In the realm of conventional finance, investors have a multitude of avenues through which they can generate returns. The predominant method involves investing in bonds, whereby buyers can anticipate receiving fixed coupon payments over a specific period, although some bonds offer variable payments. Online platforms like TreasuryDirect.gov facilitate the seamless interaction between the United States government and investors in this process.
From a functional standpoint, strategies that yield returns in the crypto space bear similarities to bond investments since they involve locking up an asset in exchange for a stream of payments. However, the mechanics underlying these payments differ significantly. Numerous methods exist for earning interest on digital assets, but the focus of this discourse lies on staking—an intricate process that entails pledging assets as collateral to a network. By doing so, participants gain the right to validate transactions on a blockchain and, in turn, receive token rewards as a form of recompense.
Blockchains are governed by a network of multiple computers known as nodes, whose owners are rewarded for their role in adding and validating transactions. Rather than relying on a centralized authority to maintain records, all nodes must reach a consensus on which new transactions are added to the blockchain. Node operators receive compensation in the form of the blockchain’s native currency, such as ether for the Ethereum network, whenever new data is incorporated. The methods of compensating nodes can vary across different blockchains. For instance, Bitcoin utilizes a process called proof-of-work (PoW), which is considered a robust and egalitarian consensus mechanism. However, the energy consumption of Bitcoin’s network surpasses that of medium-sized countries like Israel or Argentina on a daily basis. As a result, newer blockchains often employ proof-of-stake (PoS) as an alternative.
In a PoS system, node owners are required to deposit or stake a specified amount of cryptocurrency in order to validate transactions. For Ethereum, this requirement is set at 32 ether (ETH). If a node owner acts against the network’s best interests or fails to stay connected to the platform, they may risk losing their stake. Consensus mechanisms heavily rely on game theory to maintain the security and decentralization of the blockchain. Adhering to the rules yields rewards, while breaking them incurs costs.
While 32 ETH may appear as a high entry point, making it approximately $50,000 in early 2023, small investors have the option to lend or delegate their crypto to established operators in exchange for a proportional share of the returns. Another emerging approach is known as liquid staking, where stakers deposit their tokens into a platform that provides staking yield and grants them a 1:1 copy of their original tokens, which can be freely traded or lent. This significantly lowers the barrier to entry, making it nearly negligible for major PoS chains like Solana, Polygon, Cardano, Avalanche, and Polkadot.
For beginners, it is often recommended to start by delegating their crypto to an existing validator to avoid the complexities of managing hardware and meeting governance requirements.
The initial inquiry of a prospective validator often revolves around the question, “What are the returns?” Websites such as stakingrewards.com serve as a convenient and efficient resource for gauging the annual percentage rates offered on staked cryptocurrencies. This platform aggregates real-time data from various blockchains to provide a comprehensive overview. It is important to note that staking rewards can vary significantly across different chains, ranging from as low as 1% to as high as 20%, contingent upon multiple factors.
However, it is crucial for investors not to automatically pursue the highest rate available. Instead, they should approach staking as a long-term strategy rather than a means of swiftly attaining a high yield. Extraordinarily high returns are often unsustainable and can prove to be nothing more than fragile, artificial mechanisms designed to manipulate demand. A cautionary example can be observed in the TerraUSD/LUNA collapse. Once a PoS chain has been selected, and an investor feels comfortable with the projected yield, the next step involves initiating the staking process. There are three primary methods for staking: utilizing centralized exchanges, engaging directly with the blockchain, or utilizing derivative platforms that offer liquid staking options.
One of the most straightforward methods to stake your cryptocurrency is by utilizing a cryptocurrency exchange that provides staking services. Platforms like Binance and Huobi Global offer users the opportunity to stake specific digital assets. It is essential to distinguish this staking process from lending programs offered by crypto finance companies that do not operate as exchanges. It is worth noting that regulatory authorities, particularly in the United States, are closely scrutinizing staking activities. The Securities and Exchange Commission (SEC) recently reached a settlement with the crypto exchange Kraken, resulting in the permanent closure of its crypto staking service. The SEC’s position was that such services could be classified as investment contracts, subject to regulation under securities laws.
Numerous decentralized cryptocurrency wallets offer users the ability to stake directly on exchanges. For instance, on the Phantom wallet for the Solana network, users can opt for the “Start Earning SOL” feature to access a list of validators. This list provides valuable information such as the total number of delegators, validator charges, and the overall assets staked. Websites like validator.app offer performance rankings to assist users in making informed decisions. When selecting a validator, it is generally advisable to seek a balance between low commissions, high uptime, and a reliable track record.
The process is similar for other networks. Users need to locate the appropriate wallet or service to initiate the staking process. For example, the Daedalus desktop wallet is popular among users of the Cardano network, enabling them to stake the network’s native currency, ada. Avalanche and Polygon also offer their own dedicated wallets. The steps involved remain consistent across these networks, where users must select a validator from a provided list of options and delegate their tokens to begin earning rewards. Below is an example of the user interface for staking matic through Polygon’s official staking site.
When you decide to stake your cryptocurrency, it becomes locked in a smart contract and remains inaccessible until the unstaking process, known as unbonding, is completed. For many individuals, this is not a concern as they are satisfied with allowing their crypto to generate yield passively. However, for others, this presents a significant challenge since they are unable to use the staked crypto as collateral for lending and borrowing in decentralized finance (DeFi) applications.
An alternative solution is provided through liquidity staking derivatives. Users can stake their crypto on a DeFi platform and receive a receipt token in return. This receipt token can then be utilized for various purposes. For instance, staking ETH on the Lido liquidity service not only earns yield but also generates staked ETH tokens (stETH) for the user. It is important to note that if the stETH tokens are lost, the individual also forfeits their share of the staking pool.
Innovative decentralized applications like Lido and Rocket Pool are at the forefront of DeFi with their crypto derivatives. However, it is crucial to acknowledge the presence of inherent risks. The price of stETH is not pegged to the value of ETH, which was evident during the 2022 bear market when significant selling pressure on stETH caused a disconnection between the prices of the two tokens.
Every strategy that aims to generate yield carries an inherent element of risk. While bonds are generally considered one of the less risky asset classes, there is still a possibility that bondholders may cease to receive payments if the issuer faces insolvency.
In the realm of cryptocurrencies, a similar principle applies. If a user delegates their crypto to a validator that ceases operations, they will no longer receive staking rewards. However, the reassuring aspect is that in such situations, users can reclaim their crypto. On the other hand, if a validator attempts to validate fraudulent transactions or commits a technical error like running multiple validator nodes under a single identity, a portion of the crypto assets can be slashed, resulting in the loss of a percentage of the invested crypto. Hence, it becomes vital to identify validators with established track records and high uptime to mitigate these risks effectively.
One of the most secure methods to safeguard your cryptocurrency is by storing it in a hardware wallet that is not connected to the internet, also known as cold storage. By doing so, you eliminate the risk associated with counterparties. Nevertheless, it is worth considering the strategy of staking for various compelling reasons. If you possess a substantial number of tokens and firmly believe in the long-term potential of a blockchain, staking can serve as a straightforward and efficient approach to make your tokens work for you by earning interest.
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