An explanation on one of the foundations of token economies
What does it mean when you’re staking crypto tokens? Why and how do you earn passive income and what are the risks involved in staking? This article explains everything you need to know about crypto staking, from all its benefits to the dangers and the things you need to look out for.
Staking can be best compared with putting money in a savings account on a bank. This is useful for crypto projects, because it locks away tokens and takes them off the market. These practices tend to have a positive effect on the price, because they result in a scarcity of supply.
Of course staking doesn’t only benefit the issuers of a token, but also the users. In short, staking allows you to earn rewards simply by holding certain cryptocurrencies. However, there’s a variety of options on the market:
A centralized version of staking happens through centralized services, often exchanges. Think about Coinbase, BlockFi and Binance. These platforms allow users to deposit their cryptocurrencies. On some of those currencies they will then earn interest, paid in the same token or another cryptocurrency. Passive income earned from staking through centralized institutions often ranges from 2 to 10% of the initial amount staked. This also counts for USD stablecoins, meaning that these crypto services offer a better interest rate or passive income than traditional banks.
As we are all about dapps, the decentralized version of staking is far more interesting to us. Here users deposit tokens into a smart contract, a piece of software on the blockchain. Decentralized applications or dapps often try to attract an audience by offering high annual percentage yield (APY). This means you get a high interest on your deposits. These interests are often paid in either the same currency, a reward currency or a native governance token. For example, on PancakeSwap you can earn 50% APR in various cryptocurrencies based on the amount of CAKE you stake. That’s a nice passive income through staking.
Liquidity pool token staking
A liquidity pool is essential if a token project wants to offer its tokens through a decentralized exchange, for example SushiSwap. For example, users can provide RADAR and ETH in the RADAR-ETH SLP pool on SushiSwap, and earn a small piece of the transaction fees. However, things get more interesting when liquidity pool token staking comes into play. After providing liquidity to a pool like the RADAR-ETH one, users receive SLP tokens. These then need to be staked into a smart contract on the blockchain in order to receive extra rewards. For example, at the time of writing you can earn 352% APY by staking RADAR-ETH SLP in the 2x Reward Farm on SushiSwap.
Learn more about how to stake RADAR-ETH SLP tokens here. More often staking liquidity pool tokens is referred to as yield farming or liquidity mining.
The 4 dangers involved in staking
Lock-up period – Staking is quite an easy principle, yet it comes with some dangers. For example, there are staking projects where you need to lock your tokens for a certain period of time. This means that you won’t be able to move or sell your tokens whenever the price shifts. This is often referred to as a lock-up period or vesting period.
Impermanent loss – A bit more technical is the concept of impermanent loss, which can only happen when you’re staking Liquidity Pool tokens. If you put together $100 of TOKEN and $100 ETH in a liquidity pool on SushiSwap, you will receive a certain amount of SLP tokens. When the TOKEN drops 50% in value, the pool will convert ETH into TOKEN. This can ultimately mean that you end up with $50 of TOKEN and $125 of ETH. In that case your investment experienced an impermanent loss of $25. Therefore you will need to make sure that the interest or APY you get when staking LP tokens, outperforms the potential impermanent loss.
Rugpull – The biggest risk of staking is also tied to the popularity of DeFi, the rugpull. As mentioned, newly launched DeFi solutions often offer crazy amounts of interest on crypto deposits. Sometimes we’re talking about single token staking, but this also applies to staking LP tokens. Once in a while a DeFi project waits until lots of people have deposited millions in staking pools, then quickly swaps all the new tokens for ETH or BNB, and they run off. Unfortunately a rugpull is common practice in the DeFi space, and you should be aware of that. The longer a DeFi project is on the market, the more established they are and the bigger their reputation. However, again those newer projects entice people to compete in yield farming and enjoy those very lucrative interest rates.
Hack – The DeFi space is still very young, yet it has developed quite a lot. However, hacks still happen. Sometimes hackers steal a private key through key logging, other times they abuse a programming flaw in a smart contract. Some projects have an insurance fund to cover these types of losses, while others have no way of returning stolen money. Therefore don’t invest money in crypto that you’re not able to use, because both centralized and decentralized financial services can become targets for hackers.
Things to do before you start staking
- Only use money that you’re able to lose in case of a hack or rugpull
- Use the DappRadar Rankings to assess the trustworthiness of a DeFi project. Has it been around for a long time? How many daily, weekly, and monthly users does it have??
- The higher the APY, the riskier the investment. Newly launched DeFi protocols can offer an APY of 10,000% or more.
- Don’t only look at the numbers, but know what you’re investing in. When you’re staking and you know the project will be awesome 12 months from now, you’re better positioned to emotionally deal with the fluctuations of token prices.