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What is staking and what are its benefits

By Inkarias - 2020-10-25

Staking is the process of holding funds in a crypto wallet to support the operations of a blockchain network. Basically it's all about locking down crypto-assets to receive rewards frequently and for a mid or long-term vision or interest.

In most cases, projects use staking as a method to encourage users to participate in the functioning of the blockchain. The primary interest for users is of course the search for profit. Mostly, the rewards of staking are linked to cryptocurrencies with a certain volatility and this can be risky for the investor. The concept of staking is directly linked to the consensus of Proof of Stake (PoS) and in its many variants currently on the market. The primary goal of this consensus protocol is to considerably reduce the energy expenditure generated by the maintenance of its blockchain while ensuring acceptable security and improved scalability. More and more projects are using or switching to this consensus, but some of them have created their own version of PoS by adding or modifying some of its native features. This is particularly the case with Tomochain's Proof of Stake voting (PoSv) (TOMO) and Delegated Proof of Stake (DPoS) used by EOS for example.

In technical terms , POS is an algorithm that uses a pseudo-random selection process to designate a node as the next block validator, based on a combination of factors that encompass staking time, node prosperity, and randomness.

Intrinsic responsibilities and constraints of participants with staking or POS variants

For those wishing to fully invest in staking and become a full node of the network, the constraints can be numerous and diversified. We will discover in the last part that an alternative exists, however, so that everyone can access staking. These responsibilities and constraints are therefore exclusive to the owners of nodes.

Governance

In the case of some blockchains, obtaining the right to participate in the governance process can represent a real burden for the participants. For example, a staking participant may need to communicate with other node owners to develop blockchain-wide standards and best practices, participate in governance teleconferences as well as discussions on online forums. Anonymity can be preserved, but a node owner who does not integrate into the life of the community can have difficulties in the future.

Being a node owner

The process of qualifying to become a node of a blockchain can come with considerable costs. Depending on the project, there may be an application form, registration fee as well as a security deposit that future validators must deposit before they are eligible to deploy their node. According to several researchs made by top crypto companies or exchanges there is also a fairly rigorous technical aspect to respect to succeed. In the event that a user wishes to deploy a node on the network, significant costs are to be expected in order to provide a with sufficiently powerful and suitable hardware or a computing instance.

Technical aspects and possible difficulties

Node operators are generally required to maintain constant availability. In some cases, failure to meet these requirements may also result in penalties. Running a node typically requires specific security measures that can cost more than the compute resources themselves. In the event that the operator decides to manage his node locally, he will for example have to set up his own security with VPNs, a powerful firewall, private connections, etc which can generate extra costs over time. Running a full node is not within everyone's reach, both financially and technically. Fortunately for us, the door to staking does not close there and there are other means available for average users to take advantage of as well. However, staking also has its own risks and limitations.

The risks and limitations of staking

Risks

Like any type of financial investment, and more particularly in the world of cryptocurrencies, the limits and the risks must be known. The dangers of staking are not necessarily many, but its limitations can greatly influence the winnings associated with the staking features.

Risks with security

To participate in staking, some blockchains require that the funds be kept in a wallet which is itself hosted on the same machine that operates the node. This is a potential source of a security problem for users wishing to store their funds in a cold-wallet. Other blockchains require frequent actions to be taken with the funds, which once again prevents its cryptoassets from being completely stored outside the network. Some other projects thus implemented solutions where the coins doesn’t need to leave the wallet at all to be counted and considered as a full node.

Interest rate uncertainty

In the case of some cryptocurrencies, interest rates vary depending on many factors. This is particularly the case where the rewards are distributed to staking pools. Indeed, depending on the quantity of tokens locked on the network and the ranking of the staking pool among its competitors, the interest rates that you will obtain can fluctuate greatly. More generally, the higher the number of participants in a blockchain offering staking, the more the reward obtained by each user decreases. The main factor that will define the amount that the user will receive for participating in the network is that of the lock time of the assets. In order to maximize the earnings, an investor will need to lock the assets for the longest possible period. This may indirectly prevent certain rational decisions from being taken in the event of a general market downturn.

Price volatility

The most obvious risk associated with staking and trading in general of is price uncertainty. Indeed, if the price of the asset drops by a higher percentage than the return of the staking itself, the previous contribution to the blockchain will not earn anything and will not compensate for the losses either. This case may be quite common due to the volatility of the market, but also the parameters of certain assets which do not reward its contributors with a sufficient rate to compensate for this type of price movement. Some other projects have been concerned by this issue and implemented long-term solutions against price volatility.

Ever-increasing accessibility

Despite the apparent complexity of how staking works, there are several choices available to the person wishing to invest in this sector. Indeed, there are many ways to get started with staking, but the types of services provided to users can be quite different.

Staking pools

A staking group, more commonly known as a staking pool, allows several people to combine their funds in order to increase their chances of being rewarded. In other words, they unite their staking power in the process of checking and validating new blocks, with the aim of ensuring that the probability of getting the rewards from the block is the highest. In most cases, staking pools work specifically with a single cryptocurrency, such as mining pools. They are usually one of the easiest options to start staking and pay out a portion of the rewards they receive in proportion to each individual's participation. This possibility , now widely chosen in 2020 , has been a complete revolution to override the hassle of solo staking on a personal computer used at the beginning. Most of the pools in the market charge a fee, which will reduce the final reward received by participants. However, the primary advantage of this option is that passive income is assured and no technical knowledge is required for the user. In addition, a user will not have to worry about the maintenance of the node and the competition between the different pools to maximize the earnings.

Staking on exchange platforms

crypto wallet

New players who will surely overshadow staking pools are now on the market as exchanges. The list of the latter offering such a service is growing rapidly and includes Binance, Coinbase, Huobi, Poloniex and OKEx and even more. Each platform has of course its particularities, but the general operation remains the same.

This option is certainly the easiest to use and also allows the user not to have to lock his funds if he wishes to take part in the staking. Although the user sets an order, his funds remain in his wallet for a certain time pending its execution. Therefore, deferred sell orders of a cryptocurrency that relies on staking is not a problem and ensures that the user can still use their funds for trading. (Fund locking or not can differ between different exchanges and rules and conditions must be read carefully before taking any investment choice)

The fact that the exchanges offer staking is a real opportunity for cryptocurrency project teams. Thanks to this innovation, the projects ensure that they receive greater participation in their operation. This also theoretically allows prices to move upwards, because staking promotes long-term investment. It is potentially not in the best interest of a holder of a cryptocurrency offering staking to sell at the slightest downward movement. The effect of the adoption of staking by exchanges gives it real visibility and in particular makes it possible to develop an ecosystem that is interesting for projects and more attractive for investors. When a platform offers such an option, it also ensures that the user's funds will stay there and this will obviously benefit him in the long term. The interest in platforms is therefore not negligible and this partly explains why the addition of staking is often done quickly.

Since the exchanges now offer its users staking options, everything has become much simpler and accessible to all. Originally reserved for a certain elite, this investment alternative brings a breath of fresh air to such an unpredictable market. If you're interested in this investment, don't just stop at the gross return a project is offering you. As we have seen previously, staking presents some risks and some cryptocurrencies are better able to escape it than others. Other elements will therefore have to be taken into account so that you can find the asset that suits you: the consensus protocol used, the total percentage of locked tokens, the history of the project, its risk management as well as the responsibilities and the rights of participants.Now considered to be one of the best alternatives to trading for generating passive income, staking can provide you with some income while in some cases giving you decision-making power for the asset you support.