What is staking in crypto? Understanding the pros and cons

Many crypto investors follow the "hold on for dear life" (HODL) strategy, where they hold onto digital assets long-term despite market volatility. While this approach has its merits, some find it too slow to generate meaningful returns. Faster alternatives like crypto staking offer a way to earn passive income without needing to sell off assets.

Crypto staking, although still relatively new, has become standard across decentralized finance (DeFi) platforms. Despite its growing popularity, it’s not without risks. Staking can lead to losses under certain conditions, such as network failures or a drop in the value of the staked assets.

In this guide, we’ll explore what crypto staking is, outline its various types, and weigh the potential benefits against the risks you should consider before staking your digital assets.

What is cryptocurrency staking?

Cryptocurrency staking involves "locking" digital assets within a blockchain or decentralized application (dApp), a mechanism decentralized protocols use to incentivize participation and secure their networks. Investors, or "stakers," commit their crypto to a protocol and receive "staking rewards," typically in the same cryptocurrency they staked. These rewards, which vary, are usually expressed as an annual percentage rate (APR) or annual percentage yield (APY). 

Staking often plays a key role in blockchain validation, and some platforms use it to provide financial services or encourage long-term commitment to their projects. Ultimately, the goal is to boost the network's security, visibility, and decentralization while driving community engagement.

Types of crypto staking

Crypto staking primarily involves earning interest on locked digital assets, but it extends beyond this basic concept. While some forms of staking are crucial for ensuring a blockchain's security, others create new financial opportunities for earning rewards through innovative mechanisms.

Proof-of-stake (PoS)

First introduced in 2012 with the launch of Peercoin (PPC), proof-of-stake (PoS) is a consensus algorithm designed as a scalable and sustainable alternative to the proof-of-work (PoW) method used in blockchains like Bitcoin (BTC). Instead of relying on miners to run energy-intensive rigs and compete for rewards, PoS uses validators who stake their cryptocurrency for a chance to validate transactions on the blockchain.

While PoS blockchains often have high minimum staking requirements to run validator nodes (e.g., running a validator node on Ethereum requires staking 32 ETH), many allow users to delegate smaller amounts of cryptocurrency to a validator pool, which makes staking rewards more accessible to a broader range of participants.

Delegated proof-of-stake (DPoS)

Delegated proof-of-stake (DPoS) is a variation of the standard PoS method that also requires node operators to lock their crypto onchain to receive staking rewards. The main difference is that DPoS allows token holders to vote for a select group of validators, who are then responsible for validating transactions. While this method enhances scalability by streamlining the validation process, it also concentrates power in the hands of fewer validators, potentially increasing the risk of centralization.

Liquid staking

Liquid staking protocols like Lido Finance (LDO) enhance traditional staking by providing stakers with additional liquidity. The "liquid" aspect refers to the ability of stakers to receive a synthetic token (e.g., stETH for staked Ethereum) that represents their staked assets. This token not only acts as a receipt but can also be traded or used in DeFi applications, such as lending protocols, all while the staked asset continues to earn rewards. For instance, stakers on Lido receive stETH, which mirrors the market price of ETH and can be used across various exchanges and DeFi platforms. Liquid staking tokens (LSTs) enable investors to maximize returns by participating in DeFi while still earning staking rewards from their locked assets.

Restaking

Restaking involves using liquid staking tokens (LSTs) or liquid staking derivatives (LSDs) from one DeFi protocol to generate additional yield in another staking pool while providing cryptoeconomic security for other protocols, effectively creating two passive income streams. While this method can enhance returns, the added complexities and risks – such as smart contract vulnerabilities and liquidity issues – make it a riskier strategy.

Pros and cons of crypto staking

Crypto staking is appealing to many traders because it offers a way to earn interest on digital assets with minimal effort and time commitment. However, it comes with additional risks that investors should carefully consider.

Pros

• Generating passive income: One of the main draws of crypto staking is the opportunity to earn passive income on digital assets. Instead of simply holding onto cryptocurrencies and waiting for their value to appreciate, staking allows investors to put their assets to work, generating a steady stream of interest with minimal effort.
• Enhancing blockchain security: For many crypto enthusiasts, staking is about more than just earning rewards – it's a way to actively support the security and decentralization of blockchain networks. By staking, investors contribute to the validation process, helping to secure the network and uphold the principles of the decentralized economy.
• Increasing accessibility: Staking has become more accessible than ever. Investors can now easily stake their crypto directly through self-custodial wallets or decentralized applications (dApps). Several cryptocurrency exchanges also offer “staking as a service,” catering to those who prefer the convenience of using a third-party platform.

Cons

• Lock-up periods: Also known as "unbonding terms," lock-up periods refer to the time required to release and withdraw staked crypto assets from a protocol. While not all staking programs impose lock-up periods, those that do can reduce liquidity for traders, making it challenging to adjust portfolios or capitalize on market volatility.
• Slashing penalties: Whether staking through a validator node or a staking pool, investors may face the risk of "slashing" penalties for any misbehavior or technical errors. Even honest mistakes can lead to significant consequences, such as losing staked assets or being banned from the network, as protocols strictly enforce rules to maintain security and integrity.
• Risks of scams, hacks, and glitches: Bad actors may offer fake opportunities that expose stakers to malicious smart contract or third-party manipulation. Even with thorough research, stakers might still lose their crypto assets, often with no way to recover them.

Crypto staking common mistakes

Staking cryptocurrency might seem relatively straightforward, but it’s not without its fine print. Here are a few things to watch out for:

• Not reviewing validators: When delegating digital assets to a staking pool, some traders choose validators without a thorough review. Validators are crucial for maintaining security; those with poor track records increase the risk of losing crypto or incurring penalties. 
• Chasing high yields: High APYs can tempt investors to chase big returns on staking protocols. However, staking yields that far exceed average rates – especially on new or unproven projects – often comes with significant risks. In some cases, these high returns might be unsustainable, or the project could be a scam.
• Overlooking lock-up periods: Remember, staked crypto is inaccessible until any lock-up periods end, which means those assets can’t be withdrawn or traded during that time.
• Ignoring tax implications: Tax laws on staking rewards vary by country, but they’re typically categorized as “ordinary income.” Investors need to factor these taxes into their overall strategy to maintain a clear picture of gains and losses. Failing to account for staking rewards on tax forms could result in overpayment or penalties.

Maximize your crypto staking rewards while staying compliant with CoinTracker

Don’t let the complexity of reporting crypto taxes keep you from staking. If you’re serious about leveraging staking protocols, CoinTracker provides the tools you need to track, monitor, and calculate your staking income with ease. Our software integrates with over 50,000 DeFi smart contracts and accurately separates staking income from other activities when generating IRS-compliant forms. For crypto staking without surprises, sign up for a free CoinTracker account today. 

FAQs

Are the staking rewards funded through inflation or fees?

Each crypto protocol has its own way of generating rewards for staking. Some protocols issue new tokens (inflation) to fund rewards, while others use transaction fees paid by network users to compensate validators. To understand the sustainability of staking rewards, investors should examine a project's design, treasury, and tokenomics.

Are payouts made in the staking token?

Staking rewards are usually paid in the same token that was staked, which is standard on many blockchains and protocols. However, there are cases where rewards may be paid in a different token, depending on the platform or staking program.

Do you know your tax obligations?

Staking rewards are taxable and typically treated as income by tax authorities, though the specifics can vary by jurisdiction. Crypto tax software like CoinTracker helps ensure accurate reporting of staking activities and compliance with tax laws.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.