Staking in crypto allows cryptocurrency holders to earn a passive income by staking their coins in a proof of stake (PoS) network to help verify blockchain transactions in exchange for a reward.
Before we get into what staking is, we first need to have a basic understanding of how crypto works and core to all crypto is something called blockchain technology. A blockchain is basically software running on a decentralised network of computers. Unlike a centralised network, say, something like a central server in a company that stores a single copy of all company data, the blockchain is a peer-to-peer network where the data is simultaneously spread across thousands of computers. If one computer goes down, the network isn't affected and the data is safe. In the centralised company setup, however, if the central server goes down, the entire network potentially comes to a complete halt. This would not be good at all in crypto!
Now if we look at the actual blockchain in more detail. You could imagine it as something like an e-book. The e-book would represent the blockchain itself and each new page in the e-book would represent a new block. Each page is numbered sequentially and there are thousands of exact copies of this e-book scattered on computers all over the world. Each time a new page (block) is added, it is added simultaneously to every single e-book. This means that every one of those ebooks has the exact same information on the exact same number of pages. It is not possible for anyone to just randomly add a page anywhere in the book. It has to be sequential and has to correspond to data on the previous page and once complete, the following page too. This process is what is known as consensus and is what stops malicious actors from being able to add fake transactions or manipulate the system. It is therefore very clear that consensus is crucial in crypto. Without it, the whole of crypto would fall apart pretty quickly.
Proof of Work (PoW) and Proof of Stake (PoS) consensus methods
Bitcoin, the granddaddy of crypto, uses something called proof of work (Pow) as a means of consensus to verify transactions on the network and to provide the required level of network security. With proof of work, miners using high-power computer rigs solve complex computational problems in order to win the right to issue the next block in the blockchain. So, using the above analogy, to add a new page in the e-book.
Proof of work has some downsides though, these are primarily the high levels of computational power needed to solve random and complex mathematical problems and the relatively low speed at which new blocks can be added to the blockchain. As crypto and blockchain technology gets ever more popular and especially in the DeFi world new applications are added constantly, a faster, more scalable consensus method is required. This is where proof of stake (PoS) steps neatly into the picture.
In response to the above-mentioned issues, a newer consensus system called Proof of Stake has recently emerged with the goal of increasing transaction speed and efficiency whilst at the same time lowering fees. Proof of Stake also reduces infrastructure costs as the computational need is much lower due primarily to the computers not having to solve highly complex mathematical problems. Instead, transactions are validated by stakers (validators) on the network who are actually invested in the network by way of their stakes which represent real money. In effect, the network is backed by the stakers and their crypto assets.
A simple way to imagine staking could be to think of a large group of friends who each put €500 into a pool of money. The pool of money is then lent out to borrowers. Each time a new loan is created, one of the friends gets to record the loan transaction and enter it into the lending ledger and for doing this that particular person earns a small fee. Now, if that person gets caught doing something malicious, they stand to potentially lose their €500 stake. Also, if that person does not perform the transaction as required and on time they could lose some of their stake. In the blockchain world, that would be downtime or a malfunction on their computer system. In this very simple example, we can get an understanding of how this proof of stake system can ensure a level of integrity as ultimately the stakers have their own money on the line and don't want to lose it. This is the essence of proof of stake and what makes it work.
Some benefits of staking
For long-term crypto holders staking provides a means of making their assets work for them by generating income in the form of rewards as opposed to their crypto sitting in their wallet and earning nothing. In our current ultra low-interest-rate environment, crypto staking can potentially provide quite generous returns in the form of passive income for people with savings in crypto. The rewards can go anywhere from say 6% up to as much as 100% on smaller networks like PancakeSwap or Kava.
There are benefits for the entire network too. Staking contributes to the security and efficiency of the entire blockchain being supported by stakers. As more funds are staked. The blockchain becomes increasingly resistant to attacks and also improves the blockchain networks ability to process transactions.
As the proof of stake consensus method is not nearly as intensive as proof of work, less computing resources are needed thus taking less of an environmental toll and also it's possible to process transactions faster which in turn can lead to lower fees.
Lastly, some networks award stakers "governance tokens" which gives the token holders a say in future changes and protocol upgrades. This can be particularly beneficial for people with large amounts staked as they are at least able to influence decisions on the management and future of the network that they are supporting via staking.
What about the potential downsides of staking?
As with all things, there's no such thing as a free lunch! There are potential downsides too. Staking often requires a vesting or lockup period where the crypto cannot be withdrawn for a certain time period. If the price of the asset staked goes down it's not easily possible to liquidate the token and reduce the losses. Once you are staking, you are in it for a period of time and have to assume the risk that the price of your token could well go down and if this happens you have to hope it recovers again. It would be wise just to be safe to look carefully into the terms and conditions, vesting periods, etc. before going ahead as a staker.
There is always the risk of cybersecurity or hacking incident that could result in the total loss of your tokens held within a particular exchange or online wallet. To eliminate this risk, some crypto investors choose to store their crypto on a special piece of hardware like a pen drive that is not connected to the internet. This is known as cold staking.
Finally, there is a risk related to the uptime of the validator node that is holding your staked tokens. In the majority of cases, networks can penalise a validator if the ability to process transactions fails. This could result in your staking income being reduced due to validator uptime disruptions.
How can I go about staking?
In general, staking is open to anyone wishing to participate as per the general spirit of crypto. However, to become a full validator can require a substantial investment, for example, to become an ETH2 validator, a minimum of 32 ETH would be required along with a decent level of technical knowledge and of course, a good and reliable computer that can perform validations 24/7 without any downtime. As mentioned above, issues with downtime could cost you by way of your stake being slashed. Not what you want!
If you are not able to become a full validator, there is another much easier way. You can become a staker via an exchange and staking pool. Here you can contribute any amount you wish into the staking pool along with others. This provides much easier access to staking and the ability to earn a passive income without the need for your own validating hardware or technical expertise.
As crypto has continued to evolve beyond simply bitcoin, the original proof of work consensus method is showing signs of strain and to maybe save the day proof of stake has stepped in to provide an alternative and perhaps more efficient means of consensus validation. For investors holding crypto assets for the medium to long term, staking provides a means of putting those assets to work, so that potential gains are not simply tied to the price of the token but those very same tokens can provide quite a generous passive income much like investing money into stocks and earning dividends or a high dividend bond. This does not come without risks though as mentioned above, so it would be wise to look into the details and rules of the network where you are thinking of staking and also the potential cybersecurity risk of your tokens before putting them to work as stakers.