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DeFi Staking: How Does It Work, Benefits And Risks

Updated on: Jun 8th, 2024

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3 min read

In crypto trading, traders try to move a coin around different marketplaces. This is mainly done to maximise their earnings from a particular coin. Staking is one such technique used by traders to serve this purpose. 

Staking in the crypto world can be of two types – Decentralised Finance (DeFi) and Centralised Finance (CeFi). DeFi staking offers several advantages as a third party is not involved. So, if you are looking forward to maximising your income via DeFi staking, it becomes essential to know everything about it to leverage the maximum benefit.

Keep scrolling to know all about DeFi staking.

What is DeFi staking?

Decentralised finance (DeFi) staking is a popular technique where traders can use a smart contract to lock their coins. This is important to maintain the liquidity of the pool, preventing excess price swings. Only traders with the highest number of a specific coin can act as validators for the transaction of that particular coin. 

This validator is automatically selected among all the traders across the globe. Once validators validate a transaction, they receive some commission from the traders, generating a passive income.

How does DeFi staking work?

DeFi staking works using the following mechanisms:

  • Staking: 

The primary mechanism used by DeFi is Proof-of-Stake (PoS). Here a trader with the highest number of coins is automatically chosen as the validator. This validator has the authority to validate all transactions for that coin. When validators authorise a transaction, they receive a great amount of money as a commission. 

However, the number of coins a trader needs to hold to become a validator is quite high. This is the main condition that prevents a trader from becoming a validator. 

Today Ethereum has the most high-profile PoS consensus mechanism. Other coins that use the PoS mechanism include The Graph and Polkadot. Several staking service providers are emerging to help people meet their financial requirements and increase their passive income from crypto trading.

  • Swapping:

DeFi staking also uses a swapping mechanism where traders can directly exchange coins. A smart code is designed to carry out the swapping process. Since there is no involvement of a third party in DeFi staking, a trader can swap any coin with a trader of their choice. 

This technique solely relies on the liquidity of a coin in the market. Traders do not need to provide any inputs during the exchange. Hence the exchange stays error-free and non-custodial.

  • Liquidity mining:

In this technique, the traders stake their coins in different liquidity pools. This technique plays a crucial role in maintaining the liquidity of a coin. Often buyers tend to buy and hold a large proportion of coins. This is because they believe an increase in the price of coins would eventually increase their profit. However, this creates a scarcity in that coin, and the price of that coin increases exponentially. 

To avoid this situation, crypto traders have many coins at stake to maintain their liquidity. The traders, in turn, receive a reward for staking their coins. Generally, there is an algorithm that pairs two trading assets. This ensures that the price of assets paired is dynamically adjusted to be equal. 

  • Farming:

Yield-farming is another popular method of staking closely similar to earning interest on a savings account. The traders receive a fee in the form of interest when they stake a coin. Traders usually use a smart contract to lock the coins efficiently at low costs. 

A trader's incentives or interests in yield farming are usually expressed as annual percentage yield or APY. Generally, traders, such as DAI and others, use popular stable coins for yield farming. 

What are the benefits of DeFi staking?

DeFi staking offers several benefits, such as: 

  • Traders can generate much money through passive income using DeFi staking. This is generally done in two ways:
    • By becoming a validator
    • By becoming a staker
  • This technique involves smart contracts to protect traders from scams and risks. Automated Market Makers (AMM) generally automate these contracts; hence the chance of errors is much less. 
  • The process is usually less complex as it is free of the involvement of a third party. The traders can directly interact among themselves to ease the process.
  • A trader needs to pay a very nominal admission fee to start staking.
  • Stakers generally receive a large amount as a reward. This is because they can earn additional money in the form of interest.

What are the risks associated with DeFi staking?

The risks associated with DeFi are as follows:

  • Slashing occurs when a validator is unable to validate a transaction rightly. This usually happens when a validator double signs on the network. Under such circumstances, validators lose their rewards or tokens.
  • At times, the technical requirements of a blockchain are complex. Hence, traders must be cautious when setting up their crypto wallets. If not done carefully, there is a chance of losing the entire investment the trader makes on the coin.
  • Attacks and scams are widespread in DeFi staking as there is no third-party oversight. Hence, traders must stay cautious and check the background of the other trader thoroughly before dealing with them.
  • The value of a coin can fluctuate immensely. Thus, traders must consider how much money to invest in which coin. Otherwise, there lies a big chance of losing their money either partly or entirely.

Final word

Thus, DeFi staking serves as a lucrative technique of passive income. It is a perfect replica of traditional systems of financial services. Although DeFi staking is still nascent, it offers much to traders opting for this technique to generate revenue. Considering the risks and taking careful steps can safeguard a trader from hefty losses. DeFi staking is a simple technique by which traders eliminate the additional expenses generally involved in trading.

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