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What Are Risks of Staking in Crypto Industry?

January 1, 2023
12
min. read

Cryptocurrency staking and mining are at the heart of the crypto industry as the basic principles that ensure the cryptocurrencies' existence and turnover, crypto projects’ development, and their investors’ reward earning.

At the same time, as with any type of investment, staking involves a lot of risks associated primarily with the relative youth of the crypto industry, the lack of clear regulation, technical features of certain projects, etc.

Let's take a closer look at what is staking and what are the risks of staking in crypto projects.

What is crypto staking?

Cryptocurrency staking emerged as an alternative to cryptocurrency mining. Both are based on blockchain technology, thanks to which the emergence of crypto assets has become possible. As a result of mining or staking, all cryptocurrency transactions in this blockchain are confirmed and recorded in the so-called blocks, thereby creating an endless chain of records that cannot be forged or corrected retroactively.

The process participants (miners in mining and validators in staking) receive a reward from the system for each confirmed transaction. This is a competitive process that requires significant resources from the users. 

Cryptocurrency is issued via the mining process, since in addition to transaction fees, miners receive mining rewards generated by the system for solving the mathematical problem of calculating the block name. There is no cryptocurrency issue during the staking process.

In mining, whoever has more mining power (hashrate) is more likely to receive the reward, and in staking - it’s whoever staked more cryptocurrencies (blocked on the network) for a longer time. The algorithm for choosing the winner has its own nuances in each blockchain.

Thus, crypto staking is the cryptocurrencies blocking on the network in order to receive rewards for participating in the system operation process. Does crypto staking have risks? Of course it does, just like any other investment.

General risks associated with crypto staking

Are there any risks to staking crypto assets? The high volatility of crypto assets and the lack of rules governing the crypto industry are the two fundamental risks that a crypto investor assumes, especially if they want to invest in staking. While the cryptocurrency is in staking, its rate may decrease significantly, a more promising project may emerge, or some legislative initiative may even negate the very option of earning by staking in this jurisdiction.

Before investing in staking, you need to ask yourself: What are the risks of staking in crypto projects? Let's consider all types of risks associated with staking.

No consumer protection

In the crypto industry, there is no better business bureau or any regulatory bodies to complain to if something goes wrong. On the other hand, even if they did exist, it wouldn’t mean that your funds would always be completely safe. 

Blocking your funds in any project means that in the worst case scenario, you can irretrievably lose their full amount. This can happen for a variety of reasons - hacker attacks, fraud, technical failure, regulatory actions, etc.

At the same time, that’s nothing new - you can lose funds for a variety of reasons, even in the American stock market, which is as regulated as a market can be, where there is the option to complain, and the regulator has full power. A market is a market. The only way to stay in it for a long time is to limit the risks. Do not invest more in a project than you are ready to lose.

Technical knowledge required

Working in the cryptocurrency market requires a high level of relevant competencies. Staking is a financial instrument, so you need to understand how it works, and what advantages and disadvantages certain projects that offer staking have. 

Due to the complexity of the technology itself, there are many fraudulent or low-quality services on the market that aim to attract user funds at any cost under the guise of staking. Therefore, knowledge will allow you to correctly assess the prospects of staking in a particular project and to choose the most reliable and profitable one.

In addition, staking in a broad sense most often means not only participating in the system’s operation as a validator (by analogy with participation in mining), but blocking your crypto assets in any service or project for the sake of its development, in other words, its financing. Such staking is similar to a bank deposit, when you transfer your funds to a bank at some pre-agreed percentage, only in this case it is not a bank, but a crypto project.

Staking in a broad sense concerns both cryptocurrencies and tokens (crypto assets that do not have their own blockchain), and since there are tens of thousands of different tokens, it’s very difficult to judge the quality of such projects without basic technical knowledge.

Marketing resources

Project marketing will never allow you to get an affirmative answer to the question: Can you lose money staking crypto assets? Projects use all kinds of marketing techniques to make a reliable and promising impression. Many projects tend to inflate the offered rates, appealing to past results. 

When a project is just being launched and its staking pool is nearly empty, the staking rewards, which are divided among all participants in proportion to their share, can reach thousands of percent. Early investors can earn more in the first 10 days than in the rest of the year. 

Are there risks to staking crypto assets early? The younger the project, the higher the risks, but thanks to thoughtful marketing, any project can look attractive, have an impressive community on Twitter or Telegram, an outstanding website and Elon Musk’s name on the main page. 

To differentiate between marketing tricks and actual project essence, first of all, you need to study the project’s Whitepaper - a document that describes the “tokenomics,” or why this crypto asset has been created, what it stands for, what goals it pursues, etc. In and of itself, the presence of a clear Whitepaper does not guarantee anything, but it serves as a good starting point for evaluating the project regardless of its marketing efforts.

Price volatility

Oftentimes, the price of a crypto asset falls so low that even with a high staking return, the investor goes into the red. Remember, pursuing easy money in the cryptocurrency market is a direct way to lose funds.The paradigm of the crypto industry is still the same: the development and consolidation of the crypto market in the future, where the main benchmark (Bitcoin) will first reach a hypothetical number - a hundred thousand dollars, then five hundred, a million, etc., and the industry will follow it.

From this point of view, you can consider staking a passive strategy, a kind of safe haven, where with a fairly large percent you can wait for a bright future, without getting involved in trading or other, even riskier, games. Therefore, the fluctuations of staked asset exchange rate can be considered nothing more than “impermanent loss”, which in DeFi language means a loss that exists only on paper (until it is fixed when closing a position).

High transaction charges

Some projects charge an impressive commission for any transaction with their tokens. This may include  buying and/or selling, staking, withdrawing from staking, in short, everything that can be done with the token. These nuances are usually described in the Whitepaper or on the project's website, but in fine print. This underlines the need to carefully examine project documentation before investing.

Another way to invest in unfamiliar projects and avoid unpleasant surprises involves working with small amounts. In other words, by investing $20 conditionally and observing the transformations that your funds undergo, you will be able to quickly understand what will happen with $20,000 and draw appropriate conclusions. It’s a simple but very effective strategy to get the right answer to the question Is there a risk to staking crypto tokens here?

What are the risks of staking crypto assets?

Staking cryptocurrencies as a validator, or staking tokens in DeFi projects are financial instruments for obtaining passive investment income. With this approach, the risks are much smaller than with active trading using leverage or derivatives.

Let's say you have carefully studied several crypto projects, separated the promising from the worthless and invested in staking, fully aware of the fundamental risks. Is staking crypto risk free now? Let's take a closer look at the nature of crypto risks.

Market risk

Market risk is the main type of risk - not only in staking, but in the entire crypto industry. The situation on the market can be turned around literally with a few words. Recall that the bullish phase of 2021, when Bitcoin reached an absolute maximum near $70,000, ended after Elon Musk expressed his concern about Bitcoin’s unfriendliness to the environment. 

The Fed is also relentlessly hounding Bitcoin, threatening regulation not so much to it, as to all other crypto assets. In February 2023, the head of the SEC Gary Gensler, said the following in an interview with New York Magazine:

“Everything other than bitcoin, you can find a website, you can find a group of entrepreneurs, they might set up their legal entities in a tax haven offshore, they might have a foundation, they might lawyer it up to try to arbitrage and make it hard jurisdictionally or so forth.” … “They might drop their tokens overseas at first and contend or pretend that it’s going to take six months before they come back to the U.S. But at the core, these tokens are securities because there’s a group in the middle and the public is anticipating profits based on that group.”
Can Gary Gensler SurviveCrypto Winter?
Source: New York Magazine

In any case, the regulator's sentiment is quite understandable, and regardless of whether and how such initiatives will be implemented , the crypto industry will experience shocks of varying severity for a long time simply because no one knows exactly what to do with it.

Events such as the FTX collapse at the end of 2022, which Gensler repeatedly mentioned in his interviews, and the preceding summer collapse of the Terra project with the unpegging of the so-called ”algorithmic stablecoin" UST from the dollar do not add to the trust of the regulator and large investors in the crypto industry. And although the managers of such projects usually appeal to “circumstances”, for the regulator, all this is nothing more than fraud:

“We allege that Terraform and Do Kwon failed to provide the public with full, fair, and truthful disclosure as required for a host of crypto asset securities, most notably for LUNA and Terra USD,” said SEC Chair Gary Gensler. “We also allege that they committed fraud by repeating false and misleading statements to build trust before causing devastating losses for investors.” “As alleged in our complaint, the Terraform ecosystem was neither decentralized nor finance. It was simply a fraud propped up by a so-called algorithmic 'stablecoin'—the price of which was controlled by the defendants, not any code,” Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, said in his statement.”

Are there risks to staking in crypto projects? Surely, but the market risk is the main one.

Liquidity risk

Not all crypto projects can boast of great liquidity. This means that the tokens of such projects cannot always be sold (or even bought) at the market price. The lower the liquidity, the riskier the investment. 

Large projects have no liquidity problems. They can only occur in the hypothetical event that the project itself is experiencing problems (e.g. the LUNA token of the notorious Terra).

the LUNA token of the notorious Terra

A massive sale in the case of LUNA is also a kind of liquidity problem, because the volumes significantly shifted the price due to a lack of supply. But while LUNA sales volumes were about $20 billion,  several thousand will be sufficient for tokens with an insignificant market cap.

Thus, the lower a token’s market cap, the riskier it is, but misfortunes also do happen with large projects.

Lockup duration

Some projects require blocking assets for a specific period. This is very similar to a bank deposit that you cannot withdraw before the specified time. The longer the staking time, the longer you are unable to manage your asset. A lot can happen during this time, positive or negative. 

In other words, the duration of asset blocking in staking increases the factor of any market risk, in the event of which you will be forced to remain a passive observer. In view of this, you should choose projects without long-term blocking, or believe in the selected project so much that you are willing to wait out any drawdown.

Reward duration

If staking involves daily reward payouts, they can be reinvested or accumulated - in any case, getting daily evidence of successful investment is better than waiting for a year to get your first payment. However, some projects can make you wait. And although the staking conditions do not directly affect the APR (annual interest rate of return), and in the case of a deferred payment in one project, you may well earn more than in the case of a daily payment in another, any delays increase the impact of market risk on the final result.

The best solution is to balance your portfolio so that it contains projects with different staking conditions proportional to their risk level.

Validator risk (Network operation risk)

Let's get back to cryptocurrency staking as related to your work as a validator. 

In order to launch the so-called “node", i.e., a node of a decentralized network, you will need both knowledge and reliable technical resources. Your node must work 24/7, have impeccable Internet access, settings and hardware. “Validator node error” means fines, partial or complete loss of assets.

However, there are third-party platform services where you can stake tokens without having to launch your own validator node, i.e., through an intermediary (staking pool). Thus, you will remove the validator’s risks, but you will face the risks and pay the commissions of the intermediary. Perhaps you should start with the second option if your knowledge and resources are not sufficient yet.

Validator cost

Just as mining, staking is not always profitable. It is well known that when the Bitcoin exchange rate drops to critical values, the most vulnerable miners experience significant problems, potentially up to and including the need to disconnect and even sell part of their hardware to cover costs. 

Staking requires investments in hardware and electricity (albeit much less than in mining), payment of commissions, etc. If the cryptocurrency rate keeps lowering for a long time, you will inevitably end up with a loss. 

When entering a project, answer the question: What will happen if..? (the cryptocurrency exchange rate will decrease to..; operating costs will increase to... etc.) Stake exactly as much as you can hold there under the most unfavorable circumstances.

Loss or theft

The loss of crypto assets as a result of the deliberate external actions is a common phenomenon in the crypto industry. Regardless of the specific staking risks, the loss of private keys to a wallet is the worst thing that can happen to an investor.

In addition to your wallet’s vulnerability, the platforms you use, centralized and decentralized exchanges, lending protocols, liquidity pools, etc. may be just as vulnerable. And although you cannot affect their security, you can choose in such a way that the answer to the question Are there any risks to staking crypto assets? is - Yes, but I minimized them!

Scammers use all kinds of ways to collect information about you - viruses, phishing sites, mailing, promises - the whole arsenal of modern means of obtaining information, including social engineering. In the crypto industry you need to remain a private person both in terms of communication and in terms of your infrastructural “hygiene."

The risks of staking. FAQ

Is crypto staking taxable?

You should research how the crypto industry is regulated in your jurisdiction. Most likely, your crypto income is taxed, but even if it isn’t yet, times are changing, and you should get used to the idea that sooner or later you will have to pay.

Is staking better than holding?

It depends on your strategy. Staking requires more attention than holding, and it’s not always suitable for those determined to hold for a long time. On the other hand, you may want to trade, and staking may seem boring. The best thing to do is to choose the strategy which will let you sleep peacefully.

Is staking still profitable?

There are always offers on the market with good interest rates on staking. However, cases of temporary deep drawdowns of crypto assets are also common in the market, which can make staking unprofitable. One way or another - you get rewards for staking, and your portfolio grows. As for market risks, i.e., cryptocurrency and token volatility, everyone who has been in the market for a long time sees them as unavoidable rollbacks before even greater growth. Otherwise, there is no point in investing in the crypto industry.

Can staking last forever?

This does not make much sense, because as the crypto industry develops, new projects, often more promising and profitable at least in the initial stage, will emerge. You don't have to stay within the same project all your life, because it contradicts the principles of risk diversification. Even Warren Buffett sometimes shifts from one stock to another.

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