Staking has become a popular method for crypto investors to increase their assets without selling them. Staking can be seen as the cryptocurrency equivalent of placing your funds in a savings account. The difference is that when you deposit money into your savings account, the bank lends it to others, sharing the interest with you. When you stake your cryptocurrency, you lock up your digital assets to participate in maintaining the security of the blockchain network, in return for rewards.
Introduction
You can think of cryptocurrency staking as an alternative to mining that requires fewer resources. It involves holding funds in a cryptocurrency wallet to support the security and operations of the blockchain network. Simply put, staking is the process of locking up cryptocurrencies to earn rewards.
In most cases, you can stake your coins directly from your cryptocurrency wallet, such as Trust Wallet. On the other hand, many exchanges offer staking services to their users. Binance Staking allows users to earn rewards in a simple way - all you need to do is hold your coins on the exchange (more on this below).
To better understand what cryptocurrency staking is, you first need to understand how the Proof of Stake (PoS) consensus mechanism works. PoS allows blockchains to operate more energy-efficiently while maintaining a high degree of decentralization, at least in theory. Let's explore what PoS is and how cryptocurrency staking works.
What Is Proof of Stake (PoS)?
If you're familiar with how Bitcoin works, you're probably familiar with the Proof of Work (PoW) mechanism. Under this mechanism, miners record transactions in blocks and compete to solve complex mathematical problems, expanding computational resources to have a chance to add the next block to the chain.
Proof of Work has proven its effectiveness in achieving consensus in decentralized systems. The problem is that it requires a lot of arbitrary computations. The task miners compete on has no value other than securing the network. Many argue that this alone justifies the excess computation. However, one can also ask: are there ways to maintain decentralized consensus without high computational costs?
For this purpose, Proof of Stake was invented. The main idea is that participants can lock up coins (their "deposit"), and at certain intervals, the protocol randomly assigns the right to verify the next block to one of them. Usually, the probability of being chosen is proportional to the amount of locked coins: the more locked coins, the higher the chances.
Thus, what determines which participant will create a block is not based on their ability to solve mathematical problems, as is the case with PoW. Instead, it is determined by how many coins they hold.
It can be assumed that creating blocks through staking allows for a higher degree of scalability for blockchains. This is why the Ethereum network transitioned from PoW to PoS as part of a series of technical upgrades known as ETH 2.0.
Who Created Proof of Stake?
Proof of Stake was first mentioned by Sunny King and Scott Nadal in a 2012 article on the Peercoin peer-to-peer payment system. They described the mechanism as a "peer-to-peer crypto-currency design based on Satoshi Nakamoto's Bitcoin."
The Peercoin network was launched with a hybrid PoW/PoS consensus mechanism, where PoW was primarily used for creating the initial coin supply. However, this solution failed to provide long-term network stability, so its value gradually diminished. Ultimately, most of Peercoin's security was based on PoS.
What Is Delegated Proof of Stake (DPoS)?
An alternative version of this mechanism is Delegated Proof of Stake (DPoS), which was developed in 2014 by Daniel Larimer. It was first used in the BitShares blockchain, but soon other networks adopted this model. Among them are Steem and EOS, which were also created by Larimer.
DPoS allows users to stake their balances as votes, where the voting power is proportional to the amount of coins held by the owner. These votes are then used to select several delegates who manage the blockchain on behalf of their voters, ensuring security and consensus. Usually, staking rewards are distributed among the elected delegates, who then redistribute a portion of the rewards to their voters proportionally to their individual contributions.
The DPoS model allows achieving consensus with fewer validator nodes. Thus, it improves network performance. On the other hand, this can lead to less decentralization, as the network relies on a small, elected group of validator nodes. These validator nodes manage operations and overall blockchain governance. They participate in consensus processes and determine key governance parameters.
In simple terms, DPoS allows users to exert their influence through other network participants.
How Does Staking Work?
As we've discussed earlier, PoW-based systems rely on mining to add new blocks to the blockchain. Unlike PoW, PoS-based chains produce and validate new blocks through the staking process, where validators who have locked up their coins can be randomly selected to create a block. Typically, participants who stake a larger amount of coins have a greater chance of being selected as the next block validators.
This allows for block creation without the use of specialized mining hardware, such as ASICs. While ASIC mining requires significant investment in equipment, staking requires direct investment in the cryptocurrency itself. Thus, instead of competing for the next block through computational work, PoS validators are chosen based on the amount of coins they stake. Coins placed in staking, or the stake, incentivize validators to maintain the network's security. If they fail to do so, their funds may be at risk.
In most Proof of Stake chains, there is a native currency for staking, and some networks use a two-token system to split rewards as compensation.
In practice, staking is simply holding funds in a specialized wallet that allows any user to perform various network functions in exchange for rewards. The mechanism also offers the option of adding funds to a staking pool, which we'll discuss shortly.
How Is Staking Reward Calculated?
There's no short answer here. Each blockchain network may use different methods to calculate staking rewards.
Some networks adjust the reward per block, taking into account various factors. These factors may include:
the amount of coins staked by the validator;
the duration of the validator's active staking;
the total amount of coins staked on the network;
the inflation rate;
among others.
In some networks, staking rewards are determined as a fixed percentage. These rewards are distributed among validators as compensation for inflation. Inflation encourages users to spend coins rather than stake them, which can increase demand for them as a cryptocurrency. Based on this financial model, validators can accurately calculate the staking rewards they can expect.
What Is a Staking Pool?
A staking pool is a group of coin owners who pool their resources to have a higher chance of being selected for block validation and reward. They combine their resources and distribute rewards proportionally to contributions to the pool.
Creating and maintaining a staking pool often requires a lot of time and experience. They are typically most effective in networks where the entry barrier (technical or financial) is relatively high. As a result, many pool providers charge a small fee from staking rewards, which is distributed among participants.
Additionally, pools can provide participants with additional flexibility. This is because the stake must be locked for a certain period and usually has a withdrawal or unstaking period set by the protocol. Also, a significant minimum balance is required to add coins to staking, which serves as a security measure.
Most staking pools offer users a minimum entry amount and do not restrict withdrawals. Thus, joining a staking pool instead of solo staking can be an ideal option for beginners.
What Is Cold Staking?
Cold staking refers to the staking process on a wallet that is not connected to the internet. This can be done using a hardware wallet as well as with a software wallet disconnected from the network.
Networks that support cold staking allow users to stake while keeping their funds safe offline. It is worth noting that if the owner of the funds moves their coins from storage to online mode, they stop receiving rewards.
Cold staking is particularly useful for owners of large sums who want to ensure maximum protection of their funds while supporting the network and earning rewards.
Why Don't All Cryptocurrencies Use Staking?
The use of staking depends on the blockchain network's consensus mechanism. The consensus mechanism determines who in the network has the ability to confirm and verify sent transactions. In PoW-based systems, for example, staking is not part of the block generation process. Currently, most networks utilize some form of proof of stake, making it the most common mechanism.
Summary
Cryptocurrency staking opens up new opportunities for anyone who wants to participate in maintaining and governing blockchains. Moreover, it's an easy way to earn rewards simply by holding digital assets, as staking becomes increasingly accessible and the barriers to entry into the blockchain ecosystem are lowered.
However, it's important to remember that staking is not entirely risk-free. Smart contracts used for locking funds can be prone to errors, so it's always important to DYOR (Do Your Own Research) and use quality wallets.