26 Jan 2020 · 6 min read

How Does Staking Economy Work?

Everybody seems to be talking about cryptocurrency staking nowadays. As it continues to grow in popularity, exchanges all over the world seem to be lining up to offer their customers staking services – with no shortage of takers among their clientele.

Source: iStock/Pogonici

Indeed, Mirko Schmiedl, CEO of StakingRewards.com says that a staking revolution is in the cards, telling Cryptonews,

“The staking market will explode. More financial products featuring integrated staking will be created.”

But Schmiedl admits that staking is easily “misunderstood.”

So if you are one of the many people out there who have never really quite got to grips with staking – or have trouble understanding what it is, here is a basic guide to explain how it works plus a few pointers that will help you get started if you decide to begin staking.

What is staking?

Staking refers to “locking up” a network’s digital asset in order to improve the efficacy of a blockchain network. This locking away of funds is what gives the action its name, as participants must first put up a “stake.”

In exchange for staking funds and helping to secure the network, participants are often allowed to receive a share of the block rewards.

Blockchain network operators typically use staking in one of two ways.

The first is to leverage it as a consensus mechanism. Blockchain networks require a tool that allows their participants to agree on the final state of the ledger and coordinate their actions in a decentralized manner.

This consensus mechanism is often called proof-of-stake (PoS). In contrast to proof-of-work (PoW), which involves using computational power to solve complex mathematical equations, PoS requires participants to put down a minimum amount of funds to allow a new block to be added to the ledger.

Participants in this sort of initiative are called validators. In exchange for their efforts in verifying the veracity of transactions, validators receive block rewards, similar to PoW, when miners get, e.g., bitcoin.

PoS first took place on the Peercoin network.

Peercoin was created by Sunny King and Scott Nadal, and started out as a hybrid blockchain platform, leveraging both PoS and PoW. The network eventually phased out PoW and currently only leverages PoS.

Staking as a consensus mechanism began to attract a significant amount of attention from the crypto sector when it was revealed that Ethereum was working towards transitioning from its PoW consensus mechanism to PoS.

When Ethereum 2.0 finally launches, the Ethereum network will become completely reliant on PoS.

The second scenario whereby staking is leveraged is in masternodes.

Masternodes are specialized nodes that allow a blockchain network to introduce new features into its architecture.

Masternodes made their debut in the Dash ecosystem, where they were used to support private transactions.

Users who put up 1,000 Dash tokens earned the right to run nodes that had more responsibilities. As a payoff, masternode operators were entitled to greater rewards.

Dash masternodes were such a hit that a number of rival blockchain networks began emulating their success.

The importance of staking for crypto networks

The use of staking as a consensus mechanism has been lauded by many within the cryptocurrency industry thanks to a number of factors.

Firstly, proof-of-stake is energy efficient. It does not require computational power to solve mathematical equations. As a result, PoS networks only consume a small percentage of the energy consumed by an energy-guzzling PoW blockchain platform. In today’s increasingly eco-conscious world, this is a marked advantage.

Secondly, supporters of the PoS claim that this mechanism is more secure than other consensus mechanisms, particularly PoW. A number of smaller blockchains that employ PoW have fallen victim to 51% attacks.

This is possible in PoW because consensus is created through a collection of computational power. As such, if the bad actor in question can successfully deploy more hash power than the majority of the hash rate, they can seize control of the network. (However, in case of Bitcoin, one hour of an attack on this network would cost more than USD 800,000, according to crypto51.app, and would basically just allow double spending, while it doesn't allow the attacker to steal everyone's coins.)

With PoS, though, it works differently. This is due to the prohibitively large amounts of funds that a raider would need to put up as a stake in order to successfully launch a 51% attack.

Moreover, the attacker would be affecting the value of their own holdings – effectively wiping out the entire point of conducting a 51% attack.

As Ethereum co-founder Vitalik Buterin explains in a blog post,

“The ‘one-sentence philosophy’ of proof-of-stake is not ‘security comes from burning energy’, but rather ‘security comes from putting up economic value-at-loss.’”

(However, the PoW vs. PoS debate never ends. Learn more: Vitalik Buterin vs. Proof of Work Camp)

For masternodes, staking is beneficial as it allows blockchain networks to introduce new characteristics without executing complex architectural overhauls.

The previously mentioned Dash network, for example, has introduced masternodes to support private transactions. And another blockchain network, Syscoin, uses masternodes to buoy its decentralized marketplace.

"The market will explode"

Individuals who choose to participate in the staking economy – whether through a PoS network or through masternodes – usually do so for economic reasons. Contrary to popular belief, staking is anything but passive. Unlike HODLing, staking lets you generate a profit from funds that would otherwise likely be sitting dormant.

Additionally, proponents of staking consider it to be a safe way to earn income from cryptocurrency holdings.

Tokens put up as a stake never leave the control of their owner, unlike a range of other profit-raising activities. Moreover, it is generally easy to withdraw your staking funds if and when you need them.

Schmiedl, himself the founder of a staking analytics platform, is naturally bullish about the future outlook of the staking industry.

He tells Cryptonews.com,

“The staking market will explode in the coming years, since every newly-launched blockchain is based on Proof-of-Stake and layer-2 is no exception. We will see more and more financial products being created with integrated staking and the friction will go down for retail investors who want to keep their custody and liquidity.”

Possible pitfalls

Like everything in life, staking also has its drawbacks.

For one, staking rewards are typically paid out in the native token of the blockchain network in question. As such, individuals looking to turn a profit through the token need to assess the ecosystem as a whole, instead of just looking at the projected return-on-investment (ROI) of a staking coin.

In other words, if the ROI of a stakeable coin is very high but the coin has very low market capitalization and trading volumes, it would probably better to avoid it – as it will be hard to cash in on the tokens you have earned without seriously disrupting the market.

Moreover, if the cryptocurrency you are staking does not manage to increase in value or at least maintain its value, you will likely lose money. That is because the “interest” earned in the form of new tokens may not compensate for the drop in market value.

It pays to be picky, in other words.

Schmiedl says of the potential risks,

“Staking is still misunderstood by many users. It is important to look at the risk-to-reward ratio of participation. Each asset bears many reward options.”

If you manage to pick the right token, staking can be an excellent way to earn investment income. However, just like any type of investment, risks abound, knowledge is king – and fools rush in where angels fear to tread.

Learn more:
The Top 6 Do's And Don'ts of Staking
Staking Market Growth and Dangers