DeFi Staking: Everything You Need To Know

DeFi staking is the process of making passive income in crypto that involves locking funds in a smart contract.

It sounds so nice, doesn’t it? Simply send your tokens to a smart contract and watch your deposit grow day by day.

Indeed, it does. 

Yet, just like any other innovation, it comes with not only advantages but with risks as well.

Read on to find out what DeFi staking is, its pros and cons, and how to differentiate true DeFi staking solutions from false ones.

Key Takeaways

• DeFi is a set of blockchain-based applications that enable their users to exchange value on a peer-to-peer basis.
• DeFi staking involves locking crypto assets in a smart contract for a reward.
• DeFi staking variations include yield farming and liquidity mining. Both of these solutions are aimed at maximizing investors’ profits.
• Thanks to DeFi staking, investors may get much higher ROI while storing their assets in a decentralized and secure manner.
• The risks of the new solution come from the overall volatility of the crypto market and centralization.

What is DeFi?

Before we move anywhere further, it’s important to explain the key principles of DeFi itself.

Decentralized Finance, or shortly DeFi, represents a blockchain-based system that consists of lending and borrowing platforms and other applications. 

Fueled by smart contracts, these applications enable their users to exchange value on a peer-to-peer basis in a fully automated and transparent manner.

At this, one of the most popular DeFi solutions refers to lending and borrowing.

Thanks to DeFi, borrowers have gained the possibility to get loans in a fast and efficient manner. They no longer have to deal with heaps of paperwork and they do not depend on their credit scores.

Lenders, in turn, are now able to make passive income by locking their assets in liquidity pools. This has become possible thanks to the process known as DeFi staking.

What is DeFi Staking?

DeFi staking represents the process of locking digital assets in a blockchain. By staking crypto in a network, users support it and get rewards for that in the form of interest rates.

In a nutshell, the process looks as follows:

1. Users lock some amount of crypto assets to become validators for a predefined period of time. 
2. As network validators, they are responsible for network security and the verification of transactions. This makes them eligible for rewards.
3. Once the staking period ends, users can unlock their funds and withdraw rewards.

At this, DeFi staking is a great solution for crypto investors who want to put at work their assets without having to sell them.

Also, it’s worth mentioning that DeFi staking is only possible on platforms that rely on the Proof-of-stake (PoS) consensus mechanism.

Cryptocurrencies running on the Proof of Work (PoW) consensus don’t have this capability. In order to stake them, one can convert them into their wrapped versions that are compatible with PoS blockchains.

Types of DeFi Staking

Pure DeFi staking is not the only way of making passive income in crypto. 

As technology evolves, more sophisticated methods running on the same principles have emerged. 

At this, such solutions represent more sophisticated ways of DeFi staking with some distinctive features that make them a better fit for specific situations. It’s needless to say that each of them aims to further increase investors’ profits.

Yield farming

A user may have a number of different crypto assets at hand and stake them in different liquidity pools. The staked assets generate rewards in the form of transaction fees or interest from lenders.

At this, the cumulative rewards from all of these DeFi protocols will make up the yield. 

Stablecoins such as DAI or USDC are the most popular options for staking thanks to predictable rewards. Other digital assets, on the contrary, may offer risky yet quite lucrative ROI.

Liquidity mining

Liquidity mining is another form of yield farming that usually works in liquidity pools.

In a similar way, users stake tokens in these pools to provide liquidity. At this, they become automated market makers. As a typical liquidity pool consists of specific trading pairs (e.g. ETH/USDT), liquidity miners can stake either of these assets.

What makes it different is the token that users get as a reward as such services issue their own governance tokens for this purpose.

DeFi Staking Pros

DeFi staking is beneficial to all the participants of blockchain ecosystems.

At this, stakers can enjoy the following benefits:

• A chance to earn passive income in a secure and transparent manner. 
• Higher rewards in comparison with those that banks and other TradFi institutions may offer.
• Low entry fees make it easier to get started.

DeFi staking platforms get their share of profits, too:

• Better security and, therefore, smoother workflow.

• Higher liquidity and higher capitalization
• Less energy consumption in comparison with PoW-based solutions.

Also, it’s worth adding that DeFi staking protects both parties from the risks inherent to custodial solutions. Since there is no longer a centralized instance responsible for storing all the funds, the risks of losing these funds due to a hack are minimal.

DeFi Staking Cons

Just like any other technological innovation, DeFi staking comes with a set of drawbacks as well. 

Most of these disadvantages come from the generic characteristics of blockchain, though. High volatility and the lack of a proper regulatory framework surely have their say.

Here are some of the risks that stakers may come across:

• The necessity to lock liquid assets for a long period of time.
• Abrupt price movements that may result in heavy losses.
• A limited scope of usage of the technology as DeFi staking only works with on-chain assets.

Staking platforms get the short end of the stick, too:

• Abrupt liquidity losses when rogue validators are slashed by the system
• Hackers' attacks and exploits

However, all these obstacles should not become a reason to despair and give up using DeFi staking as a whole. 

The solution already outperforms traditional means of making passive income in many aspects. It’s only a question of time before the downsides will be removed as well.

True vs False DeFi Staking

There are many blockchain-based solutions that claim to provide DeFi staking services. Yet, not all of them follow the path of true decentralization.

FTX crash has become a harsh lesson to learn for the whole crypto community. At this, it’s become obvious that entrusting your funds to a centralized platform is hardy different than storing money in a bank.

Look out for the following signs to recognize a fake DeFi staking tool:

• Such tools are typically hosted on centralized exchanges that manage users’ keys.
• They come with smart contracts controlled by admin keys.

True DeFi staking tools, on the contrary, are devoid of centralization risks. Here’s how to recognize them:

• They offer self-custodial wallets that no one but users themselves can control.
• Their smart contracts have no admin keys.
• They rely on decentralized oracles.
• Other front-end solutions that they use are also decentralized.

Thus, with true DeFi solutions, users are the actual owners of their own funds. They can enjoy high rewards and do not have to fear that some centralized entity will ever let them down.

Bottom Line

Despite a number of disadvantages, DeFi staking represents a very good alternative to any TradFi solutions.

With the funds being secured by the code, users no longer have to fear losing their money because of the bank crash. 

Yet, not all the platforms that offer DeFi staking are truly decentralized. 

Thorough research together with other security practices can help investors not only protect their funds but also get a much higher ROI in comparison with other solutions.