What is DeFi Staking and How Does it Work?

Staking in DeFi involves locking crypto assets into a smart contract to earn rewards and create passive income. Typically, stakeable cryptocurrencies belong to blockchains that operate on a Proof-of-Stake (PoS) consensus mechanism. This mechanism supports transaction validation, maintains network rules, and ensures security.

PoS consensus mechanisms select validators according to how much cryptocurrency they stake. Selected validators confirm transactions and maintain blockchain network consensus. In return for this activity, validators receive rewards in the network’s native cryptocurrency.

Becoming a validator requires locking or staking a specific minimum of cryptocurrency within a blockchain network. Ethereum, for instance, requires a minimum of 32 ETH. Such high staking requirements put validator roles beyond reach for most users.

What can you get from DeFi staking

DeFi staking has grown significantly in recent years because of the attractive benefits it offers:

Earn DeFi staking rewards

Delegators earn rewards by entrusting their crypto assets to validators. These staking rewards come from a portion of the validator’s transaction fees. Rewards usually appear as an annual percentage yield (APY) or Annual Percentage Rate (APR) and differ according to each token’s reward structure. Delegators become eligible for rewards once the crypto transaction validation finishes. The staking service sets the waiting period for reward distribution.

Enhance blockchain security

Staking in DeFi spreads influence among various stakeholders. This distribution makes malicious attacks harder to execute and improves network stability. Additionally, staking funds directly support transaction validation operations.

How DeFi Staking works

DeFi staking processes vary by blockchain but generally follow these steps:

• In Proof-of-Stake blockchains, the network selects validators based on criteria such as the amount of cryptocurrency staked, staking duration, and occasionally random choice.
• Validators chosen by the network verify and confirm transactions to ensure they are authentic.
• After validation, transactions form a block added to the blockchain, which serves as a distributed ledger.
• Validators earn rewards from transaction fees and sometimes receive newly minted cryptocurrency coins for their participation.

Risks associated with DeFi staking

Although staking in DeFi offers many benefits, participants should understand several associated risks:

Penalties

Validators in Proof-of-Stake networks risk penalties or "slashing" for misbehavior or network downtime. Penalties result in losing part of the staked funds, which affect both direct stakers and staking pool participants. The severity depends on the network and ranges from minor deductions to substantial penalties.

Platform and smart contract vulnerabilities

DeFi platforms face multiple technical risks. Governance decisions might negatively affect stakers while platform weaknesses can be exploited by attackers. Even audited platforms might contain undiscovered issues.

Staking services are also vulnerable to bugs or logic errors in smart contracts. Despite broad adoption and extensive testing in DeFi, developer mistakes or unforeseen errors may still expose staked assets. These errors can have a severe impact on projects and result in significant user losses.

Illiquidity

Staking often involves locking tokens for a specified duration. During this lock-up period, stakers are unable to freely withdraw or trade their assets. Rapid changes in market conditions or urgent financial needs can make this lock-up problematic.

Impermanent loss

Impermanent loss mainly affects liquidity providers engaged in crypto farming or yield farming. It occurs when token price ratios in liquidity pools fluctuate. Such fluctuations can result in lower returns compared to holding the assets directly.

Types of DeFi staking

Different methods of staking in DeFi are available depending on your technical skills and the amount of crypto you plan to stake. Here are the most common types:

Governance staking

Governance staking involves locking specific governance tokens to support blockchain network operations. Holding governance tokens grants users voting rights on key decisions regarding blockchain development, protocol changes, or resource allocations. Users can shape the project's direction by participating in these decisions.

Governance staking reduces the circulating token supply, which increases token stability and value. Additionally, it promotes long-term investments as rewards typically increase with longer staking durations.

Native staking

Native staking involves locking crypto assets directly within their own blockchain networks. By doing this, participants help validate transactions and enhance network security. In exchange, they earn rewards in the blockchain’s native cryptocurrency.

Validators commit a specific amount of cryptocurrency as collateral in native staking. This stake ensures that validators act honestly to preserve their assets. The blockchain’s consensus algorithm randomly chooses validators based on the size of their stake. Selected validators then review and validate transactions before adding new blocks to the blockchain.

If validation occurs correctly, validators earn rewards consisting of new coins and transaction fees proportional to their stake. If validators act dishonestly or validate fraudulent transactions, their stake may be penalized through slashing, which discourages malicious behavior.

Validators can eventually withdraw their stake and accumulated rewards, but withdrawal periods vary depending on the network.

Liquid staking

Liquid staking lets participants stake cryptocurrency while maintaining access to it. In this method, participants receive Liquid Staking Tokens (LSTs), which can be traded or utilized in other DeFi applications. This approach provides staking rewards while keeping assets liquid.

Liquid staking involves depositing cryptocurrency into a staking pool managed by a trusted validator. In return, LSTs that represent staked assets are distributed. LSTs can be traded or used as collateral on crypto staking platforms, earning an additional yield while the assets remain staked. For example, staking ETH on platforms like Lido gives stETH, an LST that can be freely traded or used elsewhere without losing staking rewards.

Validators distribute rewards proportionally to holders of LSTs. If a participant chooses to withdraw staked tokens, they can simply exchange the LSTs back into the underlying cryptocurrency, minus fees.

Some platforms offer direct staking without LSTs, known as native liquid staking. Cardano's native liquid staking of ADA is one such example. This method allows staking benefits while retaining asset flexibility.

Liquid staking vs native staking

The debate between liquid staking and native staking is not just theoretical—it has practical implications for blockchain enthusiasts and investors alike. As more blockchain networks adopt staking mechanisms, understanding these staking methods can significantly impact your portfolio’s performance. Whether you are a newcomer or an experienced investor, grasping the key differences can help you maximize rewards and manage risks effectively.

Crypto restaking

Crypto restaking allows validators to stake the same cryptocurrency across multiple Proof-of-Stake networks simultaneously. This increases the utility and earning potential of their staked assets. Restaking tackles two key limitations found in traditional staking methods:

• Increased reward opportunities: Validators earn from multiple protocols using the same stake.
• Enhanced network security: Established blockchains lend their security to newer or less secure platforms, strengthening the ecosystem.

Restaking allows validators to secure services such as oracle networks, data availability layers, and blockchain bridges.

There are two main forms of crypto restaking:

Native restaking

Experienced validators who manage their own nodes typically choose native restaking. These validators install additional node software to participate safely within the restaking ecosystem and offer their staked assets across multiple networks.

Liquid restaking

This approach involves depositing LSTs, such as stETH from Lido, into specialized platforms like Puffer, Ether.Fi, or Renzo. These platforms handle the technical details of restaking and issue Liquid Restaking Tokens (LRTs). Users can trade LRTs or hold them for additional yield.