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Welcome to the fifth of PYMNTS’ eight-part series on decentralized finance (DeFi).
Over the coming days, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution.
At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.
SEE PART 1: What is DeFi?
SEE PART 2: What Are the Top DeFi Platforms?
SEE PART 3: What Is a Smart Contract?
SEE PART 4: What is Yield Farming and Liquidity Mining?
So, what is staking? At the simplest level, it’s a good way of earning passive income on crypto holdings, and it’s generally a whole lot safer and easier than yield farming.
Lock some of the appropriate crypto into a smart contract to join a staking pool, and you’ll earn interest on it.
At a less simple, but still fairly easy-to-grasp level, staking is the lifeblood of DeFi — but that’s a few steps down a fairly straight road.
A good way to think of it is a new, more efficient and far more eco-friendly way to earn rewards than by “mining” bitcoin. Staking is essentially the new mining.
Mining Begins
We’re going to move into some necessary background here, looking under the hood at bitcoin. If you know what a “consensus mechanism,” jump ahead to the next section.
Most people know that you can “mine” bitcoins and make a lot of money now that they’re priced in the $50,000 to $60,000 range. However, that’s just the reward for doing something somewhat difficult and very vital — adding new transactions to the bitcoin blockchain.
Like all blockchains, bitcoin is immutable — once a transaction is written onto the blockchain, it cannot be changed or deleted. As such, it’s very important that they are verified as legitimate. To ensure that this is done honestly, Bitcoin’s creator made the chance to write a new block and mine its bitcoins random.
Miners run computer nodes with copies of the full blockchain, and compete to solve a very complex math puzzle every 10 minutes. The winning node creates the new block. Every node agrees and is updated by this process called a proof-of-work (PoW) consensus mechanism.
This has several problems. It is slow and difficult to scale as the number of transactions grow, leading to high transaction fees — the other way miners earn. Beyond that, as bitcoin’s value grew, mining became so lucrative that an arms race for better computers erupted.
Now, major miners have whole server farms of expensive and powerful computers competing, and the power used is staggering. Annually, Bitcoin mining uses nearly as much as power as Sweden, which is wasteful and bad for the environment.
Staking Takes Over
Thus, proof-of-stake — known by the unfortunate shorthand “PoS” — consensus mechanism was born.
In a proof of stake network, transactions are verified and written into new blocks by stakers, who essentially put up a large bond for good behavior. Do something wrong or dishonest, and the smart contract running the process “slashes” your stake.
Winners are chosen randomly by algorithms that ensure that stakers are selected to write blocks in proportion to the size of their stake. For example, if you have 5% of the staking pool, you’ll earn 5% of the rewards over time.
In theory, this is just as safe as mining, but much faster, allowing the blockchain to process vastly more transactions per second. Bitcoin can do about 6 to 8 tps and Ethereum can do 10 to 20 tps, leaving them clogged and transaction fees very high. Visa handle about 1,700 tps, and its network can handle 24,000.
Virtually all of DeFi and the increasingly popular non-fungible token (NFT) projects are built on Ethereum, which is now seeing transaction fees as high as $70 or more — which is why Ethereum is transitioning to Ethereum 2.0, a PoS system that will handle up to 100,000 tps.
But that’s a years-long process, so a number of PoS blockchains that aim the be “Ethereum killers” — like Cardano, Polkadot and Solana — have surged nowhere into the top 10 cryptocurrencies by market capitalization, growing by hundreds and even thousands of percentages this year.
Their goal is to attract projects — most notably lucrative and fast-growing DeFi projects like lending protocols and decentralized exchanges — to build on them, offering speed, enormous tps numbers (Solana’s is 65,000 tps) and tiny transaction fees.
Investing in Staking
While the actual stakers have to run nodes 24/7 and generally have to put up large sums to get in on the action, staking pools allow small retail investors to earn by joining staking pools. Signing up to stake the beta Ethereum 2.0 requires a minimum of 32 ETH — more than $120,000 at a $3,800 ETH price.
Remember how stakers earn rewards in proportion to the size of their stake? Well, staking pools let them increase their size, paying members a portion of the resulting rewards. Seeing as the amount of rewards a staker will earn is a known quantity, staking pools pay off in interest rates.
Like anything in crypto there are risks — starting, as ever, with volatility. There’s also the fact that many staking pools require investors to lock up their cryptocurrency for a set period, magnifying the risks of volatility. Smaller, newer projects offer higher interest rates, but their tokens are more likely to crash while your investment is locked.
The flip side is that it is very easy to get in on, as most large exchanges offer staking as a practically one-click option.
For example, Coinbase is currently offering 5% on Cosmos, 4% on Algorand, 2% on the DAI stablecoin, and 0.15% on USDC stablecoins.
Next Up: What Are Defi’s Use Cases?
The two best-known uses of DeFi are decentralized exchanges, also known as DEXs, and lending/borrowing protocols. But we’ll also look at payment solutions, insurance, gaming prediction marketplaces, digital identity and more.
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