We’ve covered the basics of how proof-of-stake blockchains can provide fixed income growth, and guided you through choosing your very own validator.
In the past few weeks, however, significant macroeconomic and market-wide shifts have opened up the way for a change in trends. The world of centralised finance appeared to collapse on itself through the Celsius and 3AC debacles, while the shockwaves sent throughout the entire DeFi space by the beginning of a deep bear market rocked even its most ardent supporters. All the hype generated by these innovative yet precarious financial products has quickly dissipated, pushing the market into a risk-averse mentality.
This has generated the perfect breeding ground for offline or ‘cold’ staking to thrive. Arguably the safest and most accessible source of fixed income that can be derived from cryptocurrency ownership, it played a background role during the bull runs of 2020-2021 as greed dominated the market. But now the tables have turned, and it’s high time we looked into what it can offer to investors weathering the financial storm many institutions are forecasting for the short term.
To quickly recap, staking is the alternative that Proof-of-Stake (PoS) blockchains offer to counterbalance the role played by mining in Proof-of-Work (PoW) protocols. In essence, this means that ledgers and their transactions are validated and monitored not through the creation of new blocks via hardware-intensive processing, but rather by granting ‘validator’ privileges to specific users of said blockchain. These users are selected based on the number of coins or tokens belonging to said ledger they have ‘locked away’ and set aside for staking purposes, and they receive a financial bonus just like miners do for their effort.
This can either be more of the same token they’ve stashed away to stake, or a separate fungible token developed as part of a balanced dual-token system.
The crucial element of staking is that, while users retain full ownership of their coins and gain rewards for this, all their funds remain locked and non-retrievable for a set period of time. This period of time varies slightly based on the blockchain itself, or the incentives and regulations of the validator providing access to staking. This is the case when users who don’t have enough tokens to stake a full node of the network they’re engaging with.
It is important to note that this term is often misused in the space – the DeFi and centralised lending community have a tendency to refer to liquidity provision in exchange for yields as ‘staking’. This should instead be defined as ‘yield farming’ and has very different purposes and, thus, risks.
While the coins are locked away and committed to the staking cause for a period of time regardless, there are different types of repositories for these stakes.
Wallets connected to the blockchain network are called ‘hot wallets’, while offline wallets are also referred to as ‘cold’.
Perhaps confusingly, cold staking can be accessed both through your own hardware (i.e. a dedicated physical wallet like Trezor or a cold wallet app such as Exodus) and through online providers of offline staking services, who will simply migrate your coins to a wallet not connected to the ledger once you hand them over custody.
These can still be considered ‘cold’, but they are managed by a connected and thus exposed entity and do transit through a ‘hot’ wallet first on their way to being stashed away.
The Case For Cold Staking
The first great advantage of staking your coins offline is the simplest one: it’s the only yield-generating activity that doesn’t involve losing ownership of one’s wallet keys. A steady stream of passive income is gained while not needing to rely on trust for the safekeeping of hard-earned assets.
In a time of industry turbulence and in what is a decidedly young and dynamic market, some users might find it hard to entrust a single, specific third party with their life savings. And looking at the news this week, it’s hard to blame them.
Aside from corporate malpractice, this type of staking also protects investors from the risk of criminal damage. Cyberattacks and large thefts of coins from reputable exchanges or yield farming providers are luckily declining as the sector grows larger and so do its security budgets, but they remain a significant threat. And a particularly critical one, in a sector of finance totally devoid of regulatory protection.
Not all the benefits of staking are self-centred, however. It is, intrinsically, a practice with many benefits for the community.
In the world of crypto, it does good as it allows tokens to be distributed over a larger user base, and decreases the influence of market ‘whales’. In essence, reducing the amount of coins those big players can move around to manipulate price trajectories according to their interests.
In the wider world, cold staking addresses a concern often raised by crypto-sceptics: it provides a greener alternative to mining. While PoS networks are inherently more eco-friendly, and that’s one of their big selling points as they hope to overtake BTC in market dominance, cold staking does even better. With wallets being entirely offline, a neglectable amount of energy is required to keep protocols running.
The Risks of Cold Staking
It can’t be all roses, though, surely?
Even the safest yield-generating option of all comes with its own dangers. After all, the only way to have your coins be completely impenetrable is to hold them on a cold wallet and hide the physical device it sits on, but that would remove any opportunity for growth.
And it still doesn’t protect them from their owner.
That said, the likelihood of something bad happening to tokens protected through cold staking is very, very low.
The human factor is always important, and being responsible for one’s own wallet also means no one else can help if bad memory or an unaware family member lead to a loss of keys or passwords necessary for access. You best warn your spouse or flatmate about the importance of that string of seemingly random words written on a piece of scrap paper hidden under the bed, or risk losing access to your funds. No customer service rep or friendly banker will be able to help then!
As with any other earthly possession, physical wallets can be stolen by classic, ‘analogic criminals even if they’re not hackable. Just like everyone else, thieves and scammers have gotten increasingly crypto-savvy and muggings targeted specifically at retrieving access to a victim’s crypto balance are becoming more and more common.
Furthermore, as mentioned above, those moving their funds to cold wallets owned by third parties (i.e. Binance) will almost always need to do so online – thus exposing themselves to all the risks involved with hot staking, although for a short amount of time. There is also the risk that the third parties themselves might be victims of crime, whether physical or digital.
Ultimately, the main reason that rules out investors from cold staking compatibility is the desire for flexibility on funds management. Once the funds are locked away, they remain susceptible to drastic changes in value based on market fluctuations – with their owner unable to, so to speak, ‘dump their bags’ in case things go south.
This makes cold staking a solution viable only for those interested in long-term investment, HODLing and with a strong hand that’s not easily twisted by emotional downturns.
A Specialist Tool… For Now
Ultimately, cold staking is more suited to a patient, forward-looking investor who can guarantee himself a decent degree of physical security, while also remaining organised enough to run his own wallet.
It might also require a slightly deeper pocket out of the box, as the need for a physical device (be it a dedicated physical wallet or just a personal computer) is inherent. This is unlikely to be a serious limitation, however, as even the cheaper smartphones in circulation these days can run basic cold wallet apps.
Given its total independence from centralisation, it can also be said to represent the pinnacle of crypto ideology thanks to its self-sufficient nature and democratic availability.
As the industry matures and the amount of investors burned by trusting the wrong crypto corporation increases, it’s likely this tool will only gain popularity further – and technical advances will continue to improve its accessibility.