Staking of digital assets: passive income generation mechanism on blockchain networks

What is staking and why does it matter?

Staking is one of the most popular methods for cryptocurrency investors to earn yields on their holdings. Essentially, it involves locking a certain amount of digital assets in a blockchain network operating under the Proof of Stake mechanism, receiving additional cryptocurrency rewards in return.

This process not only benefits individual investors but is also fundamental to the operation and security of blockchain networks like Ethereum, Solana, Cardano, Avalanche, Polkadot, and Cosmos, among others.

Proof of Stake: the consensus that makes staking possible

Before delving into how staking works, it is essential to understand Proof of Stake (PoS), the consensus mechanism it is based on. Introduced in 2011 as an alternative to the traditional mining system used by Bitcoin, PoS eliminates the need to solve complex mathematical problems through intensive computational power.

Instead, PoS networks select validators based on multiple criteria, the most important being the amount of cryptocurrency they hold and are willing to commit as stake. This approach significantly reduces energy consumption and democratizes participation in the network.

How the staking mechanism works

The staking process follows a relatively simple but effective cycle:

Step 1 - Participant selection: Validators are chosen based on criteria such as the volume of assets staked, the duration of their participation, and in some cases, random selection. This methodology prevents a small group of actors from controlling the network.

Step 2 - Transaction validation: Selected validators verify that proposed transactions are legitimate and comply with the network protocols.

Step 3 - Packing transactions: Validated transactions are grouped into blocks that are added to the distributed ledger that constitutes the blockchain.

Step 4 - Service compensation: Validators receive a portion of transaction fees and, in many cases, new units of the cryptocurrency as an incentive.

Participation modalities in staking

There are several ways to participate, each with different levels of technical complexity and capital requirements:

Independent operation: Requires running your own validator node. Offers full control but demands deep technical knowledge and constant responsibility. Operational errors can result in loss of funds due to slashing penalties.

Through exchange platforms: Many cryptocurrency exchanges facilitate staking, allowing users to participate without managing technical infrastructure. This approach is ideal for beginners.

Delegated staking: Investors transfer their assets to validators or specialized services that handle all technical aspects. Some cryptocurrencies incorporate this functionality directly into their wallet applications.

Participation in collaborative pools: Multiple investors combine their resources to increase the chances of being selected as validators. This option allows participants with limited capital to access staking without meeting high minimum requirements.

Staking pools: democratizing participation

A staking pool is an association of cryptocurrency holders who pool their capacity to improve their chances of being selected as validators. Participants receive rewards proportional to their contribution.

This structure is especially valuable for smaller investors. However, due diligence is critical: fees, reputation, and security standards vary considerably between platforms.

Conventional staking versus liquid staking

A recent innovation is liquid staking, which allows participation in staking while maintaining liquidity over the committed assets. While traditional staking locks assets during the participation period, liquid staking introduces alternative mechanisms.

The most common approach uses liquid staking tokens (LST), which represent the locked assets. These tokens can be traded or used in other applications without interrupting reward generation.

Some platforms implement native liquid staking, as with ADA in Cardano, allowing immediate withdrawals without intermediaries for tokens.

Tangible benefits of staking

Generation of passive income: Assets that would otherwise remain inactive generate continuous yields, which is particularly attractive for long-term investors.

Contribution to network security: Staking participants strengthen the integrity and operability of blockchain networks, benefiting the entire ecosystem.

Governance rights: Many networks grant voting capabilities to stakers, allowing them to influence future strategic decisions.

Environmental sustainability: Unlike PoW mining, staking requires minimal energy consumption, aligning better with environmental responsibility standards.

Inherent risks of staking

Although rewards are attractive, there are significant risks that every investor must consider:

Price volatility risk: Market fluctuations can erode or completely eliminate gains. A sharp drop in the staked asset’s price can result in net loss even with positive returns.

Penalty risk for non-compliance: Validators operating negligently or maliciously face penalties (slashing), which can result in partial or total loss of staked funds.

Excessive centralization: If a small number of validators accumulate most of the staked assets, network security can be compromised.

Technical vulnerabilities: Smart contract failures, software errors, or connectivity issues can freeze funds or prevent access.

Third-party exposure: Using intermediary platforms involves trusting external entities with asset security. Security breaches can lead to total loss of funds.

Practical steps to start staking

Step 1: Identify a cryptocurrency that supports PoS and understand its specific requirements and reward structure.

Step 2: Set up a compatible staking wallet. Prioritize established, well-documented solutions that support the selected asset.

Step 3: Begin your participation following the network’s protocols. Choose between running a validator node, delegating to trusted validators, or joining a collaborative pool.

It is essential to thoroughly research the chosen blockchain network, evaluating its maturity, development team, and security record before committing significant capital.

Calculating staking yields

Rewards vary between networks and depend on multiple variables:

• The total capital committed in staking
• The investor’s participation duration
• The total volume of assets staked in the network
• Transaction fees and inflation rates

Many blockchains express returns as an annual percentage rate (APR), facilitating comparisons and future earnings projections.

Is it possible to withdraw staked assets?

Generally yes, although mechanisms vary depending on the platform. Some systems allow immediate withdrawals without penalties, while others impose time restrictions or partially reduce pending rewards.

Recent updates in networks like Ethereum have introduced flexibility. For example, certain protocol changes have enabled participants to withdraw locked ETH and automatically receive their rewards at any time.

Why don’t all cryptocurrencies support staking?

Staking is exclusive to blockchains operating under Proof of Stake. Proof of Work assets, like Bitcoin, use entirely different mechanisms (mining) that do not allow staking.

Even among PoS networks, some projects employ alternative incentive systems, limiting staking availability for certain assets.

Conclusion

Staking presents a legitimate opportunity for cryptocurrency investors to generate passive income while contributing to the operational security of blockchain networks. However, it requires careful risk assessment, including market volatility, technical vulnerabilities, and third-party risks.

By selecting prudent staking methodologies and thoroughly researching underlying protocols, investors can actively participate in the blockchain ecosystem while pursuing profitability. The key lies in fully understanding each network’s specific mechanisms before committing assets.