What is staking?

The word ‘stake’ refers to a personal interest or involvement in a specific matter, typically that comes with a significant consequence or outcome. It can represent a financial investment, a claim, or a share of ownership in something like a company or property. When an individual has a stake in something, there is a vested interest in whether it succeeds or fails. There’s an implied level of commitment and responsibility, and on the other side the potential to gain or lose something in association with the specific matter. 

If we put this definition into the context of cryptocurrency, staking is the process of participating in the validation of transactions on a Proof-of-Stake (PoS) blockchain. Put simply, for many crypto users staking can be viewed as a way of earning rewards whilst holding onto specific types of cryptocurrencies. For example, ETH is a cryptocurrency that can be staked.  

It is also worth noting that some projects provide staking as a method of distributing rewards to tokenholders; however, this lesson focuses on the staking approach for Layer 1 PoS blockchains.

For many crypto users, staking is known as a way to earn rewards whilst holding onto specific cryptocurrencies. Some examples of blockchains where you can stake their cryptocurrency include; Ethereum, Cosmos, Tezos and Solana. Essentially, a cryptocurrency can earn rewards whilst it is staked as the blockchain is putting it to work, but how does this actually work?

Put simply, staking is the process of participating in a blockchain network by locking up a certain amount of cryptocurrency to support network operations, such as validating transactions in exchange for rewards. In this example, the rewards are paid out in the respective cryptocurrency e.g. Ethereum would pay out in ETH, and Cosmos would pay out in ATOM. 

Cryptocurrencies that allow staking leverage a PoS consensus mechanism, which is the way in which the blockchain ensures all transactions are verified and secured without the need of a third party. If you choose to stake your crypto, in association with the respective blockchain, such as ETH for Ethereum, then you become a part of that process. In this sense, staking can be seen as a way to contribute to the security and efficiency of the blockchain project you choose to support, as in staking some of your crypto you help make the blockchain more resistant to attacks and enhance the ability for it to process transactions. 

Generally, staking is open to anyone who wants to participate. However, becoming a full validator has requirements, such as; a minimum amount of tokens staked, a high degree of technical expertise and dedicated computer equipment to consistently execute validations without downtime. This level of participation comes with a serious commitment and obligation, both from a security perspective and time commitment, as any downtime can result in a validators stake being slashed. To shed more light on validators, let’s understand more about PoS and the selection of validators. 

In a PoS consensus mechanism validators are chosen to create and validate new blocks based on the amount of their own cryptocurrency they are willing to stake as collateral. Selecting a  validator takes into consideration both the amount of cryptocurrency staked, and the amount of time it has been staked. This approach is designed to ensure validators have a vested interest in maintaining the integrity of the network.

Unlike a PoW mechanism, that leverages a more competitive rewards-based mechanism, although PoS doesn’t directly involve competition in solving cryptographic puzzles, validators are competing to validate the blocks based on their stake and performance in the network itself.

The concept of PoS and staking originated as a response to the limitations associated with the Proof-of -Work (PoW) consensus mechanism. First proposed by Sunny King and Scott Nadal for Peercoin in 2012, PoS has since evolved and been adopted by numerous blockchain projects. 

The main objective of PoS systems is to improve energy efficiency, reduce centralization risks, and incentivizing participants (staking rewards) in exchange for network security has driven its growing popularity.

For example, Ethereum requires a minimum stake of 32 ether (ETH) in order to be considered as a validator node within the network. Meaning, just like for PoW there is a direct relationship between the computational power a miner has and their chances of successfully mining a new block, there’s a similar relationship between the amount of crypto staked and the chances of being selected as a validator. 

To further expand on the selection of validators, there’s a mix of criteria:

1. Staked balance: Typically, the higher the amount of cryptocurrency a validator has staked, the higher the chances that they’ll be chosen to validate a block of transactions. However, it must be noted that some protocols have built in randomisation to ensure that those who have staked a smaller balance also have the opportunity to earn staking rewards.

2. Random selection: Some protocols will use a degree of randomness to select a validator, in an attempt to  give all participants a chance to earn a reward for validating transactions. This approach is executed by using cryptographic techniques.

3. Coin age: More often than not, when the holder of staked tokens spans over a long period of time the chances of them being chosen to create new blocks increases. This is what is known as ‘coin age’, calculated by multiplying the time period (in days) that the individual has staked their assets by the number of staked coins. We must note that once a validator has been chosen, the coin age is instantly reset to 0.

 

Advantages:

• Earning Rewards: The key benefit is predominantly the potential to earn rewards on your staked holdings. The balance between holding and staking crypto enables individuals to earn rewards based on holdings that otherwise wouldn’t have created additional returns. Most importantly, it provides the opportunity to earn revenue on their holdings without the requirement of selling the asset itself. 
• Lower barriers to Entry: Unlike with a PoW blockchain, a PoS system doesn’t require the same degree of investment in order to participate as a validator. Meaning, it’s a more accessible and potentially cheaper option as no mining equipment is required. Typically, a PoS protocol can run using a more standard computer GPU, as opposed to the ASIC machines a PoW miner would require.
• Reduce Energy Consumption: PoS requires less energy to validate when compared to PoW. In this regard it is often considered as being more environmentally friendly.
• Passive Income: Staking provides a sustainable way to earn passive income by contributing to the security and efficiency of blockchain networks.

Disadvantages:

• Risk of Loss: There is always a risk of loss when you stake your cryptocurrency. If we consider that the cryptocurrency is locked up for a certain period of time, the value of the staked coins may fluctuate. If the cryptocurrency drops in value significantly during the staked period, it may result in a loss of value when compared to simply holding the coin. 
• Opportunity cost: Similar to risk of loss, there’s also an opportunity cost between staking your holding and as a result not being able to use those same funds to pursue an alternative investment or asset that could offer higher returns.
• Lock Up period: Some staking protocols require stakers to lock up their assets for a certain period, during which they may not be able to access or sell them. This lack of liquidity can be a disadvantage for investors who may need to liquidate their holdings quickly.
• Technical Complexity: Though the process can be considered as less intense from a computation set up perspective when compared to PoW, the degree of technical complexity is not simple for a PoS staking operation. The individual must understand how to create a staking wallet, manage their staked funds and handle any issues that could arise.
• Protocol Risk: For some protocols, staking can expose stakers to risks such as bugs, vulnerabilities, or governance issues within the protocol. In the event of a protocol failure or exploit, stakers could lose their staked assets.
• Centralization Risk: Similarly, although some PoS systems use a more random approach to select validators, it is known that typically a small number of validators with a significant stake can have more control over the network as they have a higher chance of being chosen to validate transactions. With this understanding it can be thought that it also has the potential to compromise the decentralized nature and security of the blockchain, as a smaller number of validators appear to have more significant control over the network.