Everything You Need to Know About Crypto Staking
A no-nonsense introduction to DeFi, staking, and liquidity pools.
DeFi stands for decentralized finance. This is an area of financial innovation that has emerged in opposition to traditional finance, or centralized finance.
DeFi generally works through smart contracts. A smart contract details the terms of an agreement, and these terms are executed as code running on a blockchain. People use smart contracts because they are automatic, decentralized, and can be accessed anywhere there is internet.
Smart contracts allow software developers to build decentralized applications, or DApps.
When DApps are used, they interact with the underlying blockchain. These interactions need to be processed. The people who process and validate these interactions are paid for their effort. The money to pay them comes from network fees. Network fees on the Ethereum blockchain are called gas fees.
To process blockchain interactions, validators must risk their own money so they have skin in the game, which prevents mistakes and theft. This mechanism is called proof-of-stake.
Sometimes, a validator does not have enough money to meet proof-of-stake requirements, but would still like to participate in maintaining the blockchain. This validator may then ask other users to stake some money too, and then pool these resources in a staking pool, to meet minimum requirements.
The validator will then receive payments for processing transactions. These payments are then distributed to the staking pool members.
NOTE: There are two other sources of payments that are popular with staking pools. These sources increase user risk:
When a new cryptocurrency is introduced to an online exchange, it will often need a liquidity pool, a reserve of other cryptocurrencies (e.g., bitcoin, ether) that will be used to automatically buy the new token if no buyers exist.
An exchange may allow users to stake their popular cryptocurrencies (e.g., Bitcoin, Ether, Doge, etc.) to form liquidity pools for newer tokens.
Creating liquidity pools for newer tokens is extremely risky since most tokens do not survive over time. To compensate for high risk, the payments for staking these tokens are unusually high, often exceeding 20% per annum. (However, it bears repeating that the risk of total loss is extremely high.)
The second way a staking pool may source payments to users is by backing parametric insurance contracts:
To use DApps, users often need to send cryptocurrencies to and from the DApp smart contracts, which will incur gas fees.
To get around these gas fees, and make interfaces simpler to understand, DApps may use staked cryptocurrencies to execute smart contracts. This type of smart contract is at the forefront of blockchain-technology experimentation and may not be tenable without a stable digital currency, such as a stablecoin or digital reserve currency.
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