Staking: Your Different Options, and What They Mean
|— Proof of stake-based blockchains are kept running by validator nodes:to become a validator, the node must first stake a significant, minimum amount of crypto on the network.|
— Validator nodes earn rewards for keeping the network running – but the technical know-how and large amount of crypto required to become a validator deter many people from doing this themselves.
— As a result, there are indirect alternatives to becoming a validator node, which enable retail crypto holders to benefit from the rewards, without the technical know-how or a large initial contribution.
— Here, we unpack the mechanics that drive staking, and delve into the custodial and non-custodial alternatives to becoming a validator, so you can understand which one’s right for you.
Staking is one of the most popular topics in the crypto space. It facilitates crypto holders to make passive income with the coins and tokens in their wallet. But before you commit your crypto to any of the staking options available to you, it’s important to understand what they mean.
In this article, we explain the basic mechanics of staking, and explain the key differences between delegating directly to a validator node and staking indirectly, via a centralized exchange or provider.
Proof of Stake: The Origin of Staking
Staking is only possible because of the dynamics within proof of stake blockchain networks. So let’s start by recapping the details of such a system.
Proof of Stake (POS) is today the most commonly used consensus mechanism in the crypto space, offering an energy-efficient alternative to proof of work that enables blockchains to secure themselves from malicious actors. So how does it work?
Validators Run the Network
In proof-of-stake networks, actors known as validator nodes keep the blockchain active, validating new blocks of transactions and adding them to the blockchain permanently. In return, they earn rewards from the network.
Networks Require Validators to Stake Coins
In order to participate, validators must first stake a significant sum of their own crypto within that network. For example, in the case of Ethereum, validators need to stake 32 Eth in order to get started, which may prove difficult for many. This is why the blockchain is known as “proof-of-stake” – because validator nodes need to prove their stake before they can start to participate.
Staked Crypto Means Skin in the Game
You may be wondering why is this necessary?? The answer is security. Remember – there is no job interview or identification process for becoming a validator, so the network needs its own system to ensure these nodes cannot manipulate the network in any way. By taking this sort of “staking deposit” from validators, the blockchain is able to use the staked crypto to incentivize good conduct, and deter dishonest practices.
Validators Earn Rewards
In return for their efforts, computing power, and resources, validators earn rewards from the network. 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, they are never in anyone else’s custody.
So to recap: staking rewards are paid to validator nodes on proof-of-stake blockchains, because they give their efforts and computing power to help the blockchain run. Simple, right?
Barriers to Becoming a Validator Node
However, not everyone has the option of becoming a validator node, because there are some significant barriers to entry.
Technical Knowledge, Hardware and Commitment
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.
High Up-Front Cost
As you know, becoming a validator means a significant initial staking investment. Not everyone has this sort of crypto at their disposal, preventing the majority from getting involved in this process, or enjoying its rewards.
If the requirements of becoming a validator are too much, you might be wondering how you can access staking for yourself. Luckily, you have a couple of other options.
Staking Without Validating: Your Options
If you prefer to avoid the financial and technical commitment of becoming a validator, you have a couple of less direct staking options. These involve delegating your coins to a validator, who will do it for you.
Why Delegate Your Crypto?
The advantage of delegating your coins is that it lowers the barriers to entry for passive income: you do not need any equipment, or a large initial investment to get involved – someone else is doing the technical parts of the job.
But there are two distinct processes through which this can be done: one is non-custodial, meaning your coins will remain in your own crypto wallet for the staking period, and the other is non-custodial, meaning you’d cede custody of your coins to a custodian for the staking period. Understanding the difference between these two things is essential, particularly if self-custody is important to you.
There are also some key differences in terms of the rewards you’ll earn, as well as the transparency of the process as a whole.
Let’s explore your two main staking options through this lens, so you can figure out which one is best for you.
Option 1: Non-Custodial Staking – Direct Delegation
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 their chances of being selected by the network to perform work. Meanwhile, the delegator can earn rewards without undertaking the efforts of becoming a validator.
Staking through a validator node is non-custodial, meaning your coins will remain in your own crypto wallet. This means you’ll retain the ability to remove your staked coins from the protocol at any time (in conformity with the fixed, initial bonding period, which is set by the protocol).
You’ll remain in control of your funds the whole time via their private keys, and will not need to entrust ownership to anyone else.
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 behaviour, 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.
Rewards and Commission
The rewards you earn for delegating your coins to a validator are in proportion 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 varies 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.
Option 2: Custodial Staking – via Centralized Exchange or Provider
A third, less direct staking option also exists.
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 or staking providers may offer to stake your coins and give you a share of the rewards.
By doing this, these services can combine assets from thousands of users and run a high volume of validators nodes. But for you, this system also has significant consequences in terms of control, trust and rewards.
Even an absolute beginner can stake through an exchange or provider. There is no minimum required amount, and you won’t need to worry about technical aspects of staking, since the custodian and validator node deal with those.
But conversely, you’ll also forfeit control of your coins. Using a custodial staking service means 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.
Level of Trust
Trust is a big issue when it comes to custodial staking. For a start, yo’re relying on the security of the custodial platform, since you’re entrusting your crypto to their wallet.
Further to this, you will also have no say in which validator node your coins are delegated to – here again, you’ll be trusting the platform itself to manage your coins and the staking relationship.
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.
Staking Options – a Recap
Now we’ve covered the full strata of staking options available to you, let’s go back to basics.
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.
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 cypto.