While banks can certainly offer some kind of security for a large portion of your wealth, it does come at a considerable cost. Just think of the administration fees, the abysmally low-interest rates on savings, and lately, also disproportionate inflation rates. Unless you live a lavish lifestyle without any regard for future expenses, you’re pretty much working against yourself with traditional finance, at least to a certain extent. Of course, the money is out there, but unless you come with extremely deep pockets, you won’t make a significant difference for yourself before your retirement kicks in. While in the stock market, you can invest your money in safely rated stocks or spread your risk by choosing reputable ETFs and then look away for a couple of years, it also won’t generate the returns most people openly dream of.

However, since the birth of blockchain technology and the sub-industry Decentralized Finance (DeFi), a new door has opened up to people who dare to take the challenge of changing their wealth status independently.

The topic of this article revolves around Staking, a wealth optimization tool that comes with incredibly lucrative percentage yields, easily outmatching any institution from the Traditional Finance (TradFi) sector. However, despite the attractive and sometimes blinding promises of future gains, this new industry does come with considerable risks that any investor or trader should be aware of.

What is Staking?

Let’s start at the beginning. In the early days of this still young industry, crypto enthusiasts had to work to earn their rewards in the mines. Okay, the computers had to do it, but regardless, that took a lot of energy (and that cost money). Even today, mining is still a thing, especially for the sector primus Bitcoin. However, in general terms, the industry has come a long way since then, and even gas fee king Ethereum has found a way to move from Proof-of-Work to the far more efficient Proof-of-Stake concept.

In short, staking is a consensus mechanism on a blockchain protocol that allows users to lock up their tokens to support the operations and transactions of a network, earning them an interest fee (proportionally to the provided holdings) in return. The procedure is called “delegating tokens to a validator or staking pool.”

Thanks to the ever-evolving crypto space, users have many options to acquire tokens and then stake them. It can be confusing, overwhelming, and frustrating at times to keep up with everything. Let this be said early on: it’s better to focus on one thing and become an expert rather than knowing a little about everything and getting burnt left and right. The proverbial devil is in the detail.

Various Types of Staking

One of the most basic approaches is staking Layer 1 and 2 tokens directly on the blockchain without a third-party platform (for example, ETH on an Ethereum validator, CSPR on a Casper Network validator, ADA on a Cardano Validator, MATIC on a Polygon Validator, etc. you get the idea). Although the path from getting the token (usually through an Exchange platform) and then sending it to the respective blockchain to delegate the holdings to a staking pool sounds very straightforward, it can still be frustrating. It’s important to know where tokens are available and whether you can use your hardware wallet. This ensures that, as long as the chosen protocol remains active, the token keys belong to you no matter what. Staking through a third-party platform could bear major risks, especially in volatile and new markets, that bankruptcy could prevent you from accessing your holdings (i.e. Celsius). Although these tokens usually yield lower returns, the token supply dilution can be mitigated, there are few contract exploits leading to lost funds, and the potential token value can be considerably higher.

But staking can also be done via third-party platforms and exchanges. The offerings can go far beyond Layer 2 tokens. In fact, the variety is already mind-blowing and needs a whole different article. Anyway, in general terms this type of staking can come at a considerable price, which is not just gas and potential other fees but also the loss of direct control over holdings as the tokens will be locked into the staking contract itself (rather than remain inside your wallet). They are still yours, but if the contract goes down, well, so do your tokens. As soon as a third party gets involved, the financial responsibility of an investor, holder, or trader becomes even more real. Turning a blind eye is similar to throwing your money out the window. Maybe you’ll get it back by the time you run outside for it, but it might just be gone if you’re living on a busy street. The point is, to pay attention to current events and community sentiments around a project that you’re investing in. DeFi is a hands-on adventure that can be very unforgiving. It raises the question of why people would choose to go that route in the first place then? It’s very simple: the risk versus reward ratio can be a lot more favourable for those who find a method that works. Although right now, many tokens have a rather short longevity, there are certainly some gems out there to be found.

Users within the DeFi space regularly merge two or more tokens together into a Liquidity Provider (LP) token. This is a common practice to provide holdings within a liquidity pool on decentralized exchanges (DEX) to make trading of various cryptocurrencies more fluid through an automated market maker (AMM) protocol. Since the provider of the tokens takes a higher risk in offering volatile assets, the percentage yield is usually a lot more interesting. Depending on the platform, the token payout may be the native project token or another one from an affiliated project. Usually, these tokens tend to be extremely inflationary, and therefore the overall long-term benefit is rather questionable, especially when markets are looking bearish.

What are the Benefits of Staking?

There are several benefits to staking and not all of them are purely about percentage yields. Although the passive income component can be a main driver for users to get into this space, another key benefit is dollar-cost-averaging (DCA) crypto holdings over a long period of time.

Furthermore, staking also provides support to projects, protocols, and networks by locking tokens into the contract and therefore taking them out of circulation (which decreases sell-pressure, for example). This is crucial, especially for a blockchain protocol (i.e. Ethereum, Fantom, Tezos, etc.). Token delegation also increases security and efficiency.

Drawbacks of Staking?

However, if there were only benefits, it would be too easy. It’s important to stay alert, and that counts for users, but also for those who run the show. Cybercrime is not just a Web2 disease, but also a virus within Web3 and blockchain protocols. Hacks have led to the loss of many funds over the past decade, and there will surely be more to come. One way to protect yourself is to stay away from projects that have red flags (do thorough research) and use hardware wallets (such as Ledger or Trezor).

But staking can also have some other disadvantages. For example, the lock-up periods to stake in the first place can range from less than an hour to many years. Though you can potentially earn higher rewards, it does limit immediate action in case of a market downturn. Some projects have integrated a concept called Liquid Staking; however, this is also not always the answer as you’ll still need a buyer on the other end of the transaction, and many contracts are prone to exploits. Another risk is Slashing, which means that if you are staking with a dishonest validator, the network provider can take measures against improper usage, which, in turn, leads to a loss of holdings. Last but not least, if you consider staking LP tokens, you’ll need to be very careful and understand what kind of implications impermanent loss can have on your initial holdings. This risk is primarily caused by constantly fluctuating prices between the two (or more) assets that are provided to the automated market maker.

How to Learn More

Of course, this was only a brief taster into the world of staking and decentralized finance. There is so much more to this space that can create opportunities and threats to your hard-earned tokens (which most likely were fiat currencies once upon a time). It’s important to choose a niche within this segment of cryptocurrencies and learn the ins and outs to avoid bad surprises. Don’t spread yourself too thin by wanting to know and learn everything. It’s not worth your time to only learn half-truths and fall victim to FOMO (or FUD) and lose your holdings. Once you find a topic that suits your interests, risk tolerance, and time availability, you can easily consult Google, YouTube, and Twitter to find relevant documentation to educate yourself before making a decision. Especially in DeFi, many projects have Discord and Telegram servers that can provide further insights into specifics, community sentiment checks, and even direct contact with project leads.

Feel free to join the Fish & Chips Discord Server (https://discord.gg/UZxPcHSJZ7) and discuss various crypto and finance topics with your peers.