Investors have the potential to generate passive income through crypto staking, but where there is profit, there is also danger. The cryptocurrency market offers a thrilling opportunity to create passive income, just like other computational networks. Blockchain technology, which powers cryptocurrencies, necessitates work.
However, unlike traditional networks, blockchain is a decentralized computational network. This enables individual users to participate and receive rewards based on the work they complete (in this scenario, processing transactions and executing instructions that have been written into the blockchain).
The potential to receive rewards is made feasible by a concept known as proof-of-stake, which is used by cryptocurrencies like Solana (CRYPTO: SOL) and Cardano (CRYPTO: ADA), and is the same approach that Ethereum (ETH -0.00%) is progressing toward. It’s a substitute for Bitcoin’s (BTC -0.00%) proof-of-work method of verifying transactions.
As transactions are confirmed on a proof-of-stake network, you (and other participants if you pool your crypto tokens as part of a validator node) receive new crypto tokens as rewards for the work completed – this is known as “staking.” Participating in the day-to-day operation of a blockchain network can significantly enhance your investment returns, but it’s not without risk. Here’s what you should know.
In investing, the relationship between risk and reward is a critical concept. Generally, when earning passive income, a higher potential reward corresponds to a higher risk when compared to similar opportunities. Given this dynamic, investors should not merely select which cryptocurrencies to stake based solely on the annualized percentage yield (APY) declared. A higher staking yield frequently implies that there are numerous factors that increase the risk involved in participating. Here are three common factors that should be considered.
Liquidity and lockup period risk
The untamed nature of the cryptocurrency market contributes to the risk of liquidity, which is the second type of risk. An asset is labeled as “liquid” when it can be easily purchased or sold. Cryptocurrencies are among the most liquid assets since crypto exchanges operate around the clock, seven days a week, and 365 days a year. However, staking your tokens reduces some of the liquidity.
It may appear simple to unstake your holdings to sell them, but it’s essential to bear in mind that certain cryptos have a lockup period. This means you commit to keeping them staked for a specific period before you can unstake and sell them, including any rewards earned. For instance, during Ethereum’s shift to proof-of-stake, investors may need to agree to a lockup period of one or two years if they want to stake. In case you require the funds within a specific time frame, avoid cryptos with a lockup period. Additionally, bear in mind that a lockup period might hinder you from selling tokens if the market is vulnerable and the value of your holdings drops.
Another associated issue to consider is the liquidity of smaller or new crypto projects. A new network may offer a high yield to pique interest, but a lack of interest from other investors could make it hard to sell or convert your rewards into more mainstream cryptos like Bitcoin or Ethereum. Check the trading volume of a new or small crypto token before buying and staking it.
Network operation risk
Besides the conventional market risk and liquidity, there exists an additional factor that might threaten the everyday functioning of a blockchain network. This menace comes in the form of a validator node error.
In a proof-of-stake network, a validator node is picked randomly to authenticate transactions and add a new block to the blockchain. This action of validation is the key to earning rewards. In some crypto networks, individuals have the option to set up their own validator nodes, which involves downloading the blockchain network’s software and little effort, as well as a small number of tokens.
Nonetheless, if the individual’s computer system does not operate correctly or makes an error, there are possibilities of facing penalties that reduce the rewards earned from staking. Additionally, the likelihood of the network picking the user’s validator node for validating transactions decreases if it is not functioning properly.
To counteract this issue, one can assign their crypto tokens to be part of a validator pool, which is a group of investors that consolidate their tokens and select another computer to perform the actual validation (this is known as a “staking pool”). However, the validator in a staking pool levies a fee from the reward as compensation for performing the work. This fee is variable and varies from one crypto network to another. Hence, it is worth noting that this fee will lower the annualized yield from staking.
Staking crypto is an exciting aspect of the digital currency industry. However, it is not suitable for everyone as there are unique risks involved, and a high yield does not guarantee profitability. Therefore, when buying crypto and determining whether to stake it, ensure that the strategy is part of a comprehensive investment portfolio that considers other asset classes.
Crypto market risk
The foremost and conspicuous peril pertaining to cryptocurrency — and any investment asset, in point of fact — is the market hazard. Every market is susceptible to volatility, with individual assets and securities being even more so. As the price of any asset merely reflects what investors are willing to sell or buy it for at a given moment, it should come as no surprise that short-term price oscillations can fluctuate drastically.
Being just a little over a decade old, the cryptocurrency market is notably mercurial. Since Bitcoin commenced the party in 2009, cryptos, on the whole, have suffered a sharp decline every few years or so. This has been exemplified in 2022, with Ethereum experiencing a near 70% reduction during the first half of the year. While staking is a commendable way to augment your investment earnings, fluctuations in a cryptocurrency’s price can outstrip the yield and yield a negative return.
In conclusion, staking cryptocurrency can be a lucrative way to earn passive income and contribute to the security and stability of a blockchain network. However, it is essential to understand and manage the risks associated with this practice. The three primary risks that one must consider before staking cryptocurrency are market volatility, slashing penalties, and technical vulnerabilities. It is crucial to research and select a reputable staking platform, diversify your staking portfolio, and stay informed about updates and changes to the network. By taking these precautions, you can mitigate the risks and enjoy the benefits of staking cryptocurrency. Remember to always invest wisely and within your means.
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