17 March 2021| ZebPay Trade-Desk
The Basics of Staking
In simple terms, it is safe to say that Staking creates a new means through which existing token holders can earn a return on their cryptocurrencies, in the form of even more tokens. As the industry has matured, blockchains have evolved, from being based on Proof of Work (PoW) to Proof of Stake (PoS) concepts. In essence, this means that the validity of transactions in PoS blockchains is determined by the people who lock a certain predefined amount of the cryptocurrency in the protocol. This process, called “staking” allows holders of the token to earn a ‘staking reward’ for participating in the network. Staking is becoming an increasingly popular tool in the crypto community. In fact, more than $1bn dollars worth of crypto has been staked in Kraken’s platform alone, while Binance, Huobi, and other major exchanges also hold upwards of $700mn in staked crypto assets. Meanwhile, the total assets staked in DeFi platforms amount to ~$23bn in January 2021.
Staking is based on the PoS concept. PoS provides those with staked tokens on the network the right to earn rewards for validating blocks. In contrast, PoW, the consensus model used by Bitcoin (BTC), assigns block confirmation rights to those with the largest amount of computing power at their disposal. Put simply, ‘staking’ means locking crypto assets in a PoS blockchain for a certain time period. Once locked, these assets are used to achieve consensus, which is used to secure and validate every new transaction on the blockchain network. The ones who stake their coins on the PoS blockchain are called “validators.” As a reward for locking their assets and providing services to the blockchain, validators are given new coins from the network. On these types of blockchains, anyone holding the minimum required balance of a specific cryptocurrency can validate transactions and earn staking rewards. The typical staking process involves locking the minimum balance, after which a node will deposit that amount of cryptocurrency into the network as a stake, like a security deposit. The size of a stake (minimum balance) is usually directly proportional to the odd of that particular node being chosen to forge the next block. If the node is then able to successfully create a block, the validator will receive a reward, in the form of additional tokens. However, validators will lose part of their stake if they attempt to hack or attack the network in any which way. A few blockchains have a significantly longer lockup period and certain minimum thresholds for staking. As a way around this, some holders of crypto assets prefer to use staking pools. Tezos for example has a built-in mechanism that allows users who don’t want to be validators to delegate their coins to a validator on the network. This validator then performs the tasks associated with staking and shares the reward with their delegators.
As staking has become more mainstream over the past few years, many options for users who want to earn passive income with their idle crypto-assets have emerged. We will briefly touch upon a few of these, though there is a large spread of staking networks to choose from. Ethereum 2.0, is probably the most spoken about when it comes to staking, since Ethereum is the second-most popular cryptocurrency platform to date, by market capitalization. In order to stake on ETH 2.0, one needs to own a minimum of 32 ETH, as well the Eth1 mainnet client. We have covered the concept and functionality of ETH 2.0 in much detail in our previous report on ETH 2.0. Tezos came to life in 2018, with the biggest initial coin offering (ICO) of over $230 million in investment. It runs on a PoS system called liquid proof-of-stake (LPoS). Tezos’ native currency is called XTZ and the staking process is termed “baking.” Bakers are rewarded using XTZ. Malicious bakers are penalized by having their stake confiscated. To become a baker on Tezos, one must hold 8,000 XTZ coins, though in recent times third party vendors have emerged that run staking pools which allow users with a smaller amount of holding to also participate. Another example is the popular Algorand. ALGO’s provides low-cost cross-border payments. Like any PoS protocol, the network relies on stakers to process transactions in a secure fashion. Staking rewards on these networks are typically between 5%-10% annually and tend to be influenced by the platform used. Today, anyone can stake their idle tokens, as long as they meet the basic requirements of the network. There are also various DeFi staking alternatives. Maker (MKR) platform allows users to borrow stablecoins against a volatile cryptocurrency such as Bitcoin and Ethereum. Yearn Finance protocol is a DeFi aggregator. Hence, instead of facilitating lending and borrowing, it will deposit funds into platforms with the best yields and lower risk profiles. Compound allows users to borrow and lend a small range of cryptocurrencies such as ETH, USDC, BAT, and DAI. The COMP platform uses lending pools and charges interest on loans. Most exchanges have jumped into the staking business, thanks to the interest of their many users. Through staking, users tend to diversify their income stream and monetize their idle funds on exchanges.
Outlook and Conclusion:
A large number of big PoS projects are expected to go live in 2021, and hence the staking market does seem to have strong potential for growth. Ethereum’s move to PoS, with ETH 2.0, in particular brings with it great expectations and avenues for growth. Currently staking rates vary, depending on which PoS blockchain it operates on. For example, in Tezos and Cosmos, they can go as high as 80%. At the same time, for some smaller networks, it can be as low as 10%. How these rates change in the future, will be something to keep an eye out for. In addition, the development of staking is also largely dependent on the dynamic of the lending/borrowing market, and how it operates.
Staking allows users to benefit from the opportunity to generate income from holding crypto and be active participants in their favorite blockchain projects. However, users have to lock up their cryptocurrency holdings for a certain amount of time which means that if there’s a sudden market crash, they won’t be able to pull their crypto out of the staking program to sell and hence not be able to mitigate any losses. Moreover, with staking pools, users need to be aware that someone else may be taking custody of their cryptocurrencies, and that comes with some risk.
In closing, when choosing how to allocate their coins, investors must weigh the potential returns and risks of the alternative options. Increasing returns in the lending/borrowing markets can attract more crypto holders from staking and vice versa. But with all things considered, staking on blockchains is certainly a very dynamic part of the wider crypto and blockchain space, and does seem like it is here to stay.
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