One of the exciting aspects of the cryptocurrency market is its ability to generate passive income for users. Just like other computing networks, the blockchain technology that powers cryptos requires work to be done. But unlike a traditional network, blockchain is a decentralized computing network, which gives individual users the ability to participate and earn rewards based on work completed (in this case, processing transactions and executing instructions written into the blockchain).
The ability to earn rewards is thanks to a concept called proof-of-stake, which is used by cryptos like Solana (CRYPTO: SOL) and Cardano (CRYPTO: ADA), and is the same method that Ethereum (ETH 1.27%) is merging toward. It's an alternative to Bitcoin's (BTC 0.98%) proof-of-work method of validating transactions. As transactions are verified on a proof-of-stake network, you (and the other participants if you are pooling your crypto tokens as part of a validator node) earn new crypto tokens as rewards for the work performed -- a process known as "staking."
Participating in the daily operation of a blockchain network can be a great way to boost your returns on your investment, but it isn't risk-free. Here's what you need to know.
3 risks to understand before staking cryptocurrency
An important concept in investing is the trade off between risk and reward. Generally speaking, when earning passive income, a higher potential reward equates to a higher risk when compared to similar opportunities. Given this dynamic, investors should not simply choose which cryptos to stake based on the stated annualized percentage yield (APY). A higher staking yield likely means there are a number of factors present increasing the risk involved in participating. Here are three common factors to consider.
1. Crypto market risk
The first and most obvious risk with crypto -- and with any investment asset, for that matter -- is market risk. All markets are volatile, and individual assets and securities even more so. Since any asset's price is simply a reflection of what investors are willing to sell or buy it for in an instance of time, expect short-term price fluctuations to vary wildly.
The crypto industry is just over a decade old, so the cryptocurrency market is especially volatile. Since Bitcoin got the party started in 2009, cryptos overall have averaged a steep decline every few years or so. 2022 is a case in point. Ethereum is down nearly 70% through the first half of the year.
Staking is a good way to boost your investment gains, but changes in a crypto's price can outpace the yield and lead to a negative return.
2. Liquidity and lockup period risk
The wild nature of the crypto market helps contribute to the second type of risk: liquidity.
An asset is considered "liquid" if it can be easily bought or sold. Since crypto exchanges are open 24/7/365, cryptocurrencies are among the most liquid assets around. However, staking your tokens removes some of the liquidity.
It may be easy enough to simply unstake your holdings so you can sell them, but bear in mind that some cryptos have a lockup period. This means that you agree to keep them staked for a minimum period of time before you are eligible to unstake and sell them (or any rewards earned). For example, while Ethereum undergoes its merge to proof-of-stake, investors may have to agree to a lockup period of a year or two if they want to stake. If you need the money within a certain period of time, avoid cryptos with a lockup period. Also bear in mind that a lockup period might prevent you from selling tokens if market risk strikes and the value of your holdings decline.
One other related issue to bear in mind is liquidity of smaller or newer crypto projects. A newer network may offer a high yield to attract attention, but lack of other investor interest might make it difficult to sell or convert your rewards into other more popular cryptos like Bitcoin or Ethereum. Check to see how much trading volume a new or small crypto token has before buying and staking it.
3. Network operation risk
Besides market risk and liquidity, there can also be risks with the daily operation of a blockchain network itself. One of these potential issues is validator node error.
In a proof-of-stake network, a validator node is randomly selected to validate transactions and add a new block to the blockchain (this is the action that earns a reward). Some crypto networks allow individual users to set up their own validator nodes (the computer you've downloaded a blockchain network's software to that does the transaction validation) with little effort and only a small amount of tokens.
However, if your computer doesn't run properly or makes a mistake, you could be hit with penalties that reduce your staking rewards. A blockchain network could also lower the likelihood of selecting your validator node for computing transactions if it doesn't operate properly.
One workaround for this is to designate your crypto tokens to be part of a validator pool -- a group of investors that pool their tokens together and designate another computer to do the actual work (known as a "staking pool"). However, the validator in a staking pool takes a fee from the reward as compensation for doing the work. This fee is variable and differs from one crypto to another, but is worth noting as it will reduce your annualized yield from staking.
Staking crypto is an exciting aspect of the digital currency industry, but it isn't for everyone. There are unique risks involved, and a high yield offers no guarantee you'll make money. When buying a crypto and deciding whether to stake it, make sure your strategy is part of a well-rounded investment portfolio that considers other asset classes as well.
