Like a lot of things in crypto, staking can be a complicated idea or a simple one depending on how many levels of understanding you want to unlock. For a lot of traders and investors, knowing that staking is a way of earning rewards for holding certain cryptocurrencies is the key takeaway.
But even if you’re just looking to earn some staking rewards, it’s useful to understand at least a little bit about how does staking work.
What Is Staking Crypto?
Staking is an activity where a user locks or holds his funds in a cryptocurrency wallet to participate in maintaining the operations of a proof-of-stake (PoS)-based blockchain system. It is similar to crypto mining in the sense that it helps a network achieve consensus while rewarding users who participate.
You may think of staking as a less resource-intensive alternative to mining. In staking, the right to validate transactions is baked into how many coins are “locked” inside a wallet. However, just like mining on a PoW platform, stakers are incentivized to find a new block or add a transaction on a blockchain. Apart from incentives, PoS blockchain platforms are scalable and have high transaction speeds.
How Does Staking Work?
As we’ve discussed before, Proof of Work blockchains rely on mining to add new blocks to the blockchain. In contrast, Proof of Stake chains produce and validate new blocks through the process of staking. Staking involves validators who lock up their coins so they can be randomly selected by the protocol at specific intervals to create a block. Usually, participants that stake larger amounts have a higher chance of being chosen as the next block validator.
This allows for blocks to be produced without relying on specialized mining hardware, such as ASICs. While ASIC mining requires a significant investment in hardware, staking requires a direct investment in the cryptocurrency itself. So, instead of competing for the next block with computational work, PoS validators are selected based on the number of coins they are staking. The “stake” (the coin holding) is what incentivizes validators to maintain network security. If they fail to do that, their entire stake might be at risk.
On a very practical level, staking just means keeping funds in a suitable wallet. This enables essentially anyone to perform various network functions in return for staking rewards. It may also include adding funds to a staking pool, which we’ll cover next.
What is a Staking Pool?
A staking pool is a group of coin holders merging their resources to increase their chances of validating blocks and receiving rewards. They combine their staking power and share the rewards proportionally to their contributions to the pool.
Setting up and maintaining a staking pool often requires a lot of time and expertise. Staking pools tend to be the most effective on networks where the barrier of entry (technical or financial) is relatively high. As such, many pool providers charge a fee from the staking rewards that are distributed to participants.
Other than that, pools may provide additional flexibility for individual stakers. Typically, the stake has to be locked for a fixed period and usually has a withdrawal or unbinding time set by the protocol. What’s more, there’s almost certainly a substantial minimum balance required to stake to disincentivize malicious behavior.
Most staking pools require a low minimum balance and append no additional withdrawal times. As such, joining a staking pool instead of staking solo might be ideal for newer users.
How Are Staking Rewards Calculated?
There’s no short answer here as each blockchain network may use a different way of calculating staking rewards. Some are adjusted on a block-by-block basis, taking into account many different factors. These can include:
how many coins the validator is staking
how long the validator has been actively staking
how many coins are staked on the network in total
the inflation rate
other factors
For some other networks, staking rewards are determined as a fixed percentage. These rewards are distributed to validators as a sort of compensation for inflation. Inflation encourages users to spend their coins instead of holding them, which may increase their usage as cryptocurrency. But with this model, validators can calculate exactly what staking reward they can expect.
A predictable reward schedule rather than a probabilistic chance of receiving a block reward may look favorable to some. And since this is public information, it might incentivize more participants to get involved in staking.
Closing Thoughts
Proof of Stake and staking opens up more avenues for anyone wishing to participate in the consensus and governance of blockchains. What’s more, it’s an utterly easy way to earn passive income by simply holding coins. As it’s getting increasingly easy to stake, the barriers of entry to the blockchain ecosystem are getting lower.
Despite knowing how does staking work, it’s worth keeping in mind that staking isn’t entirely without risk. Locking up funds in a smart contract is prone to bugs, so it’s always important to DYOR and use high-quality wallets.
