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What Is Crypto Staking and How Does It Work?

Read 5 min

KEY TAKEAWAYS:
—Proof of stake-based blockchains stay running thanks to validator nodes. However, to become a validator, a network participant must first stake a significant amount of crypto.

— Validator nodes earn rewards for keeping the network running – but the technical know-how and amount of crypto required may deter many people from doing this themselves.

— You can stake directly from your device using the Ledger Ecosystem, allowing you to retain custody over your keys while doing so.

The underlying technology behind a blockchain directly affects the way in which the whole system runs, and how it is secured. A proof-of-work (PoW) blockchain, such as Bitcoin, is secure because the power it takes to complete a transaction or mine a coin is so great that it protects the network from bad actors.

However, proof-of-stake (PoS) networks don’t use this same method of security. Instead, they require participants who want to validate transactions to lock up a significant amount of funds. This is called crypto staking. In return for this stake, the participant wins a reward. 

But why? What are they rewarded for?

Crypto staking is a complex subject, simply due to the different methods of doing it from system to system, and from purpose to purpose. So, from the basic mechanics of staking to the key differences between delegating directly to a validator node to staking indirectly; let’s explain crypto staking, its advantages and disadvantages, and how you can stake crypto yourself.

But before we get there, let’s attack the basics.

What Is Crypto Staking?

Crypto staking is when you lock up a certain amount of cryptocurrency in order to secure a proof of stake blockchain network. Staking gives the user rewards in the form of cryptocurrency. 

Yes, we’re sure you’ve heard about the rewards. But before you commit your crypto to any of the staking options available to you, it’s important to understand how it works.

Proof-of-stake: Explained

A blockchain network relies on participants to create blocks, and in return these users receive rewards. For blockchains, such as Ethereum and Solana, this role is carried out by validators. Validators are participants in a PoS network that operate blockchain nodes. As opposed to blockchains using a PoW consensus such as Bitcoin, validators on PoS networks don’t need complex computing devices. Instead, they must stake their cryptocurrencies to prove their trustworthiness.

Staked Crypto Means Skin in the Game

The locked-up funds act as collateral, proving the nodes will act with integrity when verifying transactions. That’s because the network automatically punishes bad actors by slashing their rewards. Plus, the network favors validators with a higher amount of staked currency. That’s because the more collateral a node has, the higher the chance it will act legitimately. Accordingly, the network allows them to approve more valuable transactions than those who have lower stakes.

Validators Earn Rewards

In return for their efforts, computing power, and resources, the network rewards a validator in its native cryptocurrency. After all, they are keeping the network running for its participants. What’s more, they can do all of this while their staked coins remain in their custody. Staked funds are deposited in the blockchain’s smart contract. Meaning that although they are committed, the validator still has custody of the funds.

So to recap: staking rewards are paid to validator nodes on proof-of-stake blockchains. They give their efforts and computing power to help the blockchain run. Simple, right?

What Is Crypto Staking For?

Staking helps crypto holders make passive income from coins and tokens. Plus, staking rewards work using compound interest. This means you earn interest on your staked funds calculated with the previous reward included.

For example, if you were to stake 100 SOL and receive 1 SOL as your first reward, your next reward will be calculated from the 101 SOL rather than your initial amount deposited. The case with compound interest is that the initial growth may seem slow. However, if you stake crypto for the long term, it could make a big difference to your portfolio.

Issues with Accessing Crypto Staking

Bear in mind, not everyone has the option of becoming a validator node since there are some significant barriers to entry. For example, besides a substantial minimum investment, you also need technical knowledge and dedicated hardware that can validate continuously. This means an initial investment of time and money. Plus a commitment to running a constant power supply to power your node. 

For example, the Polkadot (DOT) network requires validators to operate a system on a high-availability server to ensure the node stays live most of the time to prevent penalties. If that weren’t enough, there are other technicalities such as setting up a cloud server, installing client software, and so on.

Furthermore, becoming a validator means a significant initial staking investment. Not everyone has this sort of crypto at their disposal. For example, on the Ethereum network, becoming a validator involves staking 32ETH. 

You’re surely wondering, “Well, that doesn’t sound as easy as you promised in the beginning!”

We know. Not many of us own such huge quantities of cryptocurrencies. Nor can we afford to operate a system 24×7 with such high processing power or understand the technicalities of the process. Thankfully, you don’t need to do any of it. You can participate in the network and get rewarded for it in a few clicks. Hear us out.

Staking Without Validating: Is it Possible?

Instead of becoming a blockchain validator node, you can delegate your cryptocurrencies to one. This allows you the freedom to delegate any small amount of cryptocurrencies and earn rewards proportional to the number of tokens you stake. Additionally, you won’t need any equipment, or to keep your computer running all day long; someone else does the technical parts of the job for you. 

There are two distinct ways to do this and they have key differences in terms of the rewards you’ll earn, as well as the transparency of the process as a whole.

Non-Custodial Staking – Direct Delegation

The first option you have is non-custodial, meaning your coins will remain in your own crypto wallet for the staking period. Certain blockchain networks enable delegation. This is where holders of the network’s native coin can contribute their coins to a validator node. The delegator will then earn a percentage of the rewards accrued by that node. This helps the validator node by increasing its chances of being selected by the network to perform work. Meanwhile, the delegator can earn rewards without undertaking the efforts of becoming a validator.

Custody

Non-custodial staking gives you the ability to remain in control of your funds the whole time. Plus, you can use a hardware wallet, like Ledger Devices, to keep the private key corresponding to that address safe. This way, your funds are protected from online hacks.

Level of Trust

This type of staking requires you to trust the validator you’re using to do its work honestly. If the node gets slashed for errant behavior, your rewards would also decrease. On the plus side, validator services tend to give users a lot of transparency in terms of the percentage of rewards offered, fees charged, and reputation of the validator node based on previous activity. So while the responsibility of DYOR falls to you, there’s a lot of transparency around the validator node, to enable an informed decision about who you’re delegating to.

Staking Rewards

The rewards you earn for delegating your coins to a validator are proportional to your stake. But you’ll also pay a small commission to the validator, as a service fee for the efforts of maintaining the node, etc. Fees vary significantly depending on the validator and the protocol. But these are clearly stated at the outset, enabling you to understand the yield before bonding your coins.

Custodial Staking on Centralized Exchanges

Custodial staking is when a third party – a custodian such as a centralized exchange or staking provider – stakes coins on your behalf. Similar to how real-world banks rehypothecate their clients’ funds to make extra income for the bank, centralized crypto exchanges also offer crypto staking services. By doing this, these services can combine assets from thousands of users and run a high volume of validator nodes. But for you, this system also has significant consequences in terms of control, trust, and rewards.

Custody

Using a custodial exchange means you’ll also forfeit control of your coins. Basically, you’re depositing your crypto into a third-party wallet. Remember: not your keys, not your coins. This means you won’t be able to control which validator node your coins are staked with or remove your coins before the end of the agreed period. Plus, if the exchange wants to, it can remove your staking rewards and disappear with your funds without warning.

Level of Trust

Trust is a big issue when it comes to custodial staking. For a start, you’re relying on the security of the custodial platform, since you’re entrusting your crypto to their wallet. Unfortunately, you also don’t get to choose which validator your coins go to. Again, you’re trusting the platform has your best interests at heart.

Staking Rewards

This option will get you the lowest rewards out of the three. After all, centralized exchanges and providers will charge fees for providing this service, reducing the final yield for the end consumer. Here, you will have to pay a premium for the convenience of a simple procedure. You may never even know how big a cut the platform is taking from the original staking reward. However, on the plus side, there is no risk of slashing here – it is borne by the platform.

How To Stake Crypto Securely

So now you know that staking crypto is always better via non-custodial services. Luckily, you can stake crypto directly with your Ledger device via the Ledger ecosystem, keeping custody of your assets the entire time.

If you’re looking to stake SOL or ATOM, you can do so directly through the Ledger validator node.  Plus, you can stake many more coins through  Ledger Live, including; Algorand (ALGO), Tezos (XTZ), Tron (TRX), Ethereum (ETH), and Polkadot (DOT). To do so, install the cryptocurrency’s corresponding application on your Ledger device. Then go to the Discover section of Ledger Live, and choose one of Ledger’s staking partners to start your journey.

Final Thoughts on Crypto Staking

Staking enables crypto users to generate passive income from idle crypto. But it can be done with varying degrees of control, involvement, and eventual rewards, depending on how you choose to stake. Make sure that whichever option you choose, you take the option of self-custody into account. Understanding the precise nature and key considerations of what you’re doing enables you to engage with staking safely. 

Knowledge is power, and nowhere is this more true than when you’re managing your hard-earned crypto.

Knowledge is power – so keep on learning! If you’re enjoying getting to grips with crypto and blockchain, check out our School of Block video, What is DeFi?


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