Staking is a process by which cryptocurrency holders lock their cryptocurrency in so-called "staking pools" to help maintain the integrity and security of the blockchain network and to earn rewards. The locked coins represent the stake that the participant has in the network. Depending on the network and cryptocurrency, funds are locked for different periods of time and the amount of the rewards vary.
Staking allows users to participate in the validator rewards that are earned for confirming incoming transactions. The ability to stake coins is unique to the Proof-of-Stake (PoS) consensus model. Users who stake their coins are rewarded with a percentage of the staked token. Staking coins stabilizes the system and the price of the cryptocurrency by incentivizing users to hold their assets through generating passive income.
How does staking work?
Staking is only possible on blockchain networks that use PoS-based consensus. Well known examples of PoS blockchain are Ethereum, Cardano or Avalanche. This is in contrast to Proof of Work (PoW), famously used by the Bitcoin blockchain. Each PoS network has a specific currency that users can stake to participate in the staking process. The staking currency is usually the native currency of the network. For example, the Ethereum blockchain uses its native cryptocurrency ETH for staking as well as for other blockchain related activities like such as being used gas transactions costs.
There are several methods of staking cryptocurrencies. How an individual chooses to stake their cryptocurrency depends on technical expertise, preferred level of control, and the amount of cryptocurrency being staked. One method is to set up a validator node for a PoS blockchain. However, setting up a node requires technical know-how to run the software, and also typically a high minimum amount of cryptocurrency to be staked in order to activate the validator node. In Etherum for example, 32 ETH are required to activate a validator node. At the current market price of ETH, this equates to a required investment of nearly CHF 110,000. The up side of setting up a node is that it gives the investor complete control over their coins and generates the highest staking reward.
If the technical knowledge and amount required to set up a node is too high, investors can allocate their cryptocurrencies to existing validators. These types of validators where users can allocate their funds to are called "staking pools". These are most easily accessed through centralized exchanges such as Binance or Kraken. This is a convenient option for novice traders. However, the staker has less control over his assets as they are held by a centralized entity. Users can also delegate their stakes to a third-party service provider that operates a validation node.
Types of Staking Investment Strategies
There are several types of staking strategies that can be employed. The strategies depend on risk tolerance, investment goals, and technical expertise. Typically, coins can be staked in the following ways:
- Restaking
Restaking refers to the process of reinvesting earned staking rewards directly back into the stake pool. Rather than withdrawing the rewards, the staker chooses to compound his earnings by adding them to their original stake. This strategy increases the amount staked and has a powerful long-term effect as the investor earns "compound interest" or "interest on interest", resulting in exponential growth the longer the investment is staked. - Leveraged staking
Leveraged staking involves using borrowed funds, or leverage, to increase the amount of cryptocurrency staked. This has the potential to amplify the rewards earned, but it also comes with increased risk as leverage magnifies both gains and losses. It's an advanced strategy that should be approached with caution. - Liquid staking
Liquid staking refers to having staked assets that remain liquid and transferable while still participating in the staking process. Typically, when you stake cryptocurrencies, those funds are locked for a period of time. During that time, the assets cannot be withdrawn or traded. Liquid staking tokenizes the staked and locked assets, making them tradable or liquid. The tokenized asset is a second type of token that represents the staked assets. These are so called "Liquid Staking Tokens" (LSTs) or "Liquid Staking Derivatives" (LSDs), which are tied to the value of the underlying asset. The LSDs can then be used for DeFi applications. This allows staked assets to be used as collateral while still receiving staking rewards. This provides greater flexibility and liquidity for stakers, allowing them to earn rewards while using their staked assets in other ways within the ecosystem.
