You may have already encountered the term “staking” (briefly covered in our “Consensus: the Backbone of Web3” article), now is the time to get a better understanding of what it is.
Staking is essential for Web3, enabling several core mechanics, such as Proof-of-Stake consensus and Liquidity Pools. The basic idea is simple: you provide your tokens to a network (some might say you’re giving a loan) to receive a future reward. The implementation details may vary depending on the ultimate goal (what your tokens are used for) and the network/protocol.
As most DeFi concepts are inspired by traditional finance, here’s an explanation using centralized banking: when you make a deposit to the bank, your money doesn’t just idly sit there; the bank is using your fund to give out consumer loans. So the interest you get on your deposit comes from the interest paid by the borrowers to the bank (minus the banks’ cut).
Of course, the bank must mitigate the risks, so it would have the money in case a lot of people at once would want to withdraw their deposits (that was one of the reasons that made the 2008 financial collapse possible, the real story is more complex, but basically, the banks gave more loans than they were able to), that’s why you have contract terms like “you can not close your deposit until X time passes” and “you can not withdraw more than Y monthly”.
The risk you take as a consumer is that the bank may make bad decisions managing your and other peoples’ money, and you have almost no tools to influence these decisions. It is believed that the deposits have lower risks compared to stock trading, that’s why they got such low-interest rates that barely cover inflation.
How do Web3 and staking fix this? Basic principles are the same as always:
- algorithms and math instead of trust and central authority
- give more tools to the people so that they can make decisions
Staking means you’re invested in some network/protocol and willing to hold your tokens (usually native to the chain) by locking them. For example, in PoS networks, you have to stake tokens to become the validator. Similar to miners, validators have a chance to add the newest block of transactions to the chain and receive a reward (the interest on your stake). The more tokens you lock up, the higher the chance. It is believed that by staking, you have “skin in the game,” which incentivizes you to help grow the network and protect the chain.
Some networks will give you another type of token in return for the ones you’ve staked (sometimes, they have a “wrapped” prefix). These are governance tokens used to vote on network-wide decisions. Again, the more you stake, the more weight you have in the vote.
While it usually requires sufficient funds to become a top-tier staking validator, you can still put your tokens to good use by participating in a liquidity pool. Remember our article on DeXes and how they provide liquidity for the trades? It comes from algorithmically managed crowdsourced pools. When the Dex makes a trade, it takes its share and redistributes it among all the pool participants.
Figuring out the best pools to participate in and strategies that would give you the best returns is called yield farming. For example, instead of trusting all your money to a single entity (the bank), you could split your tokens to create a diversified portfolio (usually, the goal of the yield farming strategy is maximizing the returns while minimizing the risks).
As most of the major networks are using PoS (recent Ethereum merge switching from PoW to PoS for lower gas fees and carbon footprint), Super Protocol is considering some exciting staking mechanics — stay tuned!