What Are the Major Risks of Staking Crypto?

Staking vs Providing Liquidity

It’s important to make a distinction between staking and providing liquidity, but both are ways in which you can stake cryptocurrencies in order to receive a return (also known as yield or APY).

Staking, as we’ll refer to it in this guide, means directly providing a single asset, whether as a delegator or validator, to a blockchain network. Staking crypto helps with securing and validating transactions on that network. In exchange for helping secure the network, you are rewarded with a payout in the digital asset that is prorated based upon your stake. Payouts are rewarded at different intervals.

For example, if you stake Cardano (ADA) to the Cardano blockchain, you’re rewarded with a payout of ADA every 5 days. If you stake Cronos (CRO) to the Cronos Blockchain, you receive CRO every block.

Providing liquidity (sometimes referred to as staking or farming), means providing either a pair of assets in equivalent dollar amounts to a decentralized exchange (DEX) such as Uniswap, or providing a single asset to a decentralized lending platform such as AAVE. The main difference between providing liquidity and staking is that when providing liquidity the returns can fluctuate greatly depending on supply and demand of either the pair of assets you’re providing to the DEX, or the demand to borrow the single asset by other users on the lending platform.

For example, if you’re providing liquidity to the ETH-WBTC pair on Uniswap, you’re likely to receive a higher return than a less in demand pool with two assets with much lower market caps and trading volume. If you’re providing ETH to AAVE, there is already so much supply that the return is barely 2%, but there is more demand than for WBTC, which has a return of 0.02%.

Now that we’ve separated the two concepts, let’s discuss their risks.

Risks of Staking

Reward Slashing

Reward slashing doesn’t occur with every asset that can be staked (meaning it’s not always part of the protocol), but refers to when either you as a validator, or the validator you’ve delegated to, does some sort of bad action. Whether this means being offline when they were assigned a block, or double submitting a transaction, it affects the rewards (they’re slashed). This doesn’t affect your principal stake, but is still undesirable. This risk can be mitigated by either ensuring you’re doing things correctly as a validator or doing due diligence on the validator you delegate your stake to. Most reputable validators have very little risk of reward slashing.

Lock-Up Period

This isn’t a serious risk in the sense that you’re never going to lose assets that are locked into a stake. However, if you need the assets, you need to be aware of the lock-up period, and the potential risk that it presents. If you’re planning to sell an asset when it hits X value, then you need to preemptively unstake it (based upon when you want to sell), or not stake it at all to avoid the issue altogether.

For example, Terra Classic (LUNC), has a lock-up of 28-days, meaning that once you stake it, you have to wait 28-days to get it back when unstaking. This greatly affected users who had staked LUNC when the Terra collapse occurred, as they couldn’t remove their funds and sell before the value dropped drastically.

Hyperinflation

This is more so a risk for algorithmic staking assets such as we saw with Terra Classic (LUNC). As the protocol continued to work using the algorithm it was designed with, LUNC stakers had their holdings greatly diluted because of the hyperinflation that occurred as the asset was dumped. The supply went from about 2 billion to over 6 trillion over the course of two days.

Risks of Providing Liquidity

Impermanent Loss

Impermanent loss occurs when you provide liquidity to a liquidity pool, such as the ones on Uniswap or PancakeSwap, and the price of your deposited assets changes compared to when you deposited them. The bigger the change in value, the more you are exposed to impermanent loss. In this case, the loss means you will have less dollar value at the time of withdrawal than at the time of deposit.

For example, if you deposit ETH and WBTC into a liquidity pool and the value of ETH goes up, the pool automatically adjusts ratios of each asset in the pair as their prices change, resulting in differing amounts when you withdraw. This means that you lose value because if you hold the asset in your wallet, the value simply rises and you have profit.

However, if it’s deposited in a liquidity pool and the value of the asset goes up, it has to adjust for the price increase to keep the dollar values equivalent. Then when you go to withdraw your share you have less than if you had held it in your wallet. This is offset depending on the rate of return you’re earning for providing the liquidity.

Protocol Hacks/Smart Contract Bugs

The other risk with providing liquidity is the vulnerabilities in DeFi due to coding mistakes. If the developers miss an issue with the code they’ve created, then a hacker or bad actor is likely to take advantage of it. This could result in a pool being drained of its liquidity, or issues wherein your assets are trapped in a smart contract.

Conclusion: Staking Superior to Centralized Services

Despite all the aforementioned risks, staking is generally safer than relying on centralized services (such as the infamous FTX or Celsius Network) to provide a yield for your crypto.

Most issues related to staking are on a protocol level (coding mistakes etc.) and if you’re using a reliable project in shouldn’t be a problem. Even in the case of a reward slashing (which is rare) you won’t lose your principal investment. Instead the penalty will simply hit your rewards.

Meanwhile DeFi does have risk of hacks but there is no centralized entity to intentionally steal your crypto.

As always, crypto is risky in general and you should only invest what you can afford to lose. That said, staking is a compelling yield-generator and it’s worth at least learning about the process.