Bitcoin, the world’s most popular cryptocurrency, uses a consensus algorithm known as Proof of Work (PoW). This system requires ‘miners’ to set up hardware that validates transactions on the Bitcoin network for a reward. However, though Bitcoin and a few altcoins use PoW, the rest of the industry has moved on.

Today, Proof of Stake (PoS) is the industry’s favorite consensus algorithm. Instead of verifying transactions using mathematical proofs, PoS uses a decentralized network of validators whose trustworthiness is measured by the size of their stake. 

Stake more tokens → validate more transactions → earn more rewards. The bigger someone’s stake is, the more they have to lose, incentivizing them to act in the network’s best interests. To the end user, staking is similar to putting money in a fixed deposit account, but in reality it’s far riskier. 

But before we get into how staking loses you money, we need to understand how staking works.

How does staking work?

Staking in crypto refers to the process of holding and locking up cryptocurrency as collateral to support the operations of a blockchain network, and in return, earn rewards in the form of more cryptocurrency.

Staking involves actively participating in the network by verifying transactions and adding new blocks to the blockchain. It requires users to hold a certain amount of cryptocurrency and “stake” it, meaning to temporarily lock it up to act as a security deposit, in order to become a validator node. These validator nodes are responsible for processing transactions, validating blocks, and maintaining the network’s overall security and stability.

In return for their participation, stakers receive rewards in the form of additional cryptocurrency. The amount of rewards depends on several factors such as the amount of cryptocurrency being staked, the duration of the staking period, and the overall health of the network.

How does it lose me money?

Imagine a year ago you invested $1000 in a Proof of Stake coin, say, Solana. At the time, SOL was trading for around $100, so you purchased a total of 10 tokens. Let’s say you decided to stake your SOL for a year at 20% APY.

One year later, instead of 10 tokens, you now have 12, which should mean that your $1000 investment is worth $1200. However, SOL now trades at $26 – a quarter of the value it originally held. Your 12 tokens are effectively worth $300, meaning you’ve lost 70% of your investment.

Sure, you can argue that if you hadn’t staked those 10 SOL, you would have made additional losses, but if you hadn’t staked, you might not have held onto it throughout the year.

What are the risks of staking?

The United States SEC is investigating the concept of crypto staking, pushing Kraken, one of the biggest digital asset exchanges in the US, to halt staking services on its platform. To put it bluntly, staking introduces the following risks to your investment portfolio: 

1. Market Risk

Which we just talked about. Volatile markets and staking don’t play well with each other. Be careful about which projects you support through staking.

2. Liquidity Risk

If you stake a micro-cap altcoin, you may find it difficult to sell or convert your staked assets.

3. Lockup Periods

Some staking systems enforce ‘lockup periods’ during which assets cannot be unstaked. Depending on the token, this period can last anywhere from between a few weeks to several years.

4. Payout Cycle

Similar to lockup periods, different staking systems pay rewards at different frequencies. Some pay daily, others take longer. This shouldn’t affect your APY if you ‘HODL’ the whole year. However, it will impact how often you can re-invest your staking rewards.

5. Validator Risk

Running a validator node for staking isn’t cheap, and needs a pretty broad technical understanding to ensure that nothing goes wrong. Nodes need to have 100% uptime to ensure maximum returns, so most people delegate their stake to existing validators.

However, if that validator node misbehaves (even by accident), you may incur penalties. In a worst-case scenario, validators can even have their stake ‘slashed’, losing a significant chunk of their staked tokens.

6. Regulatory Risk

Depending on where you live, it might be in your best interest to stay away from staking. Germany, for instance, lets crypto holders liquidate without paying taxes if they’ve held the asset for more than a year. However, this threshold jumps to 10 years if the assets have been staked.

Is staking always a bad idea?

Absolutely not. There are some situations where it’s practically impossible to profit without. For instance, networks like Tezos and Polkadot don’t have fixed supply caps, meaning that you actually lose money to inflation unless you stake your assets.

It’s also a good idea if you’re really passionate about a particular project. Staking is a means for projects to incentivize users not to sell their tokens, which funds development. With lockup periods, they can ensure that market crashes don’t instantly lead to mass selling, and even those that don’t enforce lockup periods can convince users not to unstake by increasing their reward rates for staking.

How do we deal with this?

Staking has become the default for most blockchains and its applications, but it’s crucial to be aware of how it works before you can take advantage of it. Be careful about which projects you support through staking. Do your research. Understand the fundamentals.

Additionally, avoid staking micro-cap altcoins. They introduce major liquidity risk by being hard to sell or convert, and be on the lookout for lockup periods. Chains like Solana and Cardano let you stop staking whenever you want, but staking on chains like Ethereum, Cosmos, and Tron can prevent you from exiting when you need to.

Also, make sure not to store your assets on an exchange. Hardware wallets are expensive, but you can make one at home using just a pendrive and a computer. If you’re interested in learning more about blockchain technology, and how it can make your payments cheaper and more convenient, make sure to check out binamite.com.

Binamite lets you send and receive payments in any currency – crypto or otherwise. Pay using fiat or crypto, and get paid in both. Your money, your terms. Let Binamite handle the rest. Sign up is totally free, and we’d love to hear what you think.

What do you think about staking? Disagree with something we said? Let us know in the comments, or hit us up on social media!