Staking is often associated with passive income. But what does staking mean anyway? How is it related to Proof of Stake?
The crypto market possesses many glossaries not found in other security markets. For a new investor, getting to know the basic terms is very much recommended. In this article, we will learn about staking and Proof of Stake in the crypto market. But before that, we need to discuss their predecessor briefly: the Proof of Work consensus mechanism.
- What is Proof of Work?
- How Is Proof of Stake Different from Proof of Work?
- What is Staking in Crypto?
- Methods of Staking
- How to Be a Validator
- Pros and Cons of Staking
- Things to Consider before You Stake Coins
- Final Words
What is Proof of Work?
Proof of Work (PoW) is a system that is developed to deter cyber-attacks such as dangerous e-mails and spam as well as distributed denial-of-service (DDoS) attacks. The idea behind this protocol originated from Cynthia Dwork and Moni Naor in 1993, before Markus Jakobsson and Ari Juels formulized and coined the term "proof of work" in 1999.
In 2009, an anonymous person or group by the name of Satoshi Nakomoto launched Bitcoin with a PoW consensus mechanism. As Bitcoin is not a decentralized cryptocurrency, transactions are not recorded in a ledger by a central bank. Instead, Bitcoin creates a distributed ledger called blockchain where mining takes place.
Mining is a process by which a transaction is verified in order to generate a new Bitcoin. A mining operation requires a miner with powerful computer nodes since the miner has to solve complex computational problems. The first miner to solve a problem will be rewarded in Bitcoin. Thus, mining becomes highly competitive in nature, as faster mining operation translates to bigger rewards.
Proof of Work was a groundbreaking system when it was first popularized by Bitcoin. But as time passes, its flaws become more apparent, such as the following:
- Mining requires supercomputers that are highly specialized to run the PoW consensus mechanism.
- As the consequence, mining consumes a lot of power, which in turn increases costs such as electricity bills.
- 51% attack: a case when a group of miners control the majority of the computing power, monopolize the whole network, and exploit it. Ultimately, only this group can generate new blocks and receive rewards from them.
Other consensus mechanisms are developed in a bid to eliminate the shortcomings of Proof of Work. Among them, Proof of Stake is the most popular and successful.
How Is Proof of Stake Different from Proof of Work?
Proof of Stake (PoS) replaces some terminologies in Proof of Work, such as mining becomes validation and miner becomes validator. In the PoS consensus mechanism, the number of transactions a person can validate depends on how many coins that person stakes on the platform. For example, if a validator stakes 2% of total coins, he can validate 2% of new blocks generated on the platform.
With this system, the ability to validate transactions does not rely on computing power, but rather on financial power. A validator does not need to operate a high-performance computer, nor does he need a lot of power to run the computer, thus saving costs.
When it comes to the 51% attack, a coalition of validators that seeks to control the PoS network has to own 51% of the total coins on the network. Financially, this is either unfeasible or impossible, making the attack unlikely to occur.
To summarize, here are the key differences between Proof of Work and Proof of Stake:
Proof of Stake is further developed into Delegated Proof of Stake (DPoS) consensus algorithm. In DPoS, a delegator can delegate his COINS and voting rights to a validator who then will validate transactions. The validator's voting power is in proportion to the number of coins delegated.
Since coin holders are not always validators, the DPoS protocol requires fewer validator nodes, thus improving the network performance. However, a limited number of validators also restrict the level of network decentralization.
What is Staking in Crypto?
Staking is a process by which coin holders lock up their coins in a wallet so they can be ed to participate in validating transactions and generating new blocks. In the DPoS consensus mechanism, a crypto holder may also delegate his coins to a validator of his choosing. For their contribution, the staking reward is shared among the crypto holder (as the staker/delegator) and the validator.
Staking is one of the most popular ways of earning passive income. It is quite comparable to a person who holds his money in a bank account in order to receive interest. Interested? First, let's see how staking can be done.
Methods of Staking
You can stake coins in various ways. Whether you possess abundant funds or perhaps lack the necessary operational skills, there is always an option for each staker. The following are six methods of how you can stake coins.
1. Solo Staking
Running your own validator node is perhaps the most profitable way of staking. Since you are both the staker and the validator, you don't have to delegate your own funds and can claim the entire staking rewards. In addition, you will receive validator's fees if other stakers delegate their assets to you.
That said, blockchain platforms always set minimum requirements for someone to be a validator. That's why running your own validator node requires the necessary skills and resources to meet the requirements. If you don't have the capacity for a self-run validator node, staking can be done via third-party validators.
2. Third-party Validator Services
Validator companies provide service of validation on Proof of Stake platforms. This is their specialization, thus they have qualified staff and capable hardware to do the job. Stakers provide funds for a valid node, and the companies handle the node as the validator. In return for their services, third-party providers will charge a fee.
In general, stakers will remain as the custodian of their own funds. Still, if you plan to use their service, you should make your own research on their reliability and trustworthiness. Some of the best third-party validator companies are Staked, Stake2earn, Attestant, Blox Staking, Bison Trails, Blockdaemon, Easynodes, etc.
3. Exchange Staking
Exchange staking is perhaps the least complicated method of staking for retail investors. It involves depositing coins into a crypto exchange where the investor will be rewarded with interest. The exchange then stakes these coins and provides liquidity to the market.
For investors who don't have the funds or knowledge to actively participate on the Proof of Stake platforms, exchange staking provides a simple route to enter the market. In fact, thanks to its simplicity, crypto exchanges are currently the biggest custodian of cryptocurrencies in the market.
Nonetheless, this method possesses its own problem, such as the fact that your coins are in the custody of the exchange and that the exchange fee can be questionable at times. Thus, like a third-party validator, you would want to learn more about an exchange service before investing your funds. Here are some of the best exchanges in the market: Binance, Coinbase, MXC, Kraken, AscenDEX, etc.
4. Staking Pools
Staking pools allow a group of coin holders to combine their resources so that they can improve their chance of validating transactions and earning rewards. The validation process is undertaken by a stake pool operator who will charge a fee in return. Any coin holder can stake their assets with the operator and receive proportional staking rewards from it.
Staking pools usually have a larger number of coins staked compared to stakers who run their own validator node (solo staking). In addition, staking pools tend to have high-performing hardware and software to run a validation process. In short, staking pools are more likely to be ed as the transaction validator.
Your task before using staking pools is to verify the reliability and trustworthiness of the pool. Some of the staking pools you can make research on are Stakewise Pool, Stkr, Rocket Pool, Lido Finance, Stakehound, StakeDAO, etc.
5. Cold Staking
Cold Staking is staking through a cold wallet i.e. the wallet that is not connected to the internet. When you use cold staking, you can still stake your coins despite storing them offline. Networks that support cold staking will give rewards to long-term coin holders. They will also maximize protection on larger funds in the wallet.
The opposite of a cold wallet is a hot wallet which is always online. Most blockchain networks use a hot wallet thanks to its ability for immediate coin transfers. However, it is also prone to hacking as the wallet is connected to the network at all times. Cold wallets, on the other hand, are more secure but at the cost of a slower transfer process.
Cold staking can be done through either hardware or software wallets. Some well-known hardware cold wallets are Ledger Wallet, Trezor Wallet, and CoolWallet S. For software ones, you may consider Atomic Wallet, Exodus, and Trust Wallet.
6. DeFi Staking
Alternatively, you can also stake coins on DApps (Decentralized Applications) which apply DeFi (Decentralized Finance) protocols on PoS platforms. DApps are a decentralized, open source, non-custodial system where the protocol is fueled by a governance coin.
In DeFi Staking, you need to own the governance coin and stake it on the same network. You will earn staking rewards from this. Some DApps, however, may not require the users to stake coins in order to govern the platform.
How to Be a Validator
The requirements for a validator vary among blockchain networks that run the Proof of Stake consensus mechanism. To give some idea, below we provide you with different validator requirements set by three of the most well-known PoS platforms.
Ethereum, one of the largest crypto by market capitalization, originally run Proof of Work before switching to Proof of Stake. This transition allows its user to stake ETH to the network.
Below are the requirements for running a validator node:
- Knowledge in storing data, processing transactions, and adding new blocks to the blockchain.
- A computer that can run an Eth1 and Eth2 node.
- A deposit of 32 ETH to activate validator software.
- Approval from the platform; you may wait very long for this.
Cardano is a network founded by Ethereum's co-founder Charles Hoskinson. Cardano allows its users to be a stake pool operator, stake pool owner, or both. To be an operator, the platform requires:
- Operational knowledge of how to set up, run and maintain the node continuously.
- A 24/7/365 commitment to maintaining the node.
- System operation and server administration skills.
- Experience in development and operations (DevOps) is a plus point.
- Computer requirement: 8 GB of RAM, 24 GB of hard disk space. Processor speed is an insignificant factor.
- A good network connection and about 1 GB of bandwidth per hour.
- A public IP4 address.
Polkadot was created in 2016 by Gavin Wood, also a co-founder of Ethereum. Unlike other platforms, Polkadot's rewards to validators are equal regardless of the stake. When rewards are proportional to stakes, users tend to stake their funds to a big pool to increase their chance of getting rewards. However, in an equal reward system, staking coins to a big pool will reduce the reward for each staker. Thus, this helps prevent a concentration of coins and authority in one big pool.
Here is what it takes to be a validator on Polkadot:
- System operation and server administration skills.
- The minimum stake is versatile, depending on various factors such as the stake being put behind each validator, the size of the active set, and how long is the waiting list.
- Standard hardware set-up:
- CPU Intel(R) Core(TM) i7-7700K CPU @ 4.20GHz
- Storage: NVMe SSD 80GB – 160GB for the first six months. However, the size should be re-evaluated every six months.
- Memory: 64GB
Pros and Cons of Staking
From the discussion above, we can infer that staking has its benefits and drawbacks. Let's take a look at some of the pros and cons of staking.
- Staking provides passive income, particularly for non-validator stakers.
- Staking is a relatively easy process and it does not require supercomputers, as opposed to mining in Proof of Work.
- Staking is more secure as it is less vulnerable to 51% attacks.
- The cold staking method uses cold wallets (offline), making the funds extra safe.
- Several staking pools allow derivative coins in order to provide liquidity to stakers.
- Non-validator stakers have to share their stake rewards with validators. What's more, staking pool operators may also charge additional fees.
- There is usually a lock-in period for staking coins, meaning that stakers will not be able to withdraw the stakes midway through the period. This can especially inflict substantial losses if the crypto (which is infamous for its volatility) loses its value and there is nothing stakers can do to stop their losses.
- As we have discussed earlier, exchanges are the biggest custodian of coins in the market. In recent years, staking exchanges have been converted into investment banks, thus forming a central authority for the market. This is against the very principle of decentralization of the crypto market.
- Stakers who do not hold custody of their funds may lose their funds altogether if the exchange or wallet is attacked.
- Stakers may also lose their funds if their validator is slashed for misbehaving or violating the protocol.
- Staking micro-cap coins i.e. coins with a small market capitalization and low liquidity is a risky business. It may be difficult to sell your staking returns into other cryptocurrencies.
- Big staking pools with a large amount of coins and big voting power may create centralization amongst the validators.
Things to Consider before You Stake Coins
- Wallet (hot or cold), exchange, staking pool, and validator: whichever method you choose for staking your coins, you have to thoroughly investigate their reliability, authenticity, trustworthiness, track record, and competence.
- Lock-up period: the period in which stakers are prohibited from selling their coins in order to preserve liquidity. Stacking without a lock-up period is a way to minimize the risk.
- Fee: validators or even staking pools will charge fees for their services, which will be deducted from your staking rewards.
- Fund custodian: it is of course preferable to stake coins where you have private keys to your wallet instead of leaving the funds to custodial services.
- Coin liquidity: coins with high trading volumes can minimize risks associated with low liquidity.
See also: Best Performing Cryptocurrencies
Proof of Stake consensus mechanism increasingly becomes the only main competitor of Bitcoin's Proof of Work. It is energy-efficient, relatively easy, and offers an opportunity to earn passive income through staking.
But as attractive as staking may sound, you have to take precautionary measures such as researching the platform, validator, exchange, etc. Also, always remember that crypto is very volatile. There is always a chance that you lose your fund instead.