Many DeFi protocols built on top Layer-1 blockchains offer opportunities to lock up and “stake” tokens in exchange for yield.
The advent of cryptocurrency and decentralized finance (DeFi) has created an abundance of new financial opportunities for market participants. Thanks to them, users can put their capital to work and earn a yield on their assets like never before. And, while there are many opportunities to earn yield by interacting with complex protocols, staking is one of the simplest ways to earn passive income.
What Is Staking?
There are several facets to staking, and while their complexities cannot be ignored, there are many dedicated DeFi protocols offering Staking-as-a-Service. Staking through these platforms generally simplifies the entire staking process into just a few clicks. After this, the user will automatically earn rewards either from a dedicated rewards pool or from a token’s inflation. Since the goal for any investor or user is to earn a passive income through this avenue, DeFi staking services are an ingenious evolution to make anyone’s capital work for them.
Notably, many DeFi protocols built on top Layer-1 blockchains also offer opportunities to lock up and “stake” tokens in exchange for yield. However, they do not use Proof-of-Stake as in the case of Layer-1 blockchains. The chase for yield through staking and other DeFi activities such as liquidity mining surely contributed to the space’s rapid growth in 2020 and 2021. Per data from DefiLlama, there’s now over $215 billion in total value locked across Ethereum and the broader DeFi ecosystem.
Benefits and Drawbacks of Staking
Although activities such as yield farming often pay lucrative yields, staking is an attractive option for putting capital to work for many investors because it often requires less management. While moving capital between liquidity pools in search of the highest yield can be arduous and result in high transaction costs, it doesn’t take long to start staking tokens and capturing yields.
For those who have funds sitting idle on exchanges or cold storage, staking provides a way to earn anywhere from 5 to 10% APY without having to come up with a complex portfolio management strategy.
A newer form of staking has also surfaced in the form of liquid staking, where stakers receive a liquid token that represents their deposited assets. Liquid staking lets users capture yield by depositing their assets and then earn more yield by putting the token they receive to work elsewhere in DeFi. As a result, it’s gaining popular use on protocols like Lido.
Still, there are several drawbacks. Many protocols have minimum lock-up periods for staking coins to disincentivize selling, which means stakers can face lengthy waiting periods to sell their assets. This is particularly burdensome when the market experiences a dramatic downturn. Staking tokens are, therefore, commonly adopted among those who are “long” or have high conviction in an asset and plan to hold it for the long term.
Many networks also have high minimum deposit requirements. For example, ETH stakers must deposit 32 ETH, the equivalent of around $100,000 today. While staking pools have gone some way to solving this problem, they are also more vulnerable to hacks.
Getting into Staking and Maximizing Yields
If you’re looking to earn through staking, you’ll want to find an asset that has a staking option, either in DeFi or through its own Proof-of-Stake consensus mechanism.
If you’re an advanced user, you may want to look at setting up your own validator node or staking in DeFi. Otherwise, you can always use Coinbase or Binance, which offers staking rewards on a variety of assets.
Choosing a project to invest and stake with depends on your risk tolerance. As a rule of thumb in DeFi, the higher the yield available, the higher the risk. And, with the high volatility of cryptocurrencies, staking tokens is generally only recommended for those who have a high conviction in an asset. A 6% APY won’t be much benefit if you end up selling your supply as soon as the market suffers a 30% correction.
Mitigating Risks when Staking Crypto
Users should do due diligence and seek out trustworthy platforms that have been audited by reputable sources. Popular security auditing firms include the likes of CyberUnit, HashEx, and PeckShield, among others.
It is also a good idea to stake assets that have sophisticated tokenomics models that let stakers benefit from profit distribution. Users should also understand the difference between staking on centralized exchanges and DeFi, and the risks each one present. If an exchange collapses, you could lose all your assets. Similarly, if you approve the wrong smart contract or deploy all your capital into a project that gets hacked or exploited, you may lose all your funds. When using staking pools, bear in mind that projects often deduct fees for their services, which will affect your real return.
Ultimately, staking offers a way to earn attractive yields on digital assets by putting them to work. Today there are many options for staking across both the centralized crypto space and DeFi. While there are certain risks, there’s little doubt that staking has benefited many users and become an integral part of the crypto ecosystem. Those interested in participating in staking should follow the golden rules of crypto investing: Always do your own research, and never invest more than you can afford to lose.
Brian is the CTO at Fringe Finance with almost 10 years of expertise in blockchain, cryptocurrency, fintech and DeFi. He has delivered technically-complex projects that have leveraged his engineering background and keen understanding of the industry trends and philosophies. Brian has also worked with industry blockchain bodies to lobby for legislation and government policy changes.