Jan 24, 2022 8 min read

How does crypto staking work?

Summary:
The blockchain is not safe if large mining companies, independent or joining together, could actually start making fake transactions and giving themselves free money. This has happened to Bitcoin and Bitcoin Cash in the past, so this is a big problem and proof of stake attempts to fix this issue by selecting one validator (analogous to a miner) that then gets to solve the puzzle to validate transactions and earn the block rewards while other validators double-check them and share in that reward.

When you get picked, if you mined correctly, you get what's called a staking reward - usually some of the coin - and if you mined incorrectly you actually get penalized and lose some of the coins that you initially locked up. On some networks, smaller holders can even delegate to larger whales and avoid possibly being slashed.

So in short, to participate in a proof of stake coin, you have to own a minimum amount of that coin as a validator, then you lock it up so you can't use it and you wait so that the network will pick you to mine. This process which uses their coins as collateral is called staking.

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Hey! in this article we're going to learn about crypto staking. But first, we'll introduce the concept of proof of work and consensus mechanisms, which is the method that Bitcoin and other certain cryptocurrencies use to keep track of how much money everyone has.

What is proof of crypto staking?

Crypto staking is a blockchain method to verify transactions that are much more energy-efficient and less risky than the more common proof of work method. Only one miner is chosen at a time to validate the blockchain, but that miner must lock up some of their tokens as collateral to be chosen.

The miner is punished for creating any fraudulent transactions by losing their collateral and rewarded for good transactions by the creation of new tokens.

First I'm going to tell you that proof of work sucks. In fact, we have proof of stake to fix the things that proof of work sucks at.

What is proof of stake?

A new consensus mechanism — proof of stake — is emerging which is intended to enhance speeds, efficiency and save fees. Proof of stake can be accessed by eliminating the churn of maths which is energy-intensive.

Different from the proof of work concept, transactions here are validated by people literally investing on blockchains using stakes. Staking has the same function as mining in that it involves choosing a network participant for the latest transaction in a blockchain.

Let's say you have runners lining up for a race. All eight racers are racing to the finish line. But you have some racers that have an advantage given the number of resources they have. Kind of like they have stronger legs or they weigh less or they've trained longer, even though all racers get to the finish line.

Eventually, only one person wins and they get the reward which might be a shiny Bitcoin while the other runners still had to run down the track, and those who didn't win essentially wasted their energy for no reward. And with proof of stake all the runners would line up at the starting line and then only a single racer would be selected based on a few factors which we'll talk about here soon.

Energy-intensive process

This consensus mechanism doesn't waste electricity or energy and nobody runs without getting a reward (passive income) when it comes to coins that use proof of work like Bitcoin.

Many large mining companies and banks compete to solve a block reward therefore the fastest proof of work also isn't fair to the DIY miners who don't have access to very powerful machines or supercomputers that can win the puzzle-solving tasks the quickest.

How miners are validating transactions

The blockchain is not safe if those large mining companies joining together could actually start making fake transactions. So this is a big problem and proof of stake attempts to fix this issue of digital assets like Bitcoin by only selecting one validator (miner) that then gets to solve the puzzle to validate transactions and earn the reward for the staked tokens while other validators double-check them.

It's a lot fairer this way. One key thing for start staking is that since only one validator is selected, it's very important that they solve it correctly because otherwise, they'll have to select someone else and wait for them to solve it correctly. It takes a lot of time and in the crypto space, time is money. Put in other words, staking coins to earn rewards and earn interest requires offering token staking for a certain period of time.

To solve this problem, we make sure that those participators lock up some of their coins, and then other validators can actually double-check their work. And if those users were wrong, the protocol penalizes them and takes some of the assets that are locked up.

This process which uses their coins as collateral is called staking. On some networks, smaller holders can delegate to larger whales and avoid possibly being slashed. So in short, to participate in a proof of stake coin, you have to own a minimum amount of that coin, then you lock it up so you can't use it and you wait so that the network will pick you to mine.

Earning rewards for staked assets

The way that we select who gets to be the validator is important too because in many cases proof of stake coins will bias those who are staking the most coins. This is because they have the most to lose but it is usually calculated also how long they have been locking up those coins.

If we only select them based on the age of their stake, though, or who has the most stake, we would probably also secretly be biasing the big and rich mining facilities again. And to solve this we also need to add in a bit of a random number picker.

Energy-intensive process

So now you might understand that there's a good incentive for validators to correctly verify the blockchain in a good selection process to reduce energy waste and I hope this clears things up a little bit. But now that you kind of know how it works, let's go over the risks and rewards so there will be few risks when it comes to staking some cryptocurrencies.

The risk of staking

There are a couple of threats of staking crypto to understand:

Crypto prices are unpredictable and also can go down swiftly. If your staked assets experience a large price drop, that can surpass any kind of rate of interest you gain on them.
Laying can require that you lock up your coins for a minimal quantity of time. During that period, you're incapable to do anything with your staked properties such as offering them.
When you intend to unstake your crypto, there may be an unstaking duration of seven days or longer.
The largest threat you confront with crypto staking is that the rate drops. Keep this in mind if you locate cryptocurrencies providing incredibly high staking reward rates.

For instance, numerous smaller crypto tasks supply high rates to attract investors, but their prices after that wind-up crashing. If you're interested in adding crypto to your portfolio but you'd prefer less risk, you might want to opt for cryptocurrency stocks instead.

Locking period

Risk number one is that there's something called the locking period when you go to stake your coin and during this time you will not be able to move your coins; you can't send them anywhere, and you can't cash them out.

Sometimes you have to lock them up for a certain amount of time, a minimum of a month all the way up to a year.

Knowledge lacking

Risk number two is technical knowledge, it's not as easy as just downloading some software and then pushing a button. You usually have to know how to code, how to set up your computer to validate how to accept rewards into a wallet and if there's an issue you are responsible to fix it.

Validator commission

So if you don't want to set up the validation process yourself, you can give your coins to someone else who has the knowledge and equipment to do it. These platforms usually require a validator commission and a spot wallet for the use of their computers and this commission could cut your profit. There is also the chance that they could run away with your deposit at any time.

Rewards duration

Risk number four is a rewards duration. So depending on the network that you choose, it could take minutes days, and sometimes even weeks to see the payout of your staking position. This is why it's crucial to see the network's reward payout time.

Bad behavior

Last we have risk number five, which is bad behavior. So proof of stake is built on validators and if the validation turns out to be bad, you will lose some of that. Nobody really mentions this because the likelihood is very low, but it is still a risk.

Benefits of staking crypto

Below are some of the benefits of staking crypto:

It's a simple way to gain a rate of interest on your cryptocurrency holdings
You don't need any kind of tools for crypto staking as you would for crypto mining
You're aiding to maintain the security as well as the effectiveness of the blockchain
It's more environmentally friendly than crypto mining

The main benefit of staking is that you earn more crypto, and rates of interest can be really good. In some cases, you can make greater than 10% or 20% each year. It's possibly an extremely profitable method to spend your cash. As well as, the only thing you need is crypto that utilizes the proof-of-stake model.

Additionally, it is also a means of supporting the blockchain of a cryptocurrency you're purchased. These cryptocurrencies rely on owners betting to validate transactions and keep every little thing running efficiently.

When you should or shouldn't bet crypto.

If you have crypto that you can risk and you aren't planning to trade it in the near future, you can then stake it. As we said it doesn't require any kind of work on your component and also you'll be earning more crypto with that investing approach.

What happens if you do not have any type of crypto? There are lots of offers for crypto staking, however, you must first examine whether each cryptocurrency is a good financial investment. It just makes good sense to buy crypto for staking if you additionally think it's an excellent long-term financial investment.

Which coins to stake?

And lastly, I want to go over the coin that we would stake. Currently, I'm going to go over four of the most popular staking cryptocurrencies.

Ethereum (ETH) was the initial cryptocurrency with a programmable blockchain that programmers can use to create apps. Ethereum began utilizing evidence of job, yet it's transitioning to a proof-of-stake model.
Cardano (ADA) is a green cryptocurrency. It was founded on peer-reviewed research as well as established via evidence-based techniques.
Polkadot (DOT) is a method that permits different blockchains to link and also collaborate with one another.
Solana (SOL) is a blockchain made for scalability because it provides fast deals with reduced costs.

Taking into consideration the returns you can make, it's worth looking into these and various other cryptocurrencies for staking.

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