How Does Crypto Staking Work?

Give a man a steak, he’ll eat for a day. Teach a man to stake, he’ll eat for a lifetime. Confucius said that (probably), and he was right. Staking is a way of earning yield by locking up your crypto, whether that be on a chain, in a protocol, or through a centralised retail intermediary.

Yet what exactly is staking, how does it work, and how does it lead to yields that are causing a stampede to the entry gates amongst TradFi institutions, desperate to keep up with this new financial alchemy?

The Basics of Staking

For an everyday retail user, staking looks and feels much like a savings account for crypto. Most chains or protocols (or financial products) offer a yield for depositing your capital and tying it up for a period via a program.

There’s numerous ways to go about staking that we’ll dive into, but for context, the two most popular ways are staking (or delegating) your tokens to secure a Proof-of-Stake which has inherent network utility, or locking-up your tokens for a predetermined period of time to earn rewards from a project.

While there are other means of earning yield on your tokens, such as depositing to a lending protocol or provisioning liquidity to a DEX, there is a different terminology at play in these cases.

A core feature of DeFi staking is the changeability of offered rates depending on market demand and protocol decision making. What that looks like under the hood, and how that’s behind the scenes — we’ll get to later, but let’s just say bigger is not always better.

Yet the thing in common with all of those figures is that they are vastly superior to the current bank savings rate offered by just about every bank in the western world, on account of the central banks continuing down pressure on central interest rates in order to keep money cheap and the economy going. For many analysts, this is what made DeFi so tantalising of a prospect when it was first conceived.

Types of Staking

Staking, in its original form, contributes to the process of validating transactions on the blockchain. Chain architecture, block rewards, staking pools and amount of supply locked all determine staking rewards. Proof of Stake is widely argued to be a more scalable solution and why most new chains adopt some variation on PoS.

Nowadays, there are numerous ways to earn yield with different end-goal purposes, which collaboratively create the evolving DeFi market. Some of these, albeit not all staking-based, include:

1. Staking on a PoS blockchain (or a protocol using consensus) is needed to keep the network secure. For example, staking $NOM is necessary to validate and secure the Onomy Network.
2. Staking to gain access to airdrops provided by other projects, which is a common theme in emerging L1 ecosystems like the Cosmos Network.
3. Depositing in a DeFi protocol for the purpose of lending to people who want credit (crypto loans).
4. Depositing trading pair tokens in a liquidity pool to facilitate a currency pair and earn from being a liquidity provisioner.

There are also yield aggregators, where DeFi strategies come pre-packaged in vaults. Due to DeFi’s composability, there are complex tranches of DeFi products packaged on top of one another. It is even possible to stack different vault strategies to further optimise gain.

Moreover, many protocols offer more than one type of staking, depending on the primary use case or utility of the protocol. In all these cases, the key is needing to lock up tokens for a period to earn yield.

With Onomy, for example, validators and their delegators will receive staking inflation according to a dynamic curve designed to provide sustainable inflation. Validators also earn gas fees, and they may receive additional staking incentives as highlighted in the product documentation.

Why Cross-Chain DeFi Will Boost Yields

Due to the composability of DeFi, within each ecosystem, there may be opportunity for farmed tokens to be restaked or lent out to produce yet more yields, which can be placed in other protocols. If you can navigate the market, it results in multiplicative gain. This automatic alchemy between financial products on the blockchain is just so vastly more efficient than TradFi methods of layering products their own way.

This is why a truly cross-chain ecosystem and DEX, like Onomy’s, is so exciting. By bridging to more chains and being asset-agnostic, yield farming strategies can be more expansive and diverse.

What’s the Difference Between APR or APY?

APR is a rate that is paid on a fixed deposit at a fixed percentage rate, so $100 at 10% yields $110. APY is far more tricksy, and can often be used to balloon the advertised rate. However, to achieve an APY, the interest on the deposit must also be continuously compounded according to the set of provisions laid out by a protocol.

The Different Types of Payouts

So how does this yield manifest? What do rewards actually look like?

Native Token: In many cases, staking rewards are paid out in the same token as is deposited. This token will have its own utility, such as governance rights or functional properties within the protocol, so yielding more of it is advantageous.

These staking rewards come from a supply of tokens that has been set aside by the developers for rewards or from a predetermined inflation schedule as is the case with PoS chains. This reward structure can be used as a natural way to bring inflationary and deflationary economic trends in a planned way to a tokens supply. When you hear people talk about tokenomics, they are often referring to the amount of locked supply, the vesting period, the rate paid, and other parameters that form the staking rewards.

Dual-Token Model: Similar to native staking, dual-token models are when a staked asset yields a derivative token that has a specific utility. That token could be a governance token that has voting weight, or allows holders to reap transaction fees for use of the protocol.

Crypto Payouts: Similar to native-token payouts, but with the difference that the reward is coming from users taking loans on the collateral liquidity you are providing, or you earn from being a market maker in a liquidity pool. If you supply BTC and LUNA to an AMM for example with a long term lock up, you will earn interest on that provision through transaction fees. Protocols (which have their own native token) can offer plenty of different opportunities in this sense.

Stablecoins: Yields paid in stablecoins are most sought after, granted there’s no major risk in a stable asset’s value collapsing. However, this depends on stablecoin’s traction and collateral model, whereas protocols paying out said stablecoins are doing so out of a revenue stream that may or may not dry up.

Individual Staking, Staking Pools, and Delegated Stake

Not all staking is done on an individual basis. In fact, most users participate in staking pools, as the barrier to entry is much lower. Many networks require minimum stakes, technical barriers to entry, and lock up times to yield the full rewards. By participating in a staking pool instead, users can gain these benefits (albeit less than usual, as pools take a cut) with less of a headache.

Many protocols, including Onomy, allow for staking to be delegated to validator pools. This is similar to what CEXs offer for ETH 2.0, for example, but done non-custodially. Instead of having to deposit 32 ETH yourself, you can send the exchange 0.5 ETH and they’ll stake it on your behalf. Such is the case with Onomy too — instead of having to set up a validator server and put up the minimum self-bond of NOM tokens, a delegator can simply delegate their stake to a validator who charges a small commission from the yield obtained.

Dark Side of DeFi

Ponzinomics?

How can DeFi offer interest so far and above any other financial product. Why is crypto just so vastly superior at value accrual? The truth, of course, is not so simple. Those rates come at a risk, in most cases the risk being a nosedive in cryptocurrency’s overall market cap, and in some cases even if the moon is finally reached, that protocol comes apart in flames due to unsustainable yield mechanics and the fact that — as with most novel financial instrumentation throughout history — the whole thing is built on sand. And it will fall.

It gets worse. Many protocols have a complete lack of token utility — at least from outset — and do not confer governance rights, reduce transaction fees, help validate the protocol, or anything else. These tokens have fluctuating and volatile price-action, as their price is determined simply by how much of the supply is staked. Tokens like these have accusations of being a Ponzi scheme, as the only way to grow the value of the token is to take on more investment and continue to contract the supply.

This is why, when 9000% APY is offered from the token’s own supply, that can be a red flag, as the protocol’s token must match that growth before the supply burns out being given to early adopters. With Onomy, early adoption is encouraged to bootstrap the protocol, and 100% APY is reached for a limited time through the token’s staking emission, but it tapers off to long-term sustainable rates quickly — and the entire process is governed by a pre-ordained schedule as well as inherent utility for the NOM token which may be used for collateral or governance.

In short, if a token’s only utility is it can be staked for more of itself or something else equally vacuous, it’s essentially just one giant game of Uncle. Don’t be last.

Staking for Airdrops

Airdrops by DeFi protocols like Uniswap or DYDX made airdrops a hot trend. However, airdrop models have their problems. First, they are open to hefty abuse, with sybil attacks or maliciously programmed smart contracts able to take users’ funds for interaction with the token.

Yet a more malignant problem may stem from an ever-more-teetering pile of potential airdrops for users to reinvest their tokens into to yield more airdrops. It’s a slippery slope, as users seldomly end up taking profits as they are expectant of further airdrop gains obtained by staking their airdropped tokens. While the model works in theory, airdrops done right are one in a million and necessitate a deeper study of today’s tokenomic models.

Without offering any financial advice here, we stress that DeFi users must carry their due diligence in understanding staking models. A common rule of thumb is that if you don’t know where the yield is coming from, you are the yield. Similarly, outrageous yields don’t do well for the long-term, and may lead to collapsing protocol economies as seen during the food coin yield farming frenzy in 2021.