What is staking and how does Hodl implement this?


What is staking?

As blockchains operate in a decentralized environment, there is no centralized entity such as a bank that ensures that the current state of the blockchain with its transactions and balances is correct. So for all the computers and validators to agree that the current state of the blockchain is correct, they use a consensus mechanism. This consensus mechanism rewards validators if they actively secure the network, so cryptocurrency can be seen as an economic incentive for validators to act properly. Although various consensus mechanisms have been developed, one of the most popular, especially in the last two years, is Proof-of-Stake (PoS).

One of the reasons why PoS is popular is that it doesn’t require validators to acquire special hardware to participate to secure the network such as with Proof-of-Work, the consensus mechanism of Bitcoin. With just a laptop and a few requirements, users can start validating blocks to secure the network and generate additional digital assets. One of these requirements is that validators must provide a stake, which can be seen as a security deposit. To ensure that validators don’t go rogue or act maliciously, the consensus mechanism must have an option to punish them. In PoS, if a validator chooses to act maliciously, a portion or its entire stake is confiscated, this is called slashing.

How Does Staking Work?

However, if the user successfully validates blocks, they are rewarded with the block reward of the network; these are known as staking rewards in PoS. Therefore, staking involves providing the needed cryptocurrency to aid in securing the PoS blockchain and this can be done in various ways.

What kinds of staking are there?

Throughout the years, all kinds of staking have been developed and each has its advantages and disadvantages. Staking can generally be divided into two categories:

Active staking

The first developed staking method was active staking, which requires users to set up a validator to actively validate incoming transactions and create new blocks to earn rewards. With active staking, users can maintain full control of their assets and don’t have to share the rewards with anyone else. However, a drawback is that setting up a validator demands technical expertise, and they typically require a high stake. For instance, to become an Ethereum validator, 32 Ether, approximately $96,000, is needed as a stake.

Passive staking

Passive staking is a more straightforward approach as it only requires users to lock up their tokens in a blockchain network. This helps in securing the blockchain without the technical difficulties, however, passive stakers are rewarded with fewer tokens as they have a less active role than active stakers.

Within these categories, there are different types of staking:

Types of digital assets staking

Delegated staking

With Pool staking, a group of stakers combines their staking powers into one centralized pool to increase their chances of validating the next block. The staking rewards are then divided among the stakers proportionally to their provided staking power within the pool.

Pool staking

With Pool staking, a group of stakers combines their staking powers into one centralized pool to increase their chances of validating the next block. The staking rewards are then divided among the stakers proportionally to their provided staking power within the pool.

Liquid staking

The most recently developed method of staking is Liquid Staking. It was introduced by Lido Finance which was launched as Ethereum switched to PoS. One of the main challenges of staking is that users have to lock their digital assets for a certain period, as a result, users have a less liquid position. Liquid staking solves this problem by providing users with a representative token for the staked assets and their reward. Consequently, this token can be swapped for other assets in the broader DeFi ecosystem but also on centralized exchanges.

What are the benefits of staking?

One of the main benefits of staking and why it's so commonly used is that users can genera

te additional cryptocurrency with their holdings. Furthermore, compared to other DeFi protocols, it's one of the safest methods to generate extra rewards.

Besides monetary benefits, staking offers users an easy method to secure the PoS blockchain, without the need to acquire specialized hardware. With sustainability becoming an increasingly important subject in today’s economics, PoS has an advantage compared to other consensus mechanisms. A PoS blockchain doesn’t require special hardware and doesn’t involve an intensive mining process, which consumes high amounts of energy.

How does Hodl implement staking?

The Hodl Funds choose to engage in staking activities for a couple of reasons. Firstly, security has always been one of our top priorities within our funds, and we believe that a safer ecosystem benefits all market participants. Through staking, we can aid in creating more secure blockchain networks, which in turn benefits the asset as well.

Secondly, staking allows the funds to generate additional digital assets, which are beneficial for the participants of our funds. Especially in bear markets, staking can offer unique opportunities as we can generate additional assets when prices are low, increasing the upside potential when prices increase. So, fortunately, we can have the best of both worlds by providing security while offering our participants additional returns.

As aforementioned, security is our highest priority, therefore, when participating in staking, our research analysts dedicate sufficient time to researching the protocol and establishing risk-reward metrics. Furthermore, we don't operate independent validators as that requires technical expertise to set these up. It would necessitate an additional team to ensure 24/7 operation and a mistake could be costly, especially when dealing with client assets.

Staking rewards, Hodl Funds assets

We do stake certain assets such as Ether, Avalanche, Solana, Bittensor, Axelar, Akash, and Banana through other mechanisms. One of these methods is via Lido, a liquid staking platform. This platform allows us to stake our Ether while maintaining a liquid position in it. Therefore, all of our staking activities are conducted through passive staking, utilizing only trusted platforms, preferably those that allow us to maintain liquid positions, enabling us to act on market conditions.

Despite being widely used in digital assets, staking still carries certain risks. One such risk is that the protocol you've staked your assets with might make a mistake, resulting in a slash, assets being locked for extended periods, and no guarantee of rewards. It's important to conduct thorough research before engaging in staking and the platform that offers this service

Nevertheless, staking has proven beneficial for the Hodl funds. For instance, the staking rewards from Bittensor alone covered all our participants' management fees, partly due to Bittensor's significant rally in early 2024.

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