Crypto staking is a hot new trend, but it’s not without risk to traders
By Rakesh Sharma
In a crypto winter, what should traders do with their cryptocurrencies? The standard options are to sell at a loss, or hold on and patiently hope for a reversal. Now, there’s also a third option gaining popularity with traders: crypto staking.
In staking, cryptos are used as collateral to borrow loans or earn interest. The interest rates vary based on the type of cryptocurrency and loan terms. Staking services have proliferated in tandem with the growing interest in crypto.
San Francisco-based exchange Coinbase recently announced that it has begun offering staking as a service for Tezos’s token XZT. The exchange has said it will insure these assets in cold storage to protect them against hacks. Binance, arguably the world’s biggest exchange by trading volume, has also launched a staking service for XZT on its Trust Wallet. Celsius.network, a crypto-lending firm, has announced a staking service with Battlestar Capital that boldly promises block rewards of as much as 30%.
What is Staking?
Staking enables crypto investors and traders to borrow fiat loans against their coins. It also represents an alternative to mining as a way to generate cryptocurrencies, as coins are rewarded based on their holding period in a node.
To be eligible for staking, cryptocurrencies must use the PoS consensus system. In PoS, nodes are rewarded based on the number of coins they hold. The greater the number of coins, the bigger the reward. While most newer coins, including Dash and EOS, can be staked, some major coins, including Bitcoin, are ineligible. Ethereum, the world’s second most valuable blockchain, is expected to move to a Proof of Stake (PoS) system soon.
There are three main types of PoS systems. The first is traditional staking, in which staked coins contribute to strengthening blockchain systems. (The security of blockchain systems is a function of the number of nodes involved in validating transactions on its blockchain.) The second involves running a Masternode, or a node which holds a record of all transactions that have taken place since the blockchain’s inception. Finally, there’s the delegated Proof of Stake (dPoS) system, in which rewards from running a node are shared between a community or several parties.
Staking services pool together individual coins from investors to run Masternodes in a cryptocurrency’s blockchain. In exchange, they earn rewards. For example, Dash’s network requires a minimum of 1,000 coins for Masternode operations. A service that lends against staked Dash coins would aggregate Dash coins from holders and pay them a monthly interest rate fee. That fee is sourced from the rewards that it earned as the Dash Masternode.
According to Allen Hena, cryptocurrency consultant and adviser with Celsius, staking coins offer the prospect of a higher yield as compared to non-staking coins. “We can take those Dash coins that you have and we have the infrastructure, processes, and people to generate returns (from the coins),” he said. Crypto lending companies also earn money from staked coins by lending them out for other trading tasks, such as shorting cryptocurrency markets.
Hena did not reveal the margin amounts required for such loans, but said that the staking margin calculation requires a balance between ensuring that there is an adequate supply of reserve coins (for redemptions) and covering the operational costs. Bloomberg recently reported that borrowers pony up between 20% to 50% more in cryptocurrencies in relation to the cash amount they want to borrow.
Staking and Floating Interest Rates
The secret sauce for staking services lies in the interest rates offered to investors. Advertisers for such services generally tout their highest interest rates, but those rates are probably a function of an ideal best-case scenario and, as such, reflect a situation in which markets are on an upswing. Cryptocurrency lending firms function in much the same way as mainstream financial services firms, conducting market operations in the back-end to cover costs and make profits.
On its website, Celsius network advertises three interest rates that are comparable or, in some cases, even better than conventional loans. But those rates come with fine print explaining that this could change in the future. Given the volatile nature of cryptocurrency markets, it is likely that the future will come sooner rather than later.
As always, market demand and other conditions are important factors in calculating interest rates. The methodology is complex and based on multiple criteria, said Hena. These factors include demand for the coin among borrowers, market conditions (which determine staking gains) and loan terms. The firm also uses an “internal framework” to evaluate the quality of coins and their respective rates included in its staking service. That framework consists of the usual set of factors used to evaluate cryptocurrencies, such as market volumes, and liquidity, spreads.
Things to Consider Before Staking Coins
Crypto lending firms are afflicted with the same problems that plague exchanges. For starters, they operate in a regulatory gray zone. They are not regulated by the Securities and Exchange Commission (SEC) or the Commodities Futures Trading Commission (CFTC). When a crypto-lending firm claims to be compliant, it is generally referring to state-level financial regulations. But even within that context, they must contend with a patchwork of regulations.
Security is another familiar consideration. In most PoS protocols, staking service providers do not take “custody,” or control, of staked coins. For the most part, the coins are stored in a smart contract. The staking-as-a-service issues deposit tokens which can be traded for the coins later. This means that the coins are stored on-chain and may be susceptible to hacks. Online wallets are required to store staked cryptocurrencies, which introduces another vulnerability into the equation.
There’s also the risk that a firm may default in its interest payments. The Federal Deposit Insurance Corporation (FDIC) insures fiat money, but not crypto. This means that the agency may not be able to help investors in the event of a payment default.