Cryptocurrency staking explained

Staking means locking up your coins and getting paid for the risk. Let’s examine how it works. You’ll find out that it’s not as hard as you think.

When we think about staking we have to think about risks and incentives. Either we’re talking about securing a decentralized network, or locking up capital in order to support the development of a crypto project, the idea is the same. Staking simply means putting your coins to work and being rewarded for your risk. That’s it. There are many traps and pitfalls along the way. The road of staking is littered with tales of scams and failed projects. This is why any savvy crypto investor should consider staking to be the same as marriage. It’s a long-term commitment and the love has to come from both sides. Let’s take a look at different kinds of staking and how it all works. Roll down the window and enjoy the scenery. It’s going to be a fun ride. 

Proof of work vs Proof of stake 

In the beginning, we only had proof of work. Graphic cards, CPUs ( and later ASIC and FPGA miners ) were joyfully buzzing away, crunching random numbers trying to solve a complicated puzzle to secure a never-ending chain of blocks. Within these blocks, all the transactions were neatly registered and the true consensus in the form of immutable truth was finally achieved. How cool is that? You can send ( or receive ) a payment anywhere in the world and not worry about it arriving safely, because all of those machines agreed that this payment took place. This is immutability in action. 

Lately, however, the environmental whimpering and whining have raised serious concerns about the proof of work consensus and the practice of mining in general. Any crypto OG would tell you that even the smallest part of the classic banking system uses staggeringly more power than the entire Bitcoin network, but unfortunately today’s social media NPC’s are just so easy to influence. The voices of logic, reason, and solid arguments are being trampled by emotional outbursts of politicians, eccentric billionaires, and other mass media puppets. While we know that the proof of work consensus is not harmful to the environment as the bought and paid media claims it to be, the crypto world has to “keep up with the times” and innovate its way out of this sticky situation. Enter the proof of stake or POS consensus mechanism. 

It’s all about risk, remember? In a proof of work system a miner “risks” his hard-earned money on mining machines, spare parts, and electricity to “proof his work” upfront without being sure of any financial gains ( block reward and transaction fees ). If the miner validates a block that’s faulty or is filled with corrupt data, the network will throw this block out and the miner would have run his machines for nothing. It makes financial sense to play by the rules and help the network to be as secure as possible. The risk of having no rewards is always there. 

In a proof of stake system the validator “risks” his capital. He locks up his coins and uses this capital to make sure that the blockchain is running better than a Swiss watch without any corrupted data in the newly produced blocks. The whole network makes sure that ALL participants play by the rules. If a validator tries to pass false or corrupted data, the system won’t reward him/her with a block reward and transaction fees. Furthermore, in some systems, the validator can even be kicked out of the system if he’s not playing by the rules most of the time. 

Let’s not kid ourselves. Both systems of proof of work and proof of stake are not 100% perfect. Proof of work is the best and most bulletproof way of ensuring consensus, but it’s slow as hell. Your IoT Fridge won’t tell you that you are running out of milk if the on-chain transaction is stuck in the mempool and will only be mined in a few minutes or hours. By then you probably won’t go to the store to do your shopping. The proof of work consensus is blazingly fast, but it runs the risk of centralisation. Most POS systems are by no means grandma-friendly and require some serious technical “poking around” in order to understand and use them properly. This is where the “Big dogs” can come in and make staking an “Amazon-like” one-button experience for everyone, centralising the entire network under their wing. Binance smart chain anyone? Let’s take a look at examples of decentralised staking models. 

Decentralized staking 

It’s all about risk, remember? In a decentralised proof of stake system, we are “risking” our capital in order to be a transaction validator ( same as a miner ). Usually, we get what’s called “voting power”. The network participants secure the network by validating new transactions and appending those shiny new crispy blocks to the blockchain. In return for that, the staker gets a financial reward from the network. Pretty simple right? 

Things get a bit more tricky when we talk about masternodes. Don’t let the technical mumbo jumbo throw you off course. A master node simply means a network participant with a certain amount of coins locked up. It can be a few coins ( 32 ETH for Ethereum 2.0 staking system ) or it can be thousands of coins. In proof of work, the miners tend to unite into groups called “mining pools”. This way, they combine the general number-crunching power of their machines and make a better chance of being consistently profitable collecting those sweet ass block rewards and transaction fees. The same logic goes into a “staking pool” or a masternode. There can be one whale calling the shots, or a group of people who chip in all together. This way the stakers can count on more consistent returns over time. 

Doesn’t this masternode witchcraft lead to centralisation?! Not necessarily, because in order to run a masternode one needs to have some serious technical skills, servers that run impeccably well, and, of course, capital to pull off such an ambitious endeavour. Non-tech-savvy people don’t stand a chance at running a masternode on their own. Hence the need for staking pools. 

There are many proofs of stake cryptocurrencies out there. From Polkadot, Cardano, and Neo, to hybrid creations like Dash. What’s cool about Dash, is that it uses both – proof of work consensus for daily wheeling and dealing, while ALSO using a staking pool in order to implement privacy features. Imagine instead of sending a coin from address A to address B ( revealing your transaction on-chain ), the transaction goes into a huge pool of thousands of coins, while your recipient can withdraw any random coin from this pool on the other end. This way Both A and B are happy, while the transaction gets scrambled in the process. 

Over the years we have seen many interesting proofs of stake consensus systems spring up like mushrooms. There is the classic proof of stake system ( POS ), delegated proof of stake ( DPOS ), Byzanthine fault tolerance consensus ( BFT ), proof of authority ( POA ) and merged proof of work and proof of stake systems. With time we will, for sure, see the best ( and the worst ) consensus systems in action. Now let’s take a look at centralised staking. 

Centralized staking 

 

Lately, the concept of yield farming has been on everyone’s lips. Lightning-fast gunslinging DEFI hot heads are borrowing, lending, staking and providing liquidity to their heart’s content just to maximise their yield. It’s been playing out very well for some and disastrous for others. This DEFI space is growing exponentially and there is no sign of slowing down. 

In the centralized space, we also find examples of staking. Many crypto projects that use utility tokens incentivize their users to lock up their capital, actively helping to grow the project as it moves forward and develops. There are several reward programs and countless examples of use cases to be found and it’s worthwhile learning about them as soon as possible. Imagine not needing a bank’s savings account anymore.

It’s crucially important to do your research and due diligence. Remember that staking is just like marriage. You are locking up your funds and the love ( risk and compensation ) comes from both sides. Only work with good quality crypto projects that have a proven track record and have solid fundamentals. If you don’t, god forbid you’ll be locking up your crypto into a new Ponzi scheme like Bitconnect 2.0 or some sketchy cloud mining that would disappear into thin air. Caution is key here.

Centralised staking is also very popular on large exchanges. There are several reward programs out there and many are excellent. Again, it’s a matter of “shopping around” for the right one. Generally, larger exchanges are preferable for this, since the risk of something happening to a large exchange is generally lower. Let’s take a look at a few examples of proof of stake coins and how they operate.

Real-world examples

 

One of the most interesting POS networks that are currently picking up steam is, of course, Polygon’s Matic. It’s a blazingly fast layer 2 scaling solution for the Ethereum network. The MATIC token is very important in the ecosystem and it can be used for staking. There is a handsome bounty for locking up MATIC tokens for a long period of time. It’s important to know that there is a locking period of a minimum of 9 days and that it’s wise not to stake directly, but rather “delegate” your tokens to an already existing validator ( staking pool ) who performs all of the technical wizardries under the hood. Word on the street is that MATIC is quickly growing into an important player in the crypto space and has the potential to bite at the heels of the already big and established projects. Time will tell. 

Binance’s native BNB coin needs no introduction. Being one of the largest crypto exchanges in the world, Binance has positioned itself as being pretty much THE biggest centralised player in the crypto space. Their Binance Smart Chain ( a centralised clone of the Ethereum network ) has been simply vacuuming up liquidity out of the crypto space throughout the entire 2020 and 2021. There are benefits to staking BNB and receiving those sweet trading fees as rewards, but it’s not without risk. Currently, the BSC network is plagued by rug pulls, scams, and all the unsavoury activity that has plagued Ethereum DEFI space back in 2019. Also, the network is centralised and that’s perhaps the biggest risk of all. Caution is advised! 

The last example is no other than Polkadot’s DOT token. Being a massively ambitious project, your grandmother won’t be setting up staking any time soon. The process is notoriously complicated and it requires us to lock up 300 DOT just to become a nominator. At this moment it’s a sizable investment of capital. It helps to poke around in the Polkadot ecosystem and learn everything you can about it because inevitably this tech will get copied like mad, once the parachains go live. Watching it like a hawk would be an understatement. 

There are countless more examples of working networks and crypto projects with active staking at this moment. It’s truly a material that could fit in a book or 2. This is why we have to be active in this space and follow all the developments. These days the whining and one-sided eco-fascists try to pin the blame on the crypto space for all the mortal sins of humanity. Of course, it is self-explanatory that this is just a part of the global agenda. The current powers that don’t want to surrender their financial monopolies, this is why they will hire plenty more naive schoolchildren, biassed reporters, and retired politicians to promote the fairy tales of how the dirty crypto space will gobble up all the electricity in the world. 

As we move along and embrace innovation, it truly helps to set aside some capital and learn how to put it into work in a staking pool. With time the tech will become more intuitive and user-friendly, but now, while setting up a staking operation is so damn difficult, it is precisely where the biggest opportunities lie! It’s truly worthwhile diving deeper into this topic, while inflation is slowly melting our bank accounts. Be advised, it’s not all sunshine and rainbows, so let’s check out the risks associated with staking.

Risks and dangers

 

By now you understand that in the end, it’s all about risk and reward. It’s mentioned in this article many times and you should definitely remember it. 

The systemic risk of your favourite crypto project not making it, is always there. In general, the crypto space is very risky. This is why we have to keep our bullshit radar on high alert at all times. We have to read the whitepapers, join communities and go full-blown “Karen-Mode” on the developers, drilling them with difficult questions. It’s all a part of the game. When you invest in anything, the rules and precautions taken are always similar. This is why we are very active in this space, why we learn and why you are reading this article. 

Perhaps the most important risk of staking is, of course, the human factor called negligence, ignorance, and lack of discipline. We can’t stress this enough. Yes, when you lock up your coins for staking, generally they are pretty safe, but that doesn’t mean you have to go out of your way to ignore the important rules of crypto common sense. Are you using complicated and bulletproof passwords? Do you use a different password on every app and platform? Were your seed phrases, private keys, and passwords written down on at least 3 pieces of paper and kept in different locations? Are you expanding your knowledge on crypto space and tech regularly? 

These are the questions you must ask yourself very often. If you don’t, you’re at risk of making very expensive mistakes. We’ve all been there, and sure as hell, they hurt! That doesn’t mean you should be sitting on the sidelines, while the world of tomorrow is being built today. Cheer up! Crypto is very fun and bustling with daily new developments. It’s more exciting than any Hollywood blockbuster. You have every reason to be here, and you have the front-row seat to join the party.

_______________________________________________________________________________________________________

Risk Note: Trading cryptocurrencies is subject to high risks and may result in the loss of your capital. Please make sure you fully understand the risks associated with trading cryptocurrencies and only invest as much as you can afford to lose. Be clear about your investment objectives and experience, and seek advice from an independent financial advisor if necessary. It is your responsibility to determine whether you are permitted to use Tycoons’s services under the laws of your country of residence. Investments in cryptocurrencies are not protected by a Financial Services Compensation Scheme.