Learning outcomes:
By the end of this article you will understand:
1. What a stake pool is 2. What a pledge is in a stake pool 3. The associated risks and benefits of participating in a stake pool
What are staking pools?
Staking pools allow crypto holders to earn passive income by contributing to a pool of funds that collectively earn block validation rewards from a Proof of Stake (PoS) blockchain.
Individually, small stakers can’t access the rewards available to validators of PoS chains like Ethereum. But if they collectively add their funds to a pool, the pool is large enough to generate rewards paid out to contributing stakers in proportion to the amount committed.
PoS is one method blockchains like Ethereum use to agree on the validity of information recorded in new data blocks. By requiring anyone who wants to propose a new block ( a validator) to have a financial stake in the system, PoS discourages dishonest behaviour.
Why do staking pools exist?
One of the biggest selling features of blockchains is that they are open to anyone. There are however some barriers.
Technical barriers
Solo staking in a PoS blockchain isn’t as simple as sending some funds to a specific address. If you take the manual approach, there are minimum hardware and software requirements along with a level of technical expertise.
Alternatively, you can take a Plug’n’Play approach by buying a machine with all the required validation software pre-installed and a set of instructions to get up and running. This is also described as Staking as a Service (SaaS).
Minimum stake requirements
Ethereum validators are chosen randomly to create new blocks and validate transactions based on a requirement to stake 32 ETH. At the time of writing, that amounts to a commitment of £50,000 to access a variable APR.
Considering the technical requirements of running a node along with the high minimum stake requirements, staking pools offer an attractive alternative for crypto users to generate passive income from their funds.
Two types of staking pool
There are two main types of staking pool, which give stakers differing levels of control over the funds they commit.
3rd party staking pools
Most major exchanges offer a staking pool service to their customers, described as 3rd party staking pools.
Using a 3rd party like an exchange means they have control over private keys and have custody over your funds. You trust them to manage the staking process and pass on your staking rewards based on your contribution and the agreed terms.
Non-custodial staking pools
Non-custodial staking pool options allow you to commit funds but remain in control of your private keys. Users connect through an app on a non-custodial wallet and have full control over the process of committing funds.
How to use a non-custodial staking pool
- Decide the amount you want to stake.
- Sign a transaction committing your stake – known as bonding. This will incur a fee.
- Nominate a broad set of validators to ensure the best chance of earning rewards.
- Ensure you’ve reviewed the commission each validator charges and the total funds held. You may receive a utility token representing your staked funds, giving you the option to sell your stake or generate additional DeFi returns on the token.
- Check rewards are being regularly paid, and withdraw or restake.
- To withdraw your stake, sign a transaction and wait for the unbonding period to elapse.
How to choose a staking pool
If you take the custodial approach, you’ll need to check with the terms of the exchange or 3rd party provider to ensure you understand what is involved. This may include:
- Minimum staking requirements
- Limitations on certain countries
- The length of the bonding and unbonding periods
- The returns on offer
If you take the non-custodial approach, here are some things to consider when choosing a staking pool.
- Minimum commitment: What is the minimum amount you need to stake?
- Return: What is the expected % APR?
- Pledge: Does the pool pledge a certain amount of its own funds? Pledging is a sign of a committed staking pool.
- Slashing: How does the pool handle penalties for bad validator behaviour, known as slashing.
- Open source: Is it open source to provide full transparency?
- Audited: Is the code handling the pool independently audited?
- Bug bounty: Do they offer bounties for anyone finding code flaws? This is a sign of a progressive setup.
- Diverse clients: Does it allow a diversity of client software, which helps the underlying blockchain?
- Liquidity token: Do stakers get a liquidity token, providing more utility over staked funds?
The benefits of staking pools
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Passive income Staking pools provide a way of generating a passive income on your crypto funds.
- Participation By joining a staking pool, you are helping to secure the underlying blockchain and playing an active role in the crypto ecosystem.
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Education Non-custodial staking pools give you a better insight into how the validation process for PoS blockchain works, providing a useful form of hands-on education.
The risks of staking pools
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Tax liability Depending on where you live, there might be a tax liability on the income generated from a staking pool. It’s your responsibility to keep records and submit the correct details to your tax authority.
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Protocol hacking If you use a non-custodial staking pool, there is a risk that their smart contract might be exploited, and funds lost.
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Counterparty risk If you take the custodial approach, your funds are at risk if the exchange is hacked or goes bankrupt.
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Unbonding period Funds withdrawn from a staking pool are only accessible after an unbonding period has elapsed. So, unless you are issued a liquidity token, you cannot sell to take profit from a price increase or mitigate a sudden price decline.
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Slashing penalties If a validator your stake is pooled with breaks the consensus rules of the blockchain, they can be financially penalised, known as slashing. You may have to cover some of that financial penalty.
