Earning interest by staking or lending your crypto coins might seem lucrative, but hidden within are substantial risks that demand consideration before exposing your assets.
Understanding On-Chain Staking: Unveiling the Risks
On-chain staking is associated with proof-of-stake blockchain networks where nodes validate new blocks and receive rewards in crypto coins or tokens. This process, known as ‘staking’, requires securing a certain amount of crypto coins within the node. For instance, running an Ethereum node necessitates staking 32 ETH, yielding about 5% annually.
While it offers potentially high returns, delving into this mechanism also entails navigating through several inherent risks:
Network Vulnerabilities
The rewards you earn through on-chain staking heavily rely on the network’s stability and security. In the event of network attacks or glitches, such as a 51% attack or bugs disrupting the blockchain’s functionality—think Solana’s notorious periods of downtime—it could lead to diminished rewards or, worse, loss of funds.
Liquidity Hurdles
When staking, your tokens are often locked up for a predetermined period. Ethereum’s past staking required such a commitment, potentially posing challenges if you urgently need access to your funds. To mitigate this, it’s crucial to maintain a separate cash reserve for unforeseen financial needs.
Protocol Errors
On-chain staking necessitates reliance on smart contracts and protocols. In cases of design or implementation errors, your funds could be at risk. Security loopholes can be exploited by hackers, resulting in potential financial losses.
Price Fluctuations
While earning a return of, say, 10% seems appealing, the actual value largely hinges on the cryptocurrency’s price performance. A 10% return is less meaningful if the cryptocurrency’s value plummets by 35% or if the altcoin ceases to exist, causing a complete loss of your investment.
On-chain staking demands technical expertise to maintain your node. Opting for platforms like Bitvavo, which handle these technical aspects, allows for easy access to rewards by simply enabling the staking option. For less technically-inclined individuals, exchanges are a great solution, albeit at the expense of trusting intermediaries, exposing you to additional risks like bankruptcy.
Unpacking Off-Chain Staking or Lending: Underlying Risks
In contrast to on-chain staking, off-chain staking often masquerades as a technical concept, although it essentially revolves around lending your crypto for potential returns. While it offers the allure of passive income, significant risks lurk beneath the surface.
Counterparty Exposure
Lending involves entrusting your cryptocurrencies to other users on a platform, exposing you to the risk of default by the counterparty. Failure to repay the loan can result in the loss of your funds—a risk exemplified by past incidents where platforms lent users’ assets to high-risk entities.
Platform Vulnerabilities
Specialized lending platforms face diverse risks like hacks, operational disruptions, or bankruptcy. Instances in 2022 involving platforms like Celsius and BlockFi underscored these risks, wherein customers’ funds were jeopardized due to platform mismanagement or excessive risk-taking, often leading to substantial losses.
Price Risks
Lending occurs in specific cryptocurrencies, subjecting you to price fluctuations. Even when lending stablecoins, trust in the stability of the coin itself is vital—past instances, such as UST’s depreciation, highlight the potential risks despite the coin’s stable label.
Lending gained popularity due to high interest rates, but the risks of loan defaults or stablecoin volatility necessitate viewing these high returns as compensation for potential losses.
Exchanges, Lending, and Staking: Managing Risks
Understanding the risks is imperative when engaging in on-chain or off-chain staking or lending, ensuring a cautious approach to safeguard your crypto investments. Exchanges offering lending or staking options may use intermediaries like lending platforms. In the end these platforms will manage your assets, introducing potential counterparty risks during market downturns.
At Bitvavo, enabling staking or lending options via settings automatically employs your coins for these purposes. Be aware that this means relinquishing direct control of your assets and entrusting them to third parties like the now defunct Genesis.
Whether on-chain or off-chain, staking or lending involves inherent risks. Understanding these risks vis-à-vis the offered interest rates is crucial. For a secure approach, consider managing part of your assets using a hardware wallet, offering assurance of ownership that exchanges can’t guarantee.
Ultimately, if the potential loss of coins isn’t an acceptable risk, focusing solely on self-managed bitcoin stored on a hardware wallet remains the safest route, ensuring complete ownership and mitigating exchange-related uncertainties. Trusting exchanges always carries an element of uncertainty.
Read more about crypto in our free crypto guide. Interested staking? Read about the staking service on the Bitvavo platform.
