasting staking vs traditional passive investments
Conceptually, the process of holding tokens and then being rewarded for holding them resembles certain passive-income instruments found in traditional finance, such as bonds or preference shares for instance. But fundamentally they are very different.
Staking rewards are not derived from earnings
The reward that is received in the process of staking is actually a proportion of the newly minted tokens. It is not derived from company profits or earnings.
PoS tokens are dilutive as new tokens are minted
Unless you actively maintain your stake in the PoS network, the issuance of new tokens raises supply and dilutes your relative ownership/participation in the network. Many refer to this as the staking inflation rate but what’s really happening here (all else equal) is dilution.
Choosing tokens based on the highest staking reward alone might be profitable in the short-term. However, in the long run, the proportion of staking rewards received from staking will decline (all else equal) as the supply of tokens increases over time. This is especially the case if the dilution rate (inflation rate) is greater than the share of staking rewards.
Staking is meant to be a long-term initiative and therefore you may want to consider a project where the dilution rate (or inflation rate) does not exceed the annualized staking reward. In this manner, a proportion of the reward that is received from staking could be re-staked to maintain your existing ownership/participation in the network.
Companies may issue new shares too, usually to finance growth, although this will often occur when a company doesn’t have sufficient profits and cash to finance new projects on its own. This means shareholders will have to invest more of their own capital to maintain the same shareholding in the company.
If a company is constantly issuing new shares, shareholders may eventually become discouraged and disincentivized to invest further whereas with staking the purpose of issuing new tokens to payout in the form of rewards is meant to act as an incentive mechanism for encouraging network security and promoting good behavior.
Staking as a governance system
Whilst staking is gaining popularity as a way to earn passive crypto income in the form of rewards, many seem to forget that its primary purpose is to act as a powerful governance and participation system.
All too often the reward system is perceived as a source of income but rather it is meant to be an incentive that encourages token holders and validators to secure PoS networks and to promote good behavior and decision making. The idea here is that making good decisions will result in value creation and eventually long-term price appreciation of the token that is being staked.
Although proof of stake does not necessarily imply governance, the incentive structure combined with governance has revolutionary implications for participation. To understand this better, we will take a step back and revisit the background of blockchain networks.
Background
The role of a blockchain: back to basics
The role of a blockchain is to serve as a distributed digital ledger in which the transactions occurring over the network can be stored, viewed, and unaltered once validated by users within the network. This process ensures there is a secure, trusted and transparent exchange of data.
The concept of a distributed digital ledger is key here since it contains a record of all prior transactions. It is distributed because the data is not stored in a central location but rather across a network of computers across the world and it is decentralised because it does not require a central authority for validation.
But critical to the operation of a distributed digital ledger is the consensus mechanism – that is, ensuring the entire network collectively agrees with the contents of the ledger.
The objective of a consensus mechanism is to ensure that information that is included into the ledger is valid i.e. the network is in agreement (or in consensus). This is important because it ensures that the successive blocks that are added to the ledger represent the most up to date blocks on the network.
Various consensus mechanisms have been devised, all with their pros and cons. In the following sections of this guide we will briefly go through the proof of work and proof-of-stake systems.
Proof of Work versus Proof of Stake
Proof of Work (PoW): where it all started
Initially described by Cynthia Dwork and Moni Naor in 1993, proof of work (PoW) was the first consensus algorithm. Bitcoin is the most well-known network to implement this type of algorithm. However, it was not until 1999 the actual term “proof of work” was coined by Markus Jakobsson.
To briefly describe how it works, before a Bitcoin transaction is registered onto a block, it is grouped into a memory pool (referred to as a “mempool” for short). Each transaction in the mempool requires a miner to help verify it.
To verify transactions, a network of mining nodes make use of specialized hardware ASICs to try and solve complex cryptographic problems. Once a puzzle is solved, through significant effort, the miner finds the hash value of the previous block and announces it to the network. Then the Bitcoin transaction that is within the mempool is placed into a new block and the miner gets its block reward – currently 6.25 BTC plus the transaction fee.
This process leads to the proper functioning of a proof-of-work blockchain network. However, solving these increasingly difficult mathematical puzzles requires increasingly more computation power, which in turn, requires increasingly more electricity – so proof of work is an extremely energy-intensive process.
If you want to learn more about the price dynamics of Bitcoin, read our free guide. Alternatively, anyone interested in learning more about Bitcoin’s historical pre-and-post halving (or ‘halvening‘ ) performance may enjoy reading our research.
Proof of Stake: the birth of a consensus mechanism that is less energy intensive
In 2011, proof of stake (PoS) was being explored as a way to use less energy to do the validation “work”, and thus make the process more sustainable.
In the proof-of-stake algorithm, projects often start by selling pre-mined coins. That’s right – no mining is required to validate transactions. And since no mining is required to solve complex mathematical puzzles, the process is significantly less energy-intensive than proof of work.
In proof-of-stake mechanisms, new blocks are created through a process known as ‘forging‘ or ‘minting‘ (not ‘mining’) by randomly selecting a participating node to confirm that the next block of transactions is valid.
Users wanting to participate in the forging process will be required to lock a certain amount of coins into the network as their stake. Since the selection process is random, the size of the stake is important because it helps to determine the chances for a node to be selected as the next validator to forge the next block – therefore the bigger the stake, the better the probability of being selected.
The nodes that manage to validate the transaction and register it onto the next block are selected through a pseudo-random process that is based on numerous factors such as staking age, randomization, and the node’s wealth.
It is purposely a pseudo-random process to diminish favouring only the wealthiest nodes in the network.
Unlike proof-of-work systems whereby a miner is awarded a block reward plus the transaction fees, in a proof-of-stake system the chosen node that helps to protect and run the network is rewarded with only the transaction fees.
When referring to staking its important to understand that there are different types. This guide focuses on regular proof of stake although for the sake of being thorough it is important to be aware that there are different types of staking mechanisms, and each has their pros and cons. The various types of staking protocols are briefly outlined below.
Different types of staking mechanisms
Without going into too much detail, the objective here is to help our readers understand there are different types of proof-of-stake protocols.
i. Regular Proof of Stake (PoS)
As mentioned above, regular proof of stake (PoS) was introduced in 2011. In a regular proof-of-stake system the creator of the next block is selected in a random process containing various combinations of wealth or age ( i.e., the stake) not by computing power as in the case of proof of work.
ii. Delegated Proof of Stake (DPoS)
Daniel Larimer, the founder of Bitshares, Steemit and EOS, created DPoS consensus algorithm in 2014 as an extension to regular proof of stake with the objective of solving the perceived scaling issues associated with proof of work.
DPoS essentially seeks to raise transaction speed and block creation without compromising the decentralized incentive structure of the blockchain. The DPoS algorithm does this in a democratic manner by creating a voting system that is directly dependent on the delegates’ reputation. Therefore, if an elected node fails to behave properly (in line with the rules), it will be quickly expelled and replaced by another one.
As you may have imagined, Bitshares, Steemit and EOS operate on a DPoS system.
iii. Leased Proof of Stake (LPoS)
In May 2017 Leased Proof of Stake (LPoS) was introduced and implemented in the Waves project.
This consensus mechanism is essentially similar to the regular proof of stake except users have the option of leasing their staking ability to someone else. Users must ‘lease’ a minimum amount of coins to nodes that are considered to be high quality (similar to masternodes) and in return earn a percentage of the payout as a reward.
iv. Bonded Proof-of-Stake (BPoS)
Bonded proof of stake (BPoS) is very similar to the leased proof of stake protocol except for any number of users may set aside part of their stake (i.e., bond) in order to influence block generation. BPoS was first introduced by projects such as Cosmos and IRISn.
v. Masternode Proof of Stake
Introduced in 2019, Masternode Proof of Stake (MPoS) is similar to regular proof of stake in many ways except we are dealing with extremely large stakers, which due to their size, obtain extra privileges and rewards over normal regular stakers.
As may be implied by the name, a masternode is a well-connected node that renders a valuable service to the community by maintaining an up-to-date copy of the entire blockchain. In return for taking on this responsibility and for committing to stake a significant number of coins, they receive a regular fixed reward and may even receive up to 45% of the block reward.
Since a masternode is materially invested (and have so much more skin in the game than a regular proof-of-stake node) they are considered more trustworthy because they also stand to lose much more if they attempt to become malicious.
Masternodes are usually paired with regular proof of stake or proof of work such as in DASH.
vi. Zerocoin staking
Zerocoin staking is essentially regular proof of stake except it is completely anonymous. Currently, Zerocoin staking is specific to PIVX cryptocurrency.
By presenting the different categories of staking, we hope you may appreciate how this space is evolving.
The advantages of a proof of stake system
Proof of stake was essentially developed as a way to fix the scaling problems associated with the proof of work protocol. Below we outline some of the documented advantages:
i. No expensive hardware requirements
The proof-of-stake consensus mechanism removes the need for purchasing high-end computer hardware.
ii. Solves scaling issues associated with Proof of Work
Since no expensive mining equipment is required, proof of stake can support a larger number of users to run nodes, which along with the randomisation process, helps make the network more decentralised. This process helps to speed up transactions and lower energy consumption.
iii. More energy efficient than Proof of Work
As mentioned earlier, proof of stake does not require energy-intensive mining equipment and increasingly complex puzzles to validate blocks. Proof of stake is therefore ecologically more sustainable than a proof-of-work protocol.
iv. Staking rewards
The proof-of-stake system provides a predictable source of income, unlike the proof-of-work system where coins are mostly rewarded to the highest-powered ASICs.
When a node stakes coins held in a wallet, it is rewarded with a fixed percentage of transactions on the network irrespective of its processing power.
Staking, therefore, produces a stream of ‘crypto income’ that in some way resembles the interest received on a bond.
Many people are sitting on altcoins that are currently worth significantly less than what they were initially purchased for. For these people, staking rewards may represent a viable way to recover the majority of their crypto losses.
For others, staking may represent an opportunity to earn a passive stream of rewards, which may in some cases (depending on where you live in the world) be more attractive than the returns offered by comparative instruments in the fiat space (especially in view of the low-interest rate environment).
v. Staking for participation
Staking does not only yield attractive rewards but it may also give participants a say in how a project is run. To do this, participants must remain abreast changes to a project’s consensus rules and when given the opportunity to actively vote on value-accretive decisions. Neglecting to do so risks setting up a poor alignment structure which would eventually lead the project to fail.
vi. Disincentives for a 51% attack
This is more subjective although we believe the risks associated with a 51% attack stands to diminish, especially over time as proof of stake evolves. Firstly, with proof of stake, the validation system is randomised and secondly, the selection criteria are evolving to one that is weighted more towards the quality of behaviours within the network.
What are the risks of staking?
i. Loss of your cryptocurrency holdings
Cryptocurrency investing is high risk. There is the risk of losing all of your capital invested in cryptocurrency, including all of your staked digital assets. Only invest what you can afford to lose, even if the project promises a guaranteed rate of return.
Loss of your cryptocurrency holdings may occur in many ways including negligence, hacking and scams. It is absolutely critical you never give out your mnemonic and private keys to anyone and always ensure you have a secure backup (offline) in case you need to recover your wallet. Always encrypt your wallet with a strong unique password.
Reputable hardware wallets such as Ledger are highly recommended.
Read our free guide to learn more about the risks associated with buying cryptocurrency and how to protect yourself.
ii. Price volatility (and lock-up periods)
As you may already know, the price of cryptocurrencies fluctuates considerably. But these price fluctuations are a bigger nuisance when lock-up (or lock-out) periods are introduced because the value of stakes may fall whilst in lock-up.
The lock-up period is the time you need to keep your staked coins before you may convert them back into cash. In most cases, you will only be able to redeem the coins after the lock-up period has ended. This means you may face big fluctuations in the coin price, which may not be an issue in a bull market when prices are rising, although it may become problematic during a bear market when prices are falling as the amount earned from staking is not likely to be sufficient to cover the price devaluation.
Staking may be more suitable for those of you who are taking a long-term view (e.g. HODLers). Traders, especially those who may be very active, may find long lock-up periods to be unsuitable.
iii. Changing staking rewards and/or staking rewards not being paid
Always read the fine print. The rates of return on staking rewards are not always guaranteed and may even change over time. A good example is Tron, which changed their staking rewards from 7% to less than 4%.
Even if the staking reward is ‘guaranteed‘ there is a risk it will not be paid (even though it is supposed to be paid). Therefore, do not take anything for granted. Always check to see that your rewards have been paid.
iv. Project failure and counterparty risk
Before you stake a coin make an effort to understand the project and the risks around it. The blockchain you are staking may hit a stumbling block and fail to execute at an operational level. It may also fail to grow and acquire new use cases, eventually resulting in the project winding up.
Therefore, as words of wisdom, do not only consider the projects that pay the highest staking rewards. Instead, select projects that have real fundamentals and technology as well a good community supporting it.
Since you may be staking through an exchange or wallet, there is also counterparty risk to consider. If for some reason the platform (e.g. wallet or exchange) you are staking through goes out of business and delists all the coins you will most likely lose all of the staked coins held on that platform.
v. Minimum holding
Most projects require a minimum holding of their coin in order to be eligible to receive a staking reward. Always check the terms and conditions (and whether there are changes to them) as you will not receive a staking reward unless you meet the minimum holding requirement.
vi. Exposure risk
Having all your eggs in one basket gives rise to significant exposure risk. To minimise exposure risk, you may want to consider a diversification strategy by staking coins of various projects (although be careful not to over diversify) through exchanges or wallets you consider to be safe and secure.
vii. Slashing
The proof-of-stake model rewards honest validators whilst also punishes dishonest validators and their delegators. Slashing is, therefore, a mechanism by which the network disincentivises abnormal behaviours by punishing the validator for a fault that has been conducted.
There are several instances when slashing may occur:
- Liveness fault (IRISnet, Cosmos): the validator node is penalised if it does not participate in the network consensus for an extended period of time and misses numerous blocks;
- Governance fault (IRISnet, Cosmos): The validator node is penalised if it votes various times on the same consensus process, and these votes differ from each other;
- Security fault (IRISnet, Cosmos, Tezos, and many other protocols): Cosmos and IRISnet refer to it as double signing whilst Tezos refers to this as double-baking or double-endorsing. This happens when the same block is validated twice or more.
The penalties depend on the type of misbehaviour as well as the parameters of the protocol. Most of the time, the validator/baker is penalised with a certain percentage of the coin he has under staking. In certain protocols, the validator may also be jailed, a process preventing him from re-entering the networks for a certain period of time.
viii. Network centralisation
The threat of a 51% attack, whilst diminishing, hasn’t been eradicated with all forms of proof-of-stake systems. From a security standpoint, proof of work is currently superior.
We have attempted to identify the main staking risks above. However, the list of risks identified above does not constitute a full and comprehensive list of the risks associated with staking. There may be additional risks applicable to you. Always do your own research.
Key takeaways
1. Always apply rigorous safety and security procedures to avoid losing your cryptocurrency either through negligence, scam or hack;
2. Choose staking projects carefully, understanding whether there is a real tech (with growing traction and use cases) which is also backed by a strong community;
3. Consider diversification by staking various good quality projects through various reputable staking services – but at the same time be careful not to over diversify (We have made it easy for you, check out the full list of digital assets that are available for staking through various crypto exchanges);
4. Understand the key staking terms and charges:
– minimum holding: the minimum number of coins you must stake to be eligible for the staking rewards.
– minimum holding period (also referred to as initial holding period): the minimum period you must your coins must be staked before you receive your first staking reward.
– wait period: the amount of time you must wait before the staking rewards start to accumulate on the coins you have staked.
–lock-up period: the period you are not able to withdraw your staked coins.
–Staking reward yield: refers to the annual rate of return (e.g. 5%) expected to be earned on staked coins. It is important to understand whether the return is fixed, variable or guaranteed?
– charges: certain exchanges such as Binance do not charge for the staking service although many others do. Therefore, it is important to understand whether the exchange is quoting an annual staking yield that is gross or net of charges.
– promotional rewards: certain exchanges may offer additional promotional rewards as an incentive for choosing their staking service (as opposed to a competitor).
– Jurisdictions eligible for staking: certain exchanges have rolled out staking services for the USA only whereas others for specific international countries. Always check with the exchange that your country (and jurisdiction) are eligible to receive the staking rewards for a particular coin.
Staking through an exchange
Staking may be achieved in many ways although doing it through an exchange is simple and reduces many of the risks associated with staking on your own.
Those who prefer a simple straightforward way to start earning staking rewards or who do not want to bother with risky and complicated staking methods may want to consider heading over to Coinbase, Binance or Kraken.
CoinMarketExpert has compiled a comprehensive list of staking providers, which you may sort according to the highest estimated staking yield. Check out our page Best Staking Coins 2020 for the list.
