Bitcoin was the first to invent the concept of Blockchain to create a record system that keeps track of all the transactions ever made. It needed a complete economic system to incentivise everyone who make the system exist. So miners were rewarded with new Bitcoins for confirming transactions and keeping a record of all past transactions. Simultaneously, to prevent miners from going rouge, they had to solve complex mathematical problems to participate in this system. The idea behind this is that with many miners around, a rouge miner would need serious computing power that is impossible to acquire or would not make any economic sense. This system is called proof-of-work (PoW). Staking was introduced as an alternate to this.
Most of the early cryptocurrencies, including Ethereum, Litecoin and Dogecoin, worked on the concept of proof-of-work. As new cryptocurrencies came along, they figured out that there was a different way to do things.
Miners will have to stake a significant amount of their assets to validate transactions and receive the rewards. If they go rogue, their stake is lost. Once again, there’s a financial incentive to remain straight without having to consume an enormous amount of electricity. This system is called Proof-of-Stake (PoS).
How does staking work?
For a miner to get started, they’ll have to set up a node and lock a significant amount of the currency. They then get to authenticate transactions and receive regular payouts for them.
The biggest advantage of is that it’s extremely easy to get started. Miners will not need to set up an expensive mining rig or a mining farm. Proof-of-Work mining operations have been criticised for the enormous amount of electricity they use. However, Proof of Stake hardly consumes any. This also lets the block times be much shorter, making the blockchain network much more scalable and have higher transaction speeds.
Staking also comes with its disadvantages. The biggest criticism is its entry fee. The amount of cryptocurrency required to be staked is usually high, not accessible to everyone. PoW algorithms, meanwhile, are easily accessible to everyone, including to people with low budgets. People even mine on their existing computers when they’re not being used. This sort of access is not possible with most Proof of Stake platforms.
Staking on Exchange
Since staking has a high entry point, exchanges have solved it by letting their customers participate with smaller amounts. Customers get to lock their funds in the exchange that takes care of everything required for a small fee.
Coinbase offers up to 7.5% APR for Ethereum staked. Other cryptocurrencies available for staking on Coinbase include Algorand, Cosmos, Tezos, Dai, and USDC. Any user who is registered and verified on Coinbase can get started with just $1.
Binance is another popular cryptocurrency exchange that offers Staking for its users. It has become so popular that Binance offers staking for almost 60 different cryptocurrencies. They can be locked from anywhere between 15 to 90 days and come with different returns. Cashing out before the locked period comes with a penalty. Also, the capacity is usually limited, and staking slots for popular cryptocurrencies get sold out fast.
Staking platforms are similar to exchanges where you don’t have to manage your own node. However, these are not connected to your exchange. These platforms are specialised for this purpose alone and usually serve large clients and institutional investors. Some such platforms include Figment, MyContainer, and Stake Capital.
Platforms usually offer the widest variety of cryptocurrencies. Some also double up as custodians and offer insured safekeeping.
Defi staking is something that took off in the last couple of years. It is the process of staking to bring liquidity into decentralised finance networks. An example of it is MakerDAO. Users get to stake their Dai, which is used to give out decentralised loans. The interest from these loans is paid out to the people who put up the collateral. While this might sound complex, they are incredibly popular. As of April 2021, more than $50 Billion has been locked into various DeFi platforms.
Staking on Hardware Wallet
Staking on a hardware wallet or offline is similar to the regular way. However, the staked cryptocurrencies are stored in a hardware wallet instead of a hot wallet connected to the internet. It is still bound together through smart contract with the mining node, and the funds cannot be spent till the mining is stopped. Even if a hacker gets access to the node and stops the mining activity, they will not be able to withdraw the staked cryptocurrencies as it is stored on an offline wallet.
Ledger also offers native support to staking on its hardware wallets. For now, it supports Tezos, Tron, Cosmos, Algorand, and Polkadot.
Taxes on Cryptocurrency Staking in the UK
Until recently, staking was a grey area. HMRC recently updated its guidelines to clarify that it is similar to mining. Meaning, if you’re doing it as a hobby, the profit can be declared as “Miscellaneous income.” But if you do it as a serious business, it is directly taxable.
While it is a good thing that HMRC clarified this, it is still confusing and clear that they do not understand it properly. They’ve not defined what serious activity is and isn’t. However, now that they finally recognise staking, the expectation is that they would eventually expand on it.