Staking Explained

Table of Contents

April 15, 2022 5 min read

Staking Explained

Staking, in simple terms, is a way of verifying transactions on a blockchain network and earning rewards on the cryptocurrencies that you hold. However, to better understand it, we need to delve a little deeper..

Validating transactions on a Blockchain Network

Bitcoin and other cryptocurrencies allow individuals and entities to exchange money without the need or interference of any other central authority. This is possible due to the framework of a blockchain network which notifies the entire network when a transaction takes place. Nodes on the network then proceed to verify and validate the transaction if it meets the necessary protocol requirements.

Proof of Work (PoW)

One way to validate these transactions is the Proof of Work (PoW) consensus algorithm. PoW involves “miners” confirming transactions by solving complicated mathematical puzzles (mining), which requires huge amounts of processing power. It is a trustworthy and reliable way of securing the network and maintaining decentralization. However, it is extremely resource intensive and requires setting up devices with very high computational power that consume large amounts of electricity.  Proof Work consensus algorithms have scalability issues when used by blockchain networks with heavy transactions such as Ethereum wherein multiple applications are supported on the protocol. The process of validating using Proof of Work consensus algorithm can cause longer transaction times and higher transaction fees i.e gas fees.

Proof of Stake (PoS)

Proof of Stake (PoS) is a popular alternative to Proof of Work (PoW) (introduced in 2011) that blockchain networks have started using recently to validate their transactions. A PoS consensus algorithm allows people on the blockchain network to lock a certain amount of their cryptocurrency holdings into a node (staking).  Transactions are verified and validated by using the amount staked to secure the network by the very people who have invested in the blockchain when they choose to stake their coins.

Benefits of Proof of Stake consensus mechanism

The Proof of Stake consensus algorithm has several benefits for the participants on the network in terms of rewards on their holdings as well as for the entire network itself in terms of security and stability.

  • Enables more users to become participants in validating and verifying transactions. The barriers to entry are low because users can easily stake their holdings either directly or through staking pools to stand a chance at becoming validators and earning rewards on their funds.
  • One of the main benefits is the significant reduction in the consumption of energy. It is an eco-friendly alternative to Proof of Work consensus as it does not require complex hardware with high computational power to validate transactions.
  • Proof of Stake consensus improves decentralization on the network as more nodes are able to stake their holdings and participate in the validation process.

How does Staking work?

A node or validator’s goal is to add a new block to the chain depending on certain factors. These include the total amount of funds that’s being staked and how long it has been staked for. The validators are selected by the network through a randomized selection process and based on the age of the staked coins. The randomization element ensures that no node has a monopoly over forging a new block.

Each individual’s staked coin/ tokens helps in legitimizing new transactions that are added to the chain for which they’re rewarded periodically. Different cryptocurrencies may have their own set of rules and reward mechanisms depending on what they feel is the best for their users.

Staking is looked at as a way to generate rewards off of the crypto that you plan to hold. Instead of keeping your holdings dormant in your wallet, you can actively invest into the community and help validate, secure and improve efficiency of transactions while making a sweet reward over a period of time.

Hurdles in Staking

Much like trading Crypto, it does come with a few concerns.

  • Volatility of the coin that you stake. If prices plummet quickly, it becomes a less profitable avenue.
  • The Lock-in or Vesting period of the coin. In some cases, coins are required to be staked for a minimum period which means you won’t be able to transact them till this time-frame is done.
  • Unstaking or liquidating your staked coins may take more than a week in some instances, it is important to study specific rules before you decide to take the plunge.
  • If one has staked all their holdings, their tokens get locked with the blockchain and they will be unable to trade or invest in other cryptos on exchanges.

What is Liquid Staking?

Liquid Staking is an alternative that allows users to unstake/ liquidate their tokens without a lock in period. One can essentially stake and unstake any amount of their token almost immediately.

The main benefit of liquid staking is that it allows you to get the best of both worlds. You can make your return on the staked tokens and also explore new investment opportunities in the space. This is possible by tokenizing the stakes, which can then be used to trade freely amongst other users, on exchanges or even on other blockchains. This opens up a world of opportunities in the Defi Space. Projects in the space are increasingly coming out with Liquid Staking enabled so that more users can stake, tokenize and use it to invest in other DApps. This helps build and grow the ecosystem faster.

Future of Staking

Staking is still in its nascent phase and is steadily gaining momentum in the crypto sector. It has proven to be an efficient way of improving participation of users within the network. Staking also allows users to take part in consensus and governance mechanisms of the protocol. It holds the potential to revamp the financial framework through which users earn passive income by simply locking in their funds with the protocol. With the success of spin-off processes of Staking such as liquid staking and cold staking, more and more innovation can lead to the emergence of highly dynamic decentralized finance ecosystems with improved resilience, security, stability and efficiency of capital management.

With total assets staked in Decentralized Finance Platforms amounting to around $24 Billion as on April 2022, the future of staked assets has been estimated to dramatically grow to around $40 Billion in rewards by 2025 by finance analysts. Staking is becoming an attractive alternative for investors to earn returns on their holdings and with growth and experimentation on this model over time, staking can lead to more robust, secure and stable blockchain protocols.

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