In the world of traditional finance, investors can generate yield in a variety of ways. The most common is by investing in bonds. Most purchasers are guaranteed fixed coupon payments over time, while others pay variable amounts. Websites like TreasuryDirect.gov facilitate this process between the U.S. government and investors.
Functionally, crypto yield-bearing strategies are similar to bond buying because an investor is locking up an asset to receive a flow of payments in return. However, the mechanics of these payments are very different. There are various approaches to earning interest on digital assets, but this article will focus on staking, which is the process of posting assets as collateral to network in order for the right to add transactions to a blockchain and receive token rewards in kind.
What Is Proof-of-Stake?
Blockchains are managed by multiple computers called nodes, whose owners are compensated for adding and verifying transactions. Rather than have a central authority maintain records, all of the nodes must achieve a consensus on placing new transactions on the blockchain. Node operators are paid in a blockchain’s native currency–ether on the Ethereum
With PoS, i node owners must deposit–or stake–a specified amount of cryptocurrency to be allowed to validate transactions. For Ethereum, 32 ether (ETH) is required. If a node owner acts against the interest of the network or does not remain connected to the platform, that entity can lose its stake. Consensus mechanisms rely heavily on game theory to ensure that the blockchain remains secure and decentralized. Playing by the rules gets you rewards while breaking them incurs costs.
Though 32 ETH seems like a high entry point (about $50,000 in early 2023) to become a validator, it is possible for small investors to lend, or delegate, their crypto to established operators in exchange for a prorated share of the return. A newer approach is called liquid staking, where stakers deposit their token into a platform which pays the staking yield and gives them a 1:1 copy of their original tokens that can be freely traded or lended. This brings the barrier to entry to almost zero for majorPoS chains like Solana
Beginners are often encouraged to start by delegating their crypto to an existing validator to avoid the complexities of running the hardware and meeting governance requirements.
How Much Yield?
The first question a would-be validator is likely to ask is “what are the returns?” Websites like stakingrewards.com are a quick and effective way to see annual percentage rates on staked crypto. This data is aggregated in real-time from blockchain information. Rates vary by chain. They can be as low as 1% and as high as 20%, depending on several factors.
Investors should not automatically chase the highest rate. Investors should think of staking as a long-term strategy rather than a quick way to obtain a high yield. Outsize yields are likely unsustainable, and as we saw in the TerraUSD/LUNA collapse, can be nothing more than fragile artificial mechanisms to manufacture demand. Once you have selected a PoS chain and are comfortable with the yield, the next step is to begin staking. There are three methods: on centralized exchanges, on the blockchain and with liquid staking derivative platforms.
Staking On Exchanges
The simplest way to stake your crypto is through an exchange that offers this service. Exchanges like Binance and Huobi Global allow users to stake certain digital assets. This is not to be confused with lending programs offered by crypto finance companies that are not exchanges. It is worth pointing out that at least in the U.S., regulators are taking a closer look at staking. The SEC recently reached a settlement with the crypto exchange Kraken to permanently shut down its crypto staking service under the belief that it was an investment contract that should be governed by securities laws.
Many decentralized cryptocurrency wallets let users stake directly on exchanges. For example, on Solana’s Phantom wallet, users can select the “Start Earning SOL” option to see a list of validators, with information such as the total number of delegators, validator charges and total assets staked. Websites like validator.app show performance rankings to help users make this decision, but you generally want a validator that provides a good mix of low commissions, high uptime and a reliable track record.
For other networks, the process is similar. One just has to find the wallet or service to begin staking. Daedalus is a popular desktop wallet of the Cardano network, which lets users stake the network’s ada currency. Avalanche and Polygon have their own wallets. The process is the same in that users will need to select a validator from a list of options and delegate their tokens to earn rewards. Below is the interface for staking matic through Polygon’s official staking site.
Liquid Staking Derivatives
When you stake your crypto, it is locked in a smart contract and unavailable until it is formally unstaked, a process known as unbonding. For many, that is not a problem because they are content with sitting back as the crypto earns yield. For others, this is a major problem because they cannot use that crypto as collateral for lending and borrowing in decentralized finance (DeFi).
Liquidity staking derivatives offer an alternative. Users stake their crypto on a DeFi application and receive a receipt token that can be used for other purposes. Staking ETH on the Lido liquidity service will provide yield and generate staked ETH tokens (stETH) for the user. If you lose your stETH, you lose your share of the staking pool.
Decentralized applications like Lido and Rocket Pool are on the cutting edge of DeFi with their crypto derivatives. However, there is still risk involved. The price of stETH is not pegged to ETH. Major selling pressure on stETH led to a dislocation between the prices of the two tokens in the 2022 bear market.
Every yield-bearing strategy involves risk. Though bonds are seen as one of the least risky asset classes, a purchaser will no longer receive payments if the issuer becomes insolvent.
In crypto, a user will stop receiving staking rewards if delegating to a validator that stops operating. Fortunately, you can get your crypto back if this happens. If your validator tries to approve fraudulent transactions or makes a technical error like running two validator nodes with one identity , the assets get slashed and you lose a percentage of your crypto. That’s why it’s important to find validators with proven track records and high uptime.
The safest thing you can do with your crypto is hold it in a hardware wallet not connected to the internet (cold storage) because there is no counterparty risk. However, staking is a strategy worth exploring for many reasons. If you are a long-term believer in a blockchain and have a large number of tokens,staking can be a simple and effective way to put them to work earning interest.