3 Things You Should Know Before Staking Crypto For Passive Income

While crypto staking has existed for years, it really only became mainstream with investors during the past year. This coincided with the transformation of Ethereum (ETH -0.83%) into a proof-of-stake blockchain as part of The Merge. Suddenly, people began asking what crypto staking was, and how they could make money from it. As a result, crypto staking went from something only the early blockchain and crypto pioneers were doing to something the average investor on Main Street was doing.

What makes crypto staking so unique is that it is both a technical process that involves the inner workings of a blockchain, and a form of financial investment. At times, this duality can be confusing for investors, who may only be thinking of crypto staking as a form of passive income. With that in mind, here are three things to keep in mind before staking your crypto.

A flawed analogy?

The classic analogy is that crypto staking is much like depositing your funds in a high-yield savings account. You are depositing your cryptocurrency with a blockchain, much like depositing your dollars with a bank. And, in exchange for doing so, you are paid a specified reward rate, usually expressed in terms of an annual percentage yield (APY). For most cryptos, these APYs range from 2% to 10%. For example, on Coinbase Global (COIN 2.20%), you can currently earn 3.35% on your Ethereum holdings.

Image source: Getty Images.

But this analogy has several flaws. For one, blockchains are not banks. That means your deposit is not guaranteed by anyone, and certainly not by the Federal Deposit Insurance Corporation. That helps to explain why APYs for some cryptos can be as high as 45% — think of this as a risk premium for depositing your funds with a potentially unreliable blockchain counterparty.

Moreover, when you stake your crypto, you are paid rewards in the form of the cryptocurrency you deposited, and not in dollars. Thus, when you compare APYs, you need to be thinking in terms of how much crypto your investment is yielding, and not how many dollars it is yielding.

Finally, keep in mind that staking usually requires you to “lock up” your crypto for a specified period of time, during which you will not have access to it. This might not seem like a big deal at first, especially if you are a long-term investor, but what if your crypto starts to lose value while it’s locked up? When you get your crypto back at the end of the staking period, it may have lost significant value. The math here can be brutal. If your crypto loses even 10% of its value over a 12-month period, and you are earning a 5% APY, it’s hard to see how you’re going to make a profit on this investment.

Different types of staking

Confusing matters further is that there are different types of staking.​​ One form of staking requires you to operate a node on the blockchain network and use your own computer hardware to validate transactions on the blockchain. But this is neither easy nor passive. If you want to become a validator on the Ethereum blockchain, for example, you need to make a minimum investment of 32 ETH (worth almost $64,000 at today’s prices) and have the suitable tech hardware to run a blockchain node 24/7.

That’s not what most people are talking about when they talk about crypto staking as a form of passive income. Instead, they are usually talking about staking crypto via a cryptocurrency exchange such as Coinbase. This process is much easier — it usually only requires a few clicks online, and you’re ready to go. As long as you already own the cryptocurrency you want to stake, you just tell the crypto exchange how much you want to stake and for how long, and everything else is done for you.

For more advanced investors, there’s also a form of staking your crypto without the need for a cryptocurrency exchange at all. Instead, you hold funds in your own blockchain wallet and use a third-party staking service. Typically called liquid staking, this process can reduce some of the risks of staking, since you can pull out your crypto at any time. Moreover, the staking rewards can be a bit higher, because there is no intermediary (like a crypto exchange) taking a cut of your rewards.

Regulatory concerns

Finally, there’s the pesky little matter of the Securities and Exchange Commission, which has decided that there’s something about crypto staking that it does not like. In February, it went after cryptocurrency exchange Kraken for offering staking services to customers. Then, in June, it went after Coinbase. So there’s currently a bit of uncertainty about the future of crypto staking.

The good news, if you want to call it that, is that the SEC is not so much opposed to the concept of staking, as it is to the way staking is pitched to retail investors. If you read the official SEC statement about Kraken, this becomes clear. For example, the SEC said that Kraken did not do a good enough job of explaining potential risks to customers.

Caveat emptor

That’s why I made a big deal about the flawed analogy to a high-yield bank savings account. If you are thinking about crypto staking as just crypto’s version of a savings account, then it’s easy to see how you might be in for a rude surprise. Unlike with a savings account, you can actually lose money on your staked crypto. So, certainly, before you get involved with crypto staking, make sure you do your due diligence and understand the risks.