Crypto staking and liquidity pools have recently become most heavily discussed topics in the crypto sphere. Both of these have their popularity as a means of earning passive income from crypto investments. This article will look at what differentiate crypto staking from liquidity pools.
|Criteria||Crypto Staking||Liquidity Pools|
|Definition||Staking is an activity where a user locks or holds his/her funds in a cryptocurrency wallet to participate in maintaining the operations of a proof-of-stake (PoS)-based blockchain system.|
(PoS: main idea behind this is that participants can stake their coins at particular intervals, the protocol randomly assigns the right to one of them to validate the next block)
|Liquidity pool is a smart contract that locks tokens to ensure liquidity for those tokens on a decentralized exchange. Users who provide tokens to the smart contract are called liquidity providers.|
|How does it work?||Staking involves validators who lock up their coins so they can be randomly selected by the protocol at specific intervals to create a block. Usually, participants that stake larger amounts have a higher chance of being chosen as the next block validator. |
This allows for blocks to be produced without relying on specialized mining hardware.
|In the simplest version of a liquidity pool two tokens need to be held in a smart contract to form a trading pair. |
Liquidity in the pool means that when someone wants to trade a crypto token for another, they can do so based on the funds deposited, rather than waiting for a counterparty to come along to match their trade. In other words, trade is executed against the liquidity in the liquidity pool.
|How is it rewarded?||Each blockchain network may use a different way of calculating staking rewards. It can be block-by-block basis or as a fixed percentage|
Different factors such as;
– No. of coins validator is staking
– Staking duration
– Total no. of coins staked
– Inflation rate
When calculating the staking rewards. These rewards are distributed to validators as a sort of compensation for inflation.
|Liquidity providers are incentivized for their contribution with rewards. When they make a deposit, they receive a new token representing their stake, called a pool token. The share of trading fees paid by users who use the pool to swap tokens is distributed automatically to all liquidity providers proportionate to their stake size. |
For example; if trading fee for token A-token B pool are 0.2% and a liquidity provider has contributed 10% of the pool, they’re entitled to 10% of 0.2% of the total value of all trades.
|What are the risks?||Major risks involved with crypto staking can be summarized as; |
– Risk of extreme volatility, rewards will be appealing in a bull run but when conditions change losses will overtake returns
– Validators not paying the stipulated rewards
– Reward duration is uncertain, it can take hours to days to weeks to get the rewards released
|Major risks involved with liquidity pools can be summarized as; |
– The algorithm that determines the price of an asset may fail, if an asset’s price varies from the global market price, arbitrages will move away the profits.
– In the event of price fluctuations, liquidity providers can incur a loss in the value of their deposits, known as impermanent loss.
– Due to the pricing algorithm, smaller pools can suffer from slippage if someone suddenly wants to place a large trade.
When looking at the analysis it can be said that overall crypto staking would give rise to higher returns, but that comes with its fair share of risks. Yet, it is crucial to make note that your investment should not be focused precisely on return (how much to earn?), but on the amount that is planned to invest in and the level of risk you are willing to undertake.