Nearly every investor longs for a stream of passive income, a way to earn lots of money while lounging on a beach sipping pink drinks. In other words, doing very little. Can staking crypto provide that opportunity?
What Is Staking Crypto?
Staking provides crypto holders (stakers) a way to earn rewards by locking up a portion of their cryptocurrency, said Vikas Agarwal, financial crimes unit leader at PwC. Staking enables crypto holders to earn rewards in the form of interest, or more crypto, without having to sell/trade their cryptocurrency. Staking is a passive investment because other than the initial staking, it requires no action on the part of the investor, Agarwal said.
What Is Proof-of-Stake?
If it sounds like a traditional way to earn passive income, along the lines of parking money in an interest-bearing bank account or certificate of deposit, it is, but with a few differences.
To start, the assets are used differently. When investors keep money in an interest-bearing account or CD, banks use that money for loans and other purposes. When crypto investors stake crypto, their holdings remain in place to verify transactions and keep the blockchain secure. This is necessary because crypto is decentralized. “It’s a distributed network of computers, and those computers are all over the world,” said Robert Brunner, associate dean for innovation, chief disruption officer, professor of accountancy and Arthur Andersen Faculty Fellow at the University of Illinois Urbana–Champaign.
Second, crypto stakers can earn much higher interest rates, as high as 20 percent, by staking, where traditional forms earn in the low- to mid single digits. “You could make a lot of money,” Brunner said, adding that staking is hardly risk-free.
One of those risks, in fact, is the largely unregulated crypto market. Funds stashed in traditional banks are protected by the Federal Deposit Insurance Corporation, established in 1933 after the bank runs of the Great Depression. The FDIC insures bank deposits up to a certain amount, and was formed to encourage trust in the country’s banking system.
Crypto has no such protection mechanism in the United States, though the European Union enacted some regulations in the summer of 2022. The lack of protection leaves investors somewhat exposed, but also encourages the innovation that crypto is known for, he added. “Some sense a little bit of the Wild West,” he said.
5 Staking Crypto Terms to Know
- Lock-up: The time frame, ranging on average from three to six months, during which assets must remain staked in order to earn rewards. Crypto holders don’t have access to their assets during the lock-up period.
- Proof of stake: The consensus mechanism some blockchains use to verify transactions and the security of the blockchain. Staking can only take place on blockchains that use proof of stake.
- Slashing: The burning or deletion of staked assets when a validator node goes offline.
- Staking: Committing crypto to a blockchain for a certain period of time to earn rewards and ensure the stability and security of the blockchain.
- Validator node: A place on the blockchain on which staked crypto is held. Users can build and run their own validator nodes or use staking-as-a-service (SaaS) or validator-as-a-service (Vaas) companies, which run validator nodes for stakers. SaaS and Vaas services usually charge a fee or take a percentage of the interest earned on the staked assets.
History of Staking
To understand staking, it’s necessary to understand consensus mechanisms, the tools blockchains use to verify transactions and the security of the blockchain. The very first blockchains were secured by a mechanism called proof of work, or PoW. Crypto miners solved mathematical problems to add blocks to the blockchain and keep it secure and stable.
Proof of work, however, required mining, the energy-intensive computer work that gives cryptocurrency its reputation as an energy hog. In 2012, the pseudonymous Sunny King pioneered proof of stake. Proof of stake, or PoS, requires staking currency, rather than mining for it, to secure the blockchain and verify transactions. King’s and Nadal’s Peercoin (PPC) was the first cryptocurrency to use proof of stake. Proof of stake is not only a greener method of running a blockchain, it’s also more user-friendly as it rewards stakers, said Agarwal of PwC.
What Cryptocurrencies Can You Stake?
As the name suggests, only cryptocurrencies that use proof of stake as a consensus mechanism can be staked. About 80 cryptocurrencies use proof of stake, according to this Forbes article.
Notable exceptions include the world’s two biggest cryptocurrencies by market capitalization — Bitcoin and Ethereum, both of which use proof of work. That is expected to change in the third quarter of 2022 with The Merge, a much-anticipated move by Ethereum to transition to proof of stake, Agarwal explained. “This shift will not only increase rewards to the stakers, but also address the environmental concerns related to mining,” he said.
How Does Staking Crypto Work?
To start staking, users commit assets to a smart contract (its terms are embedded in the blockchain and the contract is executed automatically when the terms are met) in a given crypto protocol, said Adam Adler, co-founder and head of creative at Myntr, a full-service NFT agency based in New York. Currencies usually require a minimum: For Ethereum 2.0, it’s 32 ETH coins and for Polkadot, it’s 160 DOT tokens.
The next step is getting the equipment in place. A desktop or laptop computer suffices for most people, the exception being those who want to run their own validator nodes. Users can start staking once the validator node is online.
That process, much riskier, requires advanced computer knowledge to configure and set up the node, said Agarwal of PwC. Other options that do not require establishing and maintaining a validator node include using exchanges, such as Coinbase, to stake, or joining staking pools offered by some cryptocurrencies. Users pay for the convenience and safety of using a validator-as-a-service, and in staking pools, the rewards can be smaller because they’re divided among everyone in the pool.
Crypto stakers retain possession of the assets in their crypto wallets, but do not have access to those assets. They are off limits during what’s known as a lockup period, which can span anywhere from three to six months, Adler said.
Benefits of Staking Coins
The top benefit? Raking in that passive income.
“The main reason to stake crypto is to receive more crypto,” Adler said. Interest rates, or annual percentage yield (APY) can range from the low single digits to the mid double digits, depending on the currency and the exchange.
Another reason: “Unlike mining, crypto staking does not require advanced equipment and costly computing resources to earn passive income,” he said. “One can get started online with only a few clicks. With major crypto exchanges now offering staking, users do not need tons of crypto to get started.”
“One can get started online with only a few clicks. With major crypto exchanges now offering staking, users do not need tons of crypto to get started.”
It’s also a greener way to dabble in crypto. “Compared to mining, staking has minimal impact on the environment,” Adler said. “This is why many blockchains (such as Ethereum) are transitioning from PoW to PoS to reduce their carbon footprint.”
Risks of Staking Coins
Here’s the biggest one: Losing money. “Tokens can lose value over time, and given the nascency of the crypto space, hacking/scams as well as the risk of an unknown flaw in the underlying smart contracts that secure the token introduces the possibility of stolen or lost tokens,” said Asad Khaliq, cofounder of Acrew Capital, a San Francisco-based venture capital company.
“Another is the volatility of the crypto market. Bear market volatility can cause token prices to decrease sharply,” Khaliq said. “However, certain protocols with strong usage, revenue generation, or cash-flow capture can still be strong investments, particularly in the longer term,” he said.
Staking also requires users to lock up their assets for a minimum amount of time, during which the assets cannot be sold or unlocked, even if the price drops precipitously. In that way, staking is unlike the stock market, where shareholders could conceivably sell if the market starts to tank.
Staking poses a particular risk for stakers who use their own validator node. The node must be constantly and consistently online; penalties for a node going offline can be steep. Going offline could indicate nefarious activity, and when it happens, validators are punished with a mechanism called slashing.
That means that a portion of their holdings are destroyed, and the validator is eventually kicked off the chain. “Notably, slashing is irreversible, meaning that users will have to generate new validator keys and deposit new stakes if they want to continue validating after being slashed,” Adler said.
How to Start Staking Crypto
It sounds easy: Buy crypto. Stake it. Reap rewards. That can happen — or crypto staking can lead to financial disaster. Here are four pieces of advice for newbie stakers.
Start Small
New to crypto? “Don’t invest a huge amount of money,” said Brunner of U of I. “Play around a little bit before you dive in,” he said, suggesting $10 or $20 as a starting point.
Some crypto trading platforms offer users a way to earn currency, for instance by taking quizzes, and then stake those earnings. Coinbase, for example, enables users to take tutorials about crypto and earn coins for each module they pass.
Do Your Own Research
“DYOR!” Adler said, echoing the mantra of Web3. “The market is constantly changing and evolving, so you must stay in the loop to make sound investing decisions.”
Find out which blockchain suits you and your investment requirements, including the lock-up periods and rewards. These vary from chain to chain, and can and will shift as more crypto is staked, Adler said. “Be proactive in your research about blockchains and their deficiencies, as they all have at least one.”
“Be proactive in your research about blockchains and their deficiencies, as they all have at least one.”
Be Aware of Lockup Dates
Always know how long you have to invest your coins into the system, Adler said. Many exchanges do offer the option to have shorter lock-up periods, but that cuts into potential long-term earnings. And remember, you have no access to your assets during that period, even if the market begins to nosedive.
Understand How Staking Works
“As the lines between technology and banking blur over the coming years, it is essential to understand how these protocols work and their economics,” Adler said. Sure enough, dozens, if not hundreds, of cryptocurrencies have vanished over the past year due to the bear market as well as iffy economics. “It is also important to keep up to date on regulations as crypto continues to evolve and change the finance industry,” he said.
Is Crypto Staking Profitable?
The answer is yes, staking can be profitable — many a multimillionaire was minted during the most recent crypto bull market. It can also be unprofitable, as the recent bear market erased much of that wealth.
Remember, too, that rewards from crypto staking are treated as income, and taxable. Brunner, the University of Illinois professor, heard a podcast presented by a tax software startup whose biggest client was the Internal Revenue Service, which wanted help figuring out who was making money on the blockchain, but perhaps not reporting that income.
So the question remains: To stake or not to stake? Brunner, for one, is a fan of at least dipping a toe into cryptocurrency. “Blockchains have the potential to bank the unbanked around the world,” he said, noting the ease of getting loans and transferring money that crypto provides. “It’s pretty powerful technology, and it’s also pretty scary because it’s so new and different,” he said. “I think it’s important that if people have the time and the interest, they should try.”
Good luck, and see you in Tahiti.
