Due to the energy and environmental consumption issues that come with crypto mining, staking is frequently considered an alternative. It is simply the act of securing cryptocurrency so as to obtain the benefits and gains that come with it.
It is a reward-based mechanism for validating proof-of-stake blockchain transactions.
Generally, from your crypto wallet, you’ll be able to stake. Many exchanges offer staking services to their users. Staking on Binance is a simple way to earn rewards, for example; all you need to do is save your cryptocurrencies on the exchange.
What Is Crypto Staking?
Crypto staking is a mechanism for validating proof-of-stake (PoS) blockchain transactions. This is different from proof-of-work (PoW) blockchain transactions, which are validated through mining. Understanding what differentiates PoS and PoW is essential to understanding the fundamentals of crypto staking.
Proof-of-Stake Vs Proof-of-Work
Proof of work (PoW) was the first consensus algorithm, first described by Cynthia Dwork and Moni Naor in 1993. The most well-known network to use this type of algorithm is the Bitcoin blockchain, which uses the PoW to approve transactions on the public ledger. Markus Jakobsson, who’s often associated with the term, did not create the term “proof of work” until 1999.
Bitcoin introduced Proof-of-Work (PoW) as a block validation technique for timestamping transactions without the oversight of a trusted third party. Bitcoin has a long history of using energy to secure its network, and PoW is no exception. People started looking into PoS as a means to save energy when doing validation “work.”
Each block in a Proof-of-Work blockchain, like the Bitcoin blockchain, must be independently confirmed. Miners do this by using their computing power to solve difficult algorithms in exchange for blockchain incentives. While all miners are attempting to solve the algorithm, only the first successful miner to do so will be awarded the prize.
Unlike proof-of-work systems, which pay miners block rewards plus transaction fees, a proof-of-stake system only pays transaction fees to the chosen node that helps defend and manage the network. PoS is more accessible and decentralized, giving currency holders greater power by allowing them to “stake” money in order to “forge” blocks by using an online wallet or node.
Risks That Come with Crypto Staking
There are risks that you should be aware of during the process to safeguard yourself from may end up losing your crypto. Here are some dangers.
The chances that digital asset(s) may fluctuate in a negative direction are usually high. Investors know that this is the most significant risk that investors face while staking cryptocurrencies.
If you earn 15% APY for staking an asset, you would have gained. But such an asset may also lose 50% of its value over the course of the year while staking. This will mean that you’ve lost money.
Due to this factor, crypto investors must carefully select the assets they wish to stake and are recommended not to choose their staking asset solely on the premise of APY figures.
Another risk factor to consider is the asset’s liquidity — or, more accurately, illiquidity.
If you are staking a cryptocurrency with little liquidity and a low market cap on crypto exchanges, you may find it difficult to sell your asset or convert your staking returns into bitcoin or stablecoins. This will make your gains insignificant as there’s no one interested in buying what you hold.
To reduce liquidity risks, investors should consider cryptocurrencies with high trading volumes and market capitalization to ensure liquidity.
The Risk of the Validator
Technical expertise is required to run a validator node. Nodes must always be up and running at all times for staking payouts to be made.
A failure or misbehavior of the validator node may cause you to be penalized, lowering your overall staking rewards. Your stakes as a validator might be “slashed” in the worst-case scenario, resulting in the loss of a portion of the staked tokens.
To avoid the hazards of staking with your own validator node, it is advised that you assign your stake to a third-party validator using a service like Trust Wallet to keep you off the risk.
Also, another factor to consider is the cost. The costs associated with staking are quite high. You would be required to fund electricity and hardware, which typically means a lot of money.
Staking using a third-party service typically costs a few percentage points of the profits. Hence, a better option so as to avoid losing money out on their staking returns.
Staking cryptocurrency is legal in many jurisdictions, however, it is frequently taxed. In the United Kingdom, for example, the HMRC clearly states that crypto staking income is taxable. It is considered miscellaneous income for individuals. In the same vein, the IRS and ATO in the United States and Australia indicate that crypto money is recognized as regular income. The laws are different in Singapore, which does not charge capital gains tax on long-term investments. Businesses may be taxed differently for crypto staking. It’s important to verify individual legislation.
The Risk of Security and Loss of Keys
Finally, if you don’t pay enough attention to security, you might end up losing your wallet’s private keys or having your assets stolen.
Whether you’re staking or simply “HODLing” your digital assets, it is important to back up your wallet and store your private keys securely. This is critical for digital asset preservation.
Rather than using custodial third-party staking services, a good option is to stake using apps over which you have complete control of the private keys.