What is crypto staking and how does it work?

Staking is a way for cryptocurrency holders to earn rewards on their assets by validating transactions on a blockchain. Blockchains need reliable ways for everyone on the network to reach agreement on the state of the chain. More granularly, that means that each transaction needs to be validated and added to a block, and that the ledger of transactions must match across nodes (or computers running its software) on the network. This process of validation, transmission, and agreement is called a consensus mechanism.

While there are many types of consensus mechanisms, Proof-of-Stake (PoS) has become a dominant one, especially after Ethereum’s Merge event in September 2022. PoS networks comprise multiple participants, called validators or stakers, who earn the right to validate transactions by locking up some of their own digital assets as a “stake.” In return for processing transactions on the network, they receive a reward.

On Proof-of-Stake blockchains like Ethereum or Polkadot, users who wish to validate transactions can opt to run a node. This usually entails obtaining the proper hardware (sometimes simply a personal computer) and running the necessary software (or client) while connected to the internet. Successful nodes are reliable and are always connected to the network, validating transactions and securing the chain without interruption.

Validators must lock up a predetermined amount of crypto (called a stake) to prove they have “skin in the game” and therefore will act only in the best interest of maintaining the network.

To compensate validators for validating the blockchain, they are eligible to receive staking rewards in the form of the chain’s native cryptocurrency. The rules that govern these rewards — the percentage yield, how often they are paid out, which validators are paid when — vary among blockchains.

In an ideal world, validators are trusted to validate transactions correctly and to always be online. However, should they become bad actors or prove unreliable (like going offline or attempting to validate transactions that are nonexistent), many blockchains impose a penalty called slashing. This generally results in the loss of some or all of a validator’s stake and removes them from their position on the network. If you're running your own validator, you're taking on this risk yourself — a missed update, a connectivity hiccup, or a simple setup mistake can lead to slashing before you even notice. To avoid this, users can choose to stake through a centralised platform or staking pool instead, which usually does a better job of staying online, keeping things backed up, and catching problems early.

Since faster, more advanced, and more popular blockchains demand increasingly complex hardware and software, running a validator node is not always easy for the average crypto enthusiast. Further, there may be a minimum stake which average participants may not be able to afford. On Ethereum, for instance, someone wishing to participate as a validator must deposit a minimum of 32 ETH into the chain’s designated smart contract.

To get around this limitation, staking pools are often created. These are either centralized services or automated protocols that allow any users to contribute smaller amounts of cryptocurrency to reach the minimum staking threshold on a chain. Staking rewards are then distributed among these services’ depositors based on their contribution.

Not every PoS blockchain works the same way. In fact, there are many types of PoS networks that aim to solve different problems. Three of the most common ones are:

Other variations, such as Leased Proof-of-Stake (LPoS) and Bonded Proof-of-Stake (BPoS), take the concepts of the three consensus mechanisms and tweak them in slightly different ways.

Staking is a common way to generate cryptocurrency rewards. However, in addition to the volatility inherent to cryptocurrency markets, there are a few unique risks associated with staking itself.

One of the downsides to crypto staking is that funds must be locked, meaning that those coins are removed from a user’s liquid assets and cannot be used for other purposes, such as in DeFi protocols or for active trading.

Additionally, staking sometimes requires a minimum lock-up period, and users may not be able to access their assets immediately upon the decision to stop staking. In other words, crypto staking carries the potential risk of opportunity loss.

Lastly, rewards may be subject to vesting, making them unavailable to users for a prespecified amount of time before they can be cashed out.

Disclosures

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that these articles are meant for information and do not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any cryptocurrency, or to engage in any investment activity or strategy.

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