What is Cryptocurrency Staking?

I’m often asked the question “what is cryptocurrency staking?” and “how does crypto staking work” when I write about my cryptocurrency investments. It’s really not that complicated but it can sometimes seem it when you Google the phrase if you’re not familiar with Cryptocurrency staking, the terminology, or you are new to the cryptocurrency asset class.

With that in mind, I’ve tried to describe it in (understandable) detail below as it really is worth looking at if you intend to “hodle” (used in the crypto space instead of “hold”) crypto assets for the long term as it can generate very attractive income.

For example, just holding Kava right now you can generate 20% returns, and PolkaDOT is paying around 14%, Cardarno (ADA) is paying around 12%. Not terrible is it? Compared to fiat currencies at less than 1%, it is certainly attractive to me. You can always see what assets I’m currently staking and rewards I have received in my Cryptocurrency Portfolio.

What is Cryptocurrency Staking

Cryptocurrency Staking for most investors means a way to make (usually very good) returns on your cryptocurrency assets while you hold them.

You might consider staking as an alternative to Crypto mining, which requires less resources to achieve rewards. Assets can be held either at a crypto broker such as Kraken or Binance, or held in a cryptocurrency wallet (software or offline hardware cold storage such as Ledger.) to help the security and transaction processing of a crypto blockchain network. Stated another way, staking is the operation of binding crypto assets to receive returns. In many cases, an investor is able to stake their tokens or coins from their cryptocurrency wallet. Most Crypto exchanges enable staking options for their customers.

To get a better idea of what cryptocurrency staking is, you’ initially need to grasp how Proof of Stake (PoS) works. Proof of Stake is a consensus system which enables blockchain systems to process transactions more energy-efficiently all while keeping a good measure of decentralization. Time to give you an overview of PoS is and how it works with staking.

What is Proof of Stake (PoS)?

Bitcoin, you may already know, works with a Proof of Work (PoW) system. This is a system which enables transactions to be collected into blocks. These blocks are then linked together which creates a blockchain. Crypto miners of a PoW system compete to unravel a complex mathematical equation, and whichever miner solves the puzzle first, obtains the permission to add the following block to the blockchain.

The Proof of Work system has shown over the years to be a very stable system to enable consensus in a decentralized way. The challenge is, that it involves a lot of arbitrary computation. The puzzle the crypto miners are competing to figure out has no purpose but to keep the network secure. We could argue, this on its own makes this computation excess justifiable. Here, you could be thinking to yourself: are there other possibilities available to keep a decentralized consensus with lower computational energy usage?

That would be Proof of Stake (PoS). The thought is that participators can lock tokens or coins (their “stake” if you will), then at certain intervals, the blockchain randomly gives the right to one of them in order to validate the following block. Usually, the probability of getting chosen is relative to the number of coins or tokens – the more tokens or coins staked, the better the chances.

Selection process for Proof of Stake

What decides which members create blocks isn’t solely based on their capability to solve hash puzzles as it is with PoW. It is determined instead by how many coins or tokens they are staking.

We may choose to argue the development of blocks from crypto staking creates a higher degree of scalability for blockchains than for PoW systems. This is one of the reasons Ethereum (ETH) is currently changing from PoW to PoS through a series of software upgrades often called ETH 2.0.

How was PoS or Proof of Stake created?

Scott Nadal & Sunny King in their 2012 paper for Peercoin outlined a what is now know as Proof of Stake. They discussed it as “peer-to-peer cryptocurrency design derived from Satoshi Nakamoto’s Bitcoin.”

The network called Peercoin was developed with a combined Poof of Work / Proof of Stake systems. PoW was mostly applied to make the first supply of coins. It wasn’t however needed for the longevity of the blockchain network, and its dominance was slowly reduced. Most of the systems security relied on PoS.

What is Delegated Proof of Stake (DPoS)?

A different version of the PoS system was designed by Daniel Larimer in 2014 referred to as DPoS or Delegated Proof of Stake. Used initially as a component of the BitShares blockchain system, however not long afterwards, other networks also decided to use the DPoS system. EOS and Steem were among the firs, also developed by Larimer.

Delegated Proof of Stake enables holders to submit their crypto balances as votes. Voting power is relational to the number of tokens or coins owned. Votes can then be used to nominate delegates which in turn oversee the blockchain system on behalf of voters they are working for, safeguarding consensus & security of the system. Normally staking returns are given to the nominated delegates, who in turn distribute some of the returns to the nominators based to the individual holdings.

The Delegated Proof of Stake system enables consensus with a much lower pool of validating nodes. This can enhance system performance. Alternatively, it can also achieve in a lower decentralization degree as the system requires a smaller group of validating nodes. The nodes handle the maintenance and overall management of the blockchain system.

How does Crypto staking work?

Proof of Work systems depend on crypto mining to create new blocks for the blockchain. Proof of Stake on the other hand create chains which produce and validate developed blocks through the crypto staking process. Crypto Staking uses validators who “bind” their tokens or coins so they are able to be selected randomly by the system at set intervals which then generate a block.

Participants that typically stake greater numbers of assets have a better opportunity to be chosen as the next validator for a particular block. Enabling blocks to be produced without having to rely on expensive crypto mining hardware like Application Specific Integrated Circuits (ASICs) for mining which requires a large investment in hardware, Proof of Stake just needs a direct investment in the cryptocurrency itself.

This means that rather than competing to produce the next block PoW, Poof of Stake validators are chosen for the number of tokens or coins they have staked. The coins or tokens a validator holds, is what motivates them to keep good network security. Should they not do that, their whole crypto stake could be at risk of being “slashed” (a term used for “fining” a validator for not adhering to the rules).

Each PoS system has its own staking currency, some systems opt for a two-token arrangement in which rewards are paid in another coin or token.

Practically speaking, crypto staking simply means keeping crypto assets in a software/hardware cryptocurrency wallet. This creates the opportunity for virtually anyone to become a validator, and to get paid for validating with staking returns. This could also mean adding assets to a “staking pool” covered in detail below.

How are staking rewards calculated?

Staking rewards are calculated in various ways . Every system uses a different method to calculate staking rewards. Many are issued on a “per-block” basis, considering multiple factors. These include (but are not limited to):

The system rate of inflation.

Length of time validators have actively been staking their assets.

Number of tokens or coins that are staked by the validator.

Number of tokens or coins that are staked in total on any network.

Certain other systems base staking rewards on a fixed percentage. These rewards are given to validators as a type of inflation compensation. Inflation is a way the system tries to encourage crypto holders to spend their assets as opposed to “hodling” them (term used instead of “holding” in the crypto world). This is intended to increase the usage of the tokens/coins as cryptocurrency rather than just an investment vehicle. This model enables validators to calculate with precision how much staking return they should expect to receive. Predictable returns are preferred by many. Also the information is public and as such, may convince more users to stake their assets or become validators.

What is a Crypto staking pool?

A staking pool refers to a number of crypto asset owners who merge their crypto holdings to improve the groups chances of being chosen as validators and in turn receiving rewards. Staking power is combined and the rewards are shared proportionally based on holders pool contributions.

Initiating and running a staking pool can require a a great deal of time and know-how. Staking Pools usually work best on networks where the cost of setting up (technical knowledge or financial cost) is quite high. Because of this, most commercial pools charge a commission from staking returns.

Large staking pools (such as exchange staking pools) can also offer some flexibility to their customers. Normally if we are staking from our own wallets, stakes have to be locked for a certain fixed period of time. Typically withdrawing (or unbinding) our assets can take time, which is set by the individual networks. Furthermore, there is sometimes a minimum amount of cryptocurrency needed to stake in order to discourage bad behavior.

For example, the minimum ETH that can be staked currently directly is 32 units. Staking pools typically require a lower stake and often offer much shorter (if any) withdrawal times. Most Kraken staking pools for example allow withdrawal instantly. Using a staking pool can be useful for newer users or users with less crypto currency to stake.

What is cold staking or offline staking?

Offline or Cold staking is the method of staking cryptocurrency assets from a wallet such as Ledger which is not connected to the Internet. This is also possible with a software (AKA air-gapped) crypto wallet.

Systems which allow offline or cold staking enable crypto holders to stake while holding their assets offline. This can also be referred to as “non custodial staking”. Non-custodial or offline staking is useful for large crypto holders that want stake their assets, but also need maximum protection of their cryptocurrency.

Summary

Cryptocurrency staking offers (sometimes) generous rewards for investors wanting to be part of the consensus and security of blockchains. Overall it’s a very easy way to make passive returns just for holding your crypto assets. Crypto staking is exceedingly easy to do once you understand how to move cryptocurrency assets around, and stake them to the network you are holding crypto with.

It should be noted that staking isn’t completely without risk. Staking funds to a smart contract can be subject to software bugs, so always be sure to do your research on the crypto you intend to stake, and only use well-researched staking pools, the larger well known exchanges such as Kraken or Binance, or if you’re doing offline, cold non-custodial staking, make sure you use a solid, well known hardware wallet such as Ledger X which is the one I use personally. You could also lose some of your rewards through “slashing” (mentioned earlier) but overall this is a rare occurrence and has yet to happen to me (touch wood).