Staking has risen in popularity since Proof-of-Stake (POS) blockchains rose to prominence. Staking has been one of the unique differentiating features offered in the crypto-industry, it offers investors a way to support the operations of a blockchain network and develop passive-income strategies. Like conventional financial products, staking relates to concepts such as liquidity parameters, currency risk, and interest rates which can cause a bit of confusion for investors. We know it can be confusing, but this article will highlight 7 mistakes to avoid when choosing a staking platform and how you can make an informed decision when investing your money.
1. Confusing custodial and non-custodial staking
Many people assume that when you stake your crypto on a staking platform it is ‘safe’ from exploits or hacks. Before staking your crypto, it is important to know whether it is a custodial or non-custodial staking service that you are using and understand what the risks are with each option.
What is a custodian?
A custodian is a company that has physical possession of your financial assets. It’s often a brokerage, commercial bank, or another type of institution that holds your money and investments for convenience and security.
Custodial staking means that you are staking your crypto through a centralized entity (i.e. Binance, Kraken, Coinbase). This means that the exchange is the custodian of your assets and you are entrusting the management of the private keys to the exchange. In addition, you are relinquishing the control of your assets to the custodian and become subject to their terms and conditions. There are various pros/cons to custodial staking which we will outline below:
- No need to manage and store private keys
- Easy to understand for beginners
- Assets are typically more liquid
- Security risks – Centralized exchanges become targets for hackers as they store a large amount of crypto for users. The problem is that their systems are off-chain, meaning they operate as escrows for their clients. This means that the transactions are not recorded on the blockchain. Historically, this has led to massive breaches of security and unsafe storage of information, funds, and private keys. However, security at top-tier exchanges has improved drastically.
- You relinquish control of your crypto – The centralized entity that you are staking with is the custodian of your assets. If the entity freezes trading or halts withdrawals of a coin for any reason – there is nothing you can do about it because you are subject to their terms and conditions. In the case of insolvency or a hack of the exchange, users are often left helpless with little to no recourse.
- Not your keys, not your crypto – You don’t own the private keys associated with your funds.
- Smaller rewards – Exchanges take a % of your rewards as a fee
- Lack of transparency – Not clear how rewards are calculated and how the assets are custodied
Non-custodial staking means that you have sole control of your private keys. This means that you have control of your crypto and that you have custody of your own assets. Non-custodial staking is typically practiced using a web wallet like Metamask or a hardware wallet like Ledger.
- Highly secure
- You have control of the private keys
- You have custody of your own assets
- Higher staking rewards
- Contributes to network decentralization
- Not beginner friendly – It requires the user to understand basic staking concepts and be familiar with how to use wallets
- Private keys need to be stored safely – The storage of private keys can be a daunting task for people
- You need to know how to choose a validator
- Assets can be illiquid – Depending on the network, it can take quite a bit of time to unstake your crypto. The illiquidity can sometimes cause problems for investors.
2. Falling for a high APY %
A common measure of returns is annual percentage yield or APY. When you stake your crypto, you will usually be quoted an APY that you can earn on your investment. Some staking platforms will offer you very high APYs to attract investors to their platform, these high APYs are usually unrealistic figures and are supported by high token inflation that pays for yield.
A very high APY is usually ‘sustained’ by:
- Token inflation – It may seem like you are getting a great deal by earning 100% staking rewards, but this is usually all from new tokens that are being issued. The problem is that these new tokens usually get sold off and cause the price of the coin you are holding to drop. So you may have earned 100% APY for the year, but the price of the token may be suppressed by the selling pressure and you actually end up losing.
A high APY is usually accompanied by a long lock-up period, this leads us to our next mistake to avoid.
3. Locking up your tokens for longer than necessary
Staking involves lock-up periods during which your assets are locked and untradeable. The lock-up period varies between different Proof-of-Stake (POS) networks and usually ranges from a few days to a month. Some staking platforms lock up your assets for longer than the actual lock-up determined by the network, it is important to compare it to the unstaking period for native staking. In addition, some platforms might offer 120-day lock-ups and offer a higher yield to attract users to this option. There are a few problems when locking up your tokens for long periods of time:
- Illiquidity – Investors face a liquidity problem where they don’t have immediate access to their tokens. Crypto markets are extremely volatile and locking up tokens for long periods of time is usually not the best idea for new investors. Unsuspecting users are attracted to the slightly higher yield offered when locking up tokens for long periods of time but don’t truly take into account the risk of locking up your crypto for long periods of time.
- Market risk – Many people don’t realize how much coins can go down in a bear market. Usually, when they decide to stake with a staking provider like Binance/Kraken, the yield they can earn on the coin is at the forefront of the offering. The market risk that you take on by locking up your coins for long periods of time is underappreciated and not illustrated clearly by staking providers.
- Lockups exceeding native staking times – Some staking providers lock up your tokens for a longer period than native staking does but offers you the same yield. There is nothing wrong with this, but it is not usually communicated clearly to investors and is important for you to take note of.
4. Don’t be fooled by “Earning up to…” versus actual yield
Some custodial staking services advertise to investors that they can earn ‘up to %…’ on certain coins. This is usually advertised when users log in or on the home page of the website. The high staking % being offered may seem attractive but it is often times very different from the actual yield that you earn, it is simply a marketing ploy to attract investors.
The ‘up to…’ yield is a theoretical yield and does not represent the actual yield that you will earn. This is because of fees, downtime on validators, and other hidden costs. Do not be fooled by a really high staking APY on a specific coin, always do your due diligence before being lured into a high-yielding investment.
Another example could be an ‘Estimated APY’ on an investment, in the example below a CEX is offering an estimated APY of 39.86% and 73.99% for a 90 and 120-day lockup.
However, the yield on native staking is ~18.5% – so you need to ask yourself how a CEX is offering much higher yields while still charging fees and commissions?
5. Paying hefty fees on Staking Platforms
Staking platforms don’t always explicitly tell you the fees they charge when staking your crypto with them. New users may not know how to check the actual yield and may be unwilling to put in the effort to do so. Some staking platforms will take advantage of this and charge a hefty fee for using their staking services, which the end-user doesn’t usually realize. Check for fees like:
- Commission fees
- Network fees
It is not an issue to pay fees on staking platforms, just make sure of what you are paying and whether you are willing to pay the fees for their services.
6. Are they staking your coins, or are they lending them out?
Recently, many centralized finance (CeFi) firms (Celcius, Voyager, BlockFi etc.) ran into liquidity problems and ultimately insolvency in some cases as the market downturn and broader selloff ensued. Many retail investors chose to ‘invest’ their coins on these platforms while not having a true understanding of how these yields were being generated.
However, unbeknownst to the users, their funds might be lent out to market makers or other parties to generate yield – which is much riskier than staking and often times not explicitly disclosed to the actual client. Before choosing in a staking platform, try and find answers to the following:
- Are my assets being staked or lent out?
- How is the yield being generated?
- Is the yield I am earning higher than I can get from native staking, and if so how are they generating a higher yield?
These are important questions to find answers to before you invest your money in a staking platform, many people tend to overlook this.
7. If you don’t know where the yield comes from, you are the yield
This is a common saying amongst crypto natives. It means that if the source of the yield on an asset is obscure and unclear and you can’t really explain it clearly, then you are the yield. As a result, your activity and participation ‘creates’ a yield and often only lasts as long as new participants join after you – commonly termed a ‘ponzi’.
Crypto can be the wild-west when it comes to crazy yields in DeFi, staking and other forms of income-based products. The asset class is still relatively new and the technology is difficult to understand for most retail investors. Consequently, most new market participants are attracted to high-yielding investments without understanding how that yield is being produced. Always take the time to at least try and understand how the yield is generated and if it is sustainable in the long run, if you cannot figure it out, ask a knowledgeable friend or someone in the crypto community.
Staking can be a daunting process for anyone that is new to crypto. We know it is difficult to understand the jargon and see through the marketing tactics of different staking platforms. Rest assured, if you learn from the points that we discussed in this article you will be on your way to a safe and successful journey in the world of staking.