Cryptocurrency staking is
one of the best ways to earn passive income with digital assets, but is cryptocurrency staking safe? Well, the answer to this question generates other questions that we will answer, but the general answer is yes. Now this doesn’t mean there aren’t risks to cryptocurrency staking, but the level of risk you’re facing depends on whether you’re simply targeting crypto on a blockchain network or providing liquidity to a decentralized financial platform (DeFi).
In this guide, we’ll break down the difference between these two distinctly different ways of stakeling, before outlining the risks associated with each. Let’s start by comparing staking and liquidity provision.
Staking vs liquidity provision
It is important to make a distinction between staking and providing liquidity, but both are ways in which you can bet on cryptocurrencies to receive a return (also known as a return or APY).
Staking, as we’ll call it in this guide, means directly providing a single asset, either as a delegator or as a validator, to a blockchain network. Staking cryptocurrencies helps secure and validate transactions on that network. In exchange for helping protect the network, you are rewarded with a payment in the digital asset that is prorated according to your stake. Payments are rewarded at different intervals.
For example, if you download Cardano (ADA) on the Cardano blockchain, you are rewarded with an ADA payment every 5 days. If you stakes Cronos (CRO) on the Cronos Blockchain, you receive CRO every block.
Providing liquidity (sometimes referred to as staking or farming), means providing an asset pair in equivalent dollar amounts to a decentralized exchange (DEX) such as Uniswap or providing a single asset to a decentralized lending platform such as AAVE. The main difference between providing liquidity and staking is that when providing liquidity the returns can fluctuate greatly depending on the supply and demand of the asset pair you are providing to the DEX or the request to borrow the individual asset from other users on the lending platform.
For example, if you are providing liquidity to the ETH-WBTC pair on Uniswap, you are likely to receive a higher return than a less demanded pool with two assets with much lower market capitalization and trading volume. If you’re providing ETH to AAVE, there’s already so much supply that the yield is just 2%, but there’s more demand than WBTC, which has a yield of 0.02%.
Now that we have separated the two concepts, let’s discuss their risks.
Risks of staking
Reward cutting doesn’t occur with every asset that can be wagered (meaning it’s not always part of the protocol), but refers to when you as the validator, or the validator you’ve delegated to, do some sort of wrong action. Whether this means being offline when a block has been assigned or sending a transaction twice, it affects the rewards (they are cut). This does not affect your main share, but it is still undesirable. This risk can be mitigated by making sure you do things correctly as a validator or by doing due diligence on the validator you delegate your bet to. The most reliable validators have very little risk of reward reduction.
This is not a serious risk in the sense that you will never miss activities that are stuck in an episode. However, if you need the resources, you need to be aware of the lockdown period and the potential risk it presents. If you are going to sell an asset when it reaches X, you need to pre-emptively split (depending on when you want to sell) or not bet it at all to avoid the problem altogether.
For example, Terra Classic (LUNC), has a 28-day lock-up, which means that once you bet, you have to wait 28 days to recover it when you stake. This greatly affected users who had bet on LUNC when the collapse of Terra occurred, as they could not remove their funds and sell before the value dropped dramatically.
This is more of a risk to algorithmic staking assets as we saw with Terra Classic (LUNC). While the protocol continued to work using the algorithm with which it was designed, LUNC stakers had their holdings greatly diluted due to the hyperinflation that occurred when the asset was dumped. The supply went from about $2 billion to more than $6 trillion over the course of two days.
Risks of providing liquidity
Impermanent loss occurs when you provide liquidity to a pool of liquidity, such as those on Uniswap or PancakeSwap, and the price of deposited assets changes from when you deposited them. The greater the change in value, the more exposed you are to impermanent losses. In this case, the loss means that you will have less dollar value at the time of withdrawal than at the time of deposit.
For example, if you deposit ETH and
WBTC in a liquidity pool and the value of ETH goes up, the pool automatically adjusts the ratios of each asset in the pair as their prices change, resulting in different amounts when you withdraw. This means that you lose value because if you keep the asset in your portfolio, the value simply increases and you have profit.
However, if it is deposited in a liquidity pool and the value of the asset rises, it must adjust to the price increase to maintain dollar equivalents. Then when you go to withdraw your share you have less than if you had kept it in your wallet. This is offset depending on the rate of return you are earning to provide liquidity.
PROTOCOL HACKS / SMART CONTRACTS BUGS
The other risk with providing liquidity is vulnerabilities in DeFi due to coding errors. If developers lose a problem with the code they’ve created, a hacker or bad actor is likely to take advantage of it. This could result in draining a pool of its liquidity or issues where your assets are trapped in a smart contract.
Conclusion: Pointing Higher than Centralized Services
Despite all the above risks, staking is generally safer than relying on centralized services (such as the infamous FTX or Celsius Network) to provide a return for your cryptocurrency.
Most staking issues are at the protocol level (coding errors, etc.) and if you’re using a reliable project it shouldn’t be a problem. Even in the case of a reward cut (which is rare) you will not lose your main investment. Instead the penalty will simply hit your rewards.
Meanwhile DeFi has the risk of hacking, but there is no centralized entity to intentionally steal your encryption.
As always, cryptocurrencies are risky in general and you should only invest what you can afford to lose. That said, staking is a convincing return generator and it’s worth at least knowing about the process.