Today, earning a passive income has almost become a necessity more than a trend. You’ll see every influencer or business magnate advocate the importance of a passive income. In all fairness, they are not wrong. Given the crazy inflation rates, without some extra dough, you may face some financial difficulties. There are literally a gazillion ways to earn some extra money but given our love for the crypto world, let’s today talk specifically about staking cryptocurrency.
What is crypto staking? How does crypto staking work? We will touch on every topic and possibly go even further. Let’s dive in.
What is Crypto Staking?
If you’re familiar with how mining works, you would also probably understand that it is a system that gathers transactions into blocks by solving complex mathematical problems; and these blocks are then linked together to form a blockchain. This process is widely used in mining new tokens. It is also known as Proof of Work (PoW) and it requires a lot of computational prowess, which is worth a king’s ransom.
Now, you might be thinking, is there a sustainable and feasible way of earning cryptocurrency without the extravagant computational cost? Enter crypto staking or Proof of Stake (PoS). This process significantly reduces the large amount of computational work required to validate blocks and transactions which are needed to keep both cryptocurrency and blockchain secure. PoS uses the validators’ staked (locked) tokens to secure the blocks and in return, and they receive the transaction fees paid by the users as a reward.
How Does Crypto Staking Work?
Now that we know what is crypto staking, let’s see how does crypto staking works. There are mainly two ways you can stake your coins:
- Independent staking
- Staking pools
In independent staking, you are solely the validator and stake your coins directly and thus you earn all the rewards. Whereas in staking pools, a group of investors locks their assets together. You aren’t the sole validator and you receive a piece of the rewards after deducting the pool’s fees.
What is a Staking Pool?
When a group of token holders merges their resources to enhance their chances of verifying and validating blocks to earn rewards, it is known as a staking pool. Even the rewards are shared proportionally. As simple as it may sound, creating and managing a staking pool is quite difficult as it requires a lot of expertise and time. Staking pools are extremely effective on networks where the technical or financial barrier to entry is very high. In return, pools charge a certain amount of fee from the rewards distributed to their participants.
In individual staking, the coins are often locked in for a fixed period of time and generally have an unbinding time which is regulated by the protocol. Staking pools, on the other hand, require a minimum balance and have no withdrawal time. Thus, for beginners, a staking pool is much more profitable and risk-free.
What Must You Have to Start Crypto Staking?
To become a validator and independently stake coins, you must have a certain amount of tokens. The best-known example is Ethereum where you need a minimum of 32 Ether (ETH) to stake independently. This is a huge entry barrier.
Staking pools charge a platform fee which reduces your returns a bit. For instance, if you stake 3 ETH worth $5,000, you are not eligible to become an independent validator. In this case, you have to pool your coins in a staking pool and the platform will deduct a certain percentage of the fee from your yields. When the pooling period is over, you might earn 0.075 ETH worth $300. At this juncture, you can either continue to stake your coins and keep earning rewards or you can withdraw the funds.
How is Crypto Staking Reward Calculated?
Different blockchain networks use different methods of calculating staking rewards. Some use a block-by-block method to adjust the rewards and consider several other factors. These factors can include:
- The number of coins staked by the validator
- The time period the validator staked his coins
- Total number of coins staked on a network
- The inflation rate
- Other elements
However, a few networks offer a fixed percentage of staking rewards which are distributed to the investors as compensation for inflation. Validators spend their coins due to inflation, increasing their usefulness as cryptocurrency. With this model, predicting your skating reward can be calculated easily and this predictability is favorable to a lot of validators.
Is Staking Cryptocurrency Profitable?
For crypto investors, staking their coins can become a lucrative source of passive income. It can be even higher than the yields you’d receive from an online savings account in the form of fiat currency. For instance, if you stake Cardano (ADA) worth $5,000 at 6 percent then you can earn around $618 over two years. This is more than an online savings account. If you plan to hold your tokens for the long term then you could include the returns in your investment strategy.
Can You Lose Money While Staking Crypto?
While it sounds like a profitable investment strategy and a good source of passive income, we must keep in mind that no investment strategy is free from risk.
A few risks of staking cryptocurrency:
- Market risk: If you are an individual stakeholder then you have to lock in your tokens for a fixed amount of time. During this time, you can’t withdraw your token and you are vulnerable if the price of your token drops. If during this time the value of your token drops by 30 percent then you are facing a significant loss
- Liquidity risk: It is difficult to sell your digital assets if you stake them with less liquidity. This could stop you from reaping the benefits of staking.
- Smart contract risk: Staking pools that are enabled by smart contracts are prone to risk too. They are subject to human error, coding errors could cause vulnerabilities, loopholes, and hacks.
What Are Some of the Best Coins for Staking?
Unfortunately, every cryptocurrency isn’t eligible for staking. Keep in mind that you are a validator for the PoS blockchain. So, you can’t stake crypto coins on PoW blockchains. This means that you can’t stake Bitcoin.
Most popular coins for staking:
- Ether (ETH)
- Polkadot (DOT)
- Cardano (ADA)
ETH is Ethereum’s cryptocurrency and Ethereum is a popular fundamental blockchain for a lot of decentralized finance transactions. When Ethereum 2.0 releases, ETH holders can become validators and stake their coins. However, to stake this coin, you must have 32 ETH and you can earn 5.6 percent APY.
ADA is Cardano’s native cryptocurrency and it runs on Cardano’s PoS blockchain network. One of the benefits of staking ADA is the lack of lockup period of Cardano. It also offers an annual yield of around 4.6 percent.
One of the co-founders of Ethereum, Gavin Wood, launched the Polkadot PoS blockchain. Its USP is that it provides cross-chain communication. Tokens and data can be easily transferred across open, public, private permission blockchains as well as permissionless blockchains. The yields on staking Polkadot are approx. 14 percent and hence is an attractive opportunity for validators around the globe.
Who Created Proof of Stake?
The birth of Proof of Stake can be accredited to Scott Nadal and Sunny King. In a 2012 paper for Peercoin, Nadal and King described PoS as a peer-to-peer crypto design taken from Satoshi Nakamoto’s Bitcoin. The network of Peercoin was launched with a hybrid PoW/PoS mechanism in mind. PoW was initially used to mint the supply but it wasn’t required for long-term sustainability and its importance was slowly reduced. Later, the majority of the networks’ security depended on PoS.
Steps to Start Crypto Staking
- For staking cryptocurrency, you must choose a token that is based on a PoS blockchain network.
- You must have a crypto wallet to stock your asset. Also, you can choose a centralized platform such as Gemini or Coinbase.
- After step two, you can buy the token you want to stake. However, you must have the minimum amount of tokens as per the rules of the network.
- Visit the platform or the centralized crypto exchange and begin staking.
What is Cold Staking?
Cold staking uses a wallet for staking that is not connected to the web. Cold staking can be done using an air-gapped software wallet or a hardware wallet. Blockchain networks that allow cold staking enable users to secure their funds offline. It is usually beneficial for large stakeholders who want maximum protection.
How is Staking Taxed?
Internal Revenue Service (IRS) has no specific guidance on staking. But, in the eyes of the IRS, staking is similar to mining and therefore could have tax implications. As per IRS notice 2014-21, a staking reward is treated as ordinary income and is eligible for taxation at its market value on the date you acquired it. Later, if you sell the tokens earned as rewards, you have to pay capital gains tax. You have to pay either short-term or long-term based on the period of time you held it. While short-term gains have ordinary tax implications, long-term gains get discounted.
For instance, if you stake 5 ETH worth $20,000 in a staking pool that pays 7 percent APY after deducting the fees. In the same year, you received 0.5 ETH valued at $1,450 and then you withdrew your tokens. If you sell your received token after 6 months when the value has increased up to $1,800, you have to include $1,450 in your gross income for that year. The additional gain of $350 will be taxed as capital gains.
Goals of Staking
PoS is designed with environmental sustainability and scalability in mind. As opposed to PoW, which is a competitive space that verifies transactions, miners look for ways to get an edge over the competition, since the monetary reward is involved in it. Let’s see in detail how PoW can be detrimental to the environment.
Bitcoin miners earn tokens by validating transactions and blocks. For this, they invest in resources such as mining rigs that require a lot of electricity. The miners pay the electricity expenses through fiat currency. As a result, they exchange energy for crypto tokens. The energy needed to mine tokens affects the market dynamics of profitability and pricing.
This is where the PoS mechanism shines. It doesn’t require massive computational power and the mining ability is based on the network. This directly translates to a drastic decrease in energy consumption which doesn’t affect the environment negatively.
The Financial Takeaway
With the popularity of crypto at an all-time high, staking cryptocurrency is one of the best ways to make passive income. Think of it as owning a stock and earning dividends, or interest from a bank account. However, before staking your cryptocurrency, do your homework, understand the landscape thoroughly and the risks as well.