What is staking, and what are the risks?

Staking began as a way to secure certain blockchains. Instead of relying on computing power, proof-of-stake networks choose validators based on the coins they commit, and reward them for keeping the network running honestly. Exchanges have built products around this idea, along with similar reward programmes, so customers can earn on assets they would otherwise leave idle.

How exchange staking products usually work

You pick a product, commit an amount of an asset, and earn rewards at an advertised annual percentage rate (APR). Products typically come in two shapes:

• Flexible: you can redeem at any time, and rewards accrue for as long as your assets remain committed. Rates are usually lower.
• Fixed term: you commit for a set number of days in exchange for a higher advertised rate. Early redemption may not be possible, or may cost some of the rewards.

Rewards are normally paid in the same asset you staked. An APR is a simple yearly rate; it only compounds if rewards are added back to your principal.

Reading an APR correctly

An APR describes the reward rate, not the value of your holding. If you stake an asset at a 6% APR and its price falls by a third over the year, you finish with more coins that are worth less in total than when you started. The rate tells you how many extra units you earn and nothing about where the price goes.

The main risks

• Price risk: the staked asset can lose value while it is committed, and a fixed term may stop you from selling.
• Liquidity risk: committed assets cannot be traded, withdrawn or used elsewhere until they are redeemed.
• Rate risk: rewards can be adjusted, especially on flexible products.
• Platform risk: assets placed in an exchange product depend on that platform operating properly.
• Network risk: on-chain staking can carry penalties, sometimes called slashing, if a validator misbehaves, and protocol changes can affect rewards.

Questions to ask before staking

1. 1Can I redeem early, and what happens to my rewards if I do?
2. 2How often are rewards calculated, and when are they paid?
3. 3What happens at the end of a fixed term? Do the assets return to my balance automatically?
4. 4Would I be comfortable holding this asset for the whole term even if its price fell?

If the honest answer to the last question is no, staking that asset probably does not fit your situation, whatever the advertised rate.