How Can Crypto Enthusiasts Protect Themselves When Starting Staking?

By Armagan Ercan & Philippe Schommers

Since the completion of the Shanghai upgrade, the amount of staked ETH has increased by 91%. But to the uninitiated, staking crypto may come across as intimidating, what with price volatility, security concerns, and the risk of frozen assets stoking fears. So how can crypto enthusiasts better protect themselves when they start their staking journeys?

What is staking?

The term staking derives from the “proof-of-stake” consensus mechanism used to secure blockchain networks like Ethereum or Gnosis Chain. Users become validators by choosing to stake some of their cryptocurrency with a selected network to validate new transactions, operating as part of a validator node.

A validator node will be selected based on the collective amount of crypto they have staked to validate new transactions and be subsequently rewarded with crypto. This, however, requires a consistent online presence, which usually would equate to roughly 6 months of the year in order to be profitable for the operator.  node operators can often be penalised for downtime.

Should users not wish to become a validator, they can pay a fee to a staking pool and delegate their stakes to a larger pool through protocols like StakeWise. This way, they can still earn staking rewards without having to maintain a constant online presence.

Then why become a validator?

Staking plays an important role in securing proof-of-stake networks while offering investors and network participants the chance to earn passive income. A natural flow is established and investors' investments are kept in a more secure network.

This process makes it more difficult for malicious actors to attack the blockchain, thus enhancing its stability and security. Although staking cryptocurrencies is attractive for these reasons, it is important to remember that staking potential should not be the only factor in investment decisions.

Do your research and understand your investment

When becoming a validator, users must also account for penalties for acting against the network's best interests. These include validating fraudulent transactions, using incorrect data or node downtime. By committing these, they risk having their staked crypto “slashed” and taken as forfeit.

A network's staking requirements can differ vastly from one project to another. On Ethereum and Gnosis Chain for example, unless voluntarily acting against the best interests of the network, a validator can only ever be penalised as much in one day for being offline than they'd be rewarded in a day by being online.

However, other projects might have more stringent requirements, whereby stakers could lose their stake simply by not having a perfect track record. Some do not have any requirements and merely avoid paying out rewards to offline nodes.

Regardless of staking requirements, factors like network security, decentralization level and participation barriers, smart contract quality, team experience, and project maturity all contribute to the risk profile.

Think of it as investing in a new company. Before deciding to part with an investment, would an investor not first do the due diligence to understand the quality and conditions of what they are putting their money into?

Investors or node operators should review the security documents and risk analysis report of the network and decide whether it is battle-tested or not as a result of their own research.

Common mistakes

A simple yet devastating mistake is improperly securing private keys. If private keys are not secured correctly, then malicious actors can compromise the security of the network and steal staked crypto. There are several solutions such as using secure hardware to store private keys or self-custody/cold wallets. However, the inverse is also relevant as over securing private keys can also lead to losing access to wallets, so users should aim to strike a balance between the two.

Similarly, a lot of stakers neglect tax considerations. If staking rewards are treated as income, they will be subject to income tax and if they are seen as capital gains, they will be subject to the relevant capital gains tax.

Maximising returns and minimizing risks

The main focus should be on security to maximize returns and minimize risks. After that, consider diversifying staking portfolios, compounding rewards regularly, and staying informed about network changes. Liquid staking options which allow stakers to access their staked crypto to use as collateral offer more flexibility but have their own trade-offs.

However, no matter what new technology is on offer or how enticing the programme's rewards are, it’s essential to do thorough research and set realistic expectations for returns before starting staking.