One of the main drivers of Decentralized Finance (DeFi) is that it can turn anyone with internet access into a virtual bank. And we all know how banks make their money — through interest rates set for borrowing and lending. On a DeFi protocol, from Uniswap and Aave to Compound, users become banks the moment they lock their funds into liquidity pools.
Then, they become liquidity providers for other traders who either exchange tokens or borrow them for crypto trading. This process is called staking, vastly superior in APR (annual percentage rate) than a traditional savings account at 0.06%
Depending on the stablecoin chosen for staking (DAI or USDC),
APR rates will vary. Source: DeFiRate.com
The stark difference between DeFi staking and traditional savings accounts is glaring, but should one lock their crypto funds into staking instead of trading?
Different Crypto Staking Types
Unlike with validators (Proof-of-Stake or PoS blockchains) and miners (Proof-of-Work or PoW blockchains), you don't need to devote your computer resources to earn a reward. Both centralized and decentralized crypto staking services, from BlockFi and Binance to Aave, run independently of your computer.
Furthermore, there are three types of staking:
1. Crypto funds are locked from within time-locked smart contracts for a specified time period (in which funds cannot be withdrawn). For example, Binance withdraws funds from your account, placing them into a smart contract running on Binance Smart Chain, which is a PoS blockchain. Such platforms rely on validators to secure the network through the staking process.
In other words, validators lock up their crypto funds in order to be randomly picked by the PoS consensus algorithm to generate a transaction block. The larger the staking amount, the higher the chance the algorithm will pick your staked cryptos for block validation. The same principle applies to other platforms as well, such as Solana or Cardano.
2. Staking as a liquidity provider. To illustrate, if you want to stake cryptos on Uniswap, you can do so in three easy steps.
- Visit the Uniswap pool page and click on “Connect Wallet” (MetaMask is the most popular).
- On the “Add Liquidity” tab, if you pick the ETH/DAI token pair, choose how much of ETH/DAI you are willing to stake.
- Once you enter the sum, confirm the transaction in your MetaMask wallet, at which point you will see the transaction fee in both USD and ETH. And that's it!
You have staked your crypto funds by adding liquidity to a liquidity pool — token pair. Now, whenever other traders want to exchange ETH/DAI, they will tap into your pool. In return for your staking service, you will receive interest. This tool
is useful for overviewing existing liquidity pools and checking ROIs (Return On Investments).
3. Crypto funds can be withdrawn at any time. Although not staking per se, it is still commonly called that and is interchangeable with yield farming. Case in point, if you transfer crypto funds to BlockFi, you don't need to do anything else to generate interest. They are staked by default and everything else is handled by the company.
Upsides and Downsides to Crypto Staking
As noted from the first table, you are able to earn up to 15% or more in annual interest rate. The rates are especially high if you are staking PoS coins or stablecoins, as demonstrated by
BlockFi's Interest Account (BIA).
For more decentralized staking, you are investing your crypto funds in the blockchain you believe in. And the more validators there are, the higher the network's security will be. This is also a good alternative to crypto mining because you don't need any specialized computer hardware.
When it comes to downsides, they are the same as with regular trading. Cryptocurrencies are inherently volatile, especially those with small market caps (under $1 billion). In turn, if there is a rapid price drop, your staked assets go down with them, outweighing the potential yields.
Likewise, if you suspect that a coin's price might fall and you want to unstake it, some platforms have long unstaking periods, a minimum of one week. Therefore, it is always prudent to check for minimum lockup periods and other conditions. The greater the flexibility, the greater the chance to recover your funds.
Which Blockchains Offer Crypto Staking?
Ethereum currently runs parallel consensus algorithms, both PoW and PoS. This transitory period will last until at least H2 2022, when it will complete its merger with Beacon Chain — the new Ethereum 2.0. You can stake your ETH in that future version now, but you can't withdraw funds until it launches.
If not, you need a minimum of 32 ETH to stake in the present version of Ethereum. However, there is a way around this. The two largest crypto exchanges, Binance and Coinbase, offer ETH staking without having a minimum ETH requirement.
Alternatives to Ethereum offer staking as already deployed PoS blockchains. These are Polkadot (DOT), Cardano (ADA) and Solana (SOL). Crypto exchanges also offer staking for these coins. However, you can use their native wallets for staking as well. This way, you would have complete control over your funds because these wallets are non-custodial. That means you would own your own private key to the funds.
Which DeFi Investing Strategy To Pick?
From the simplest to the most advanced, there is HODLing and DeFi farming. HODLing simply means that you invest and forget your staking, as your strategy would rely on the coin's long-term appreciation, for at least six months. Such a strategy is then dependent on the project's core values. For example, Ethereum has the largest number of developers, the highest number of dApps (2,888) and the most powerful network effect.
However, rising blockchains should not be underestimated — Solana, Avalanche and Cardano.
The most complex form of investing involves yield farming. Especially the type that combines staking with both borrowing and lending. To illustrate, a crypto investor could take out a loan. Then, they would swap the borrowed coins for another token that’s performing better. One could then use that token as collateral for an extra loan, with the borrowed assets staked.
Needless to say, this multi-chaining strategy requires intimate familiarity with different protocols, tokens and DeFi ecosystems.