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Oct 15, 2020

17 min

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17 min

Risk Management for Staking: What is Slashing?

slashing cover

Staking is one of the best ways to earn a passive income in crypto. The year 2020 saw a proliferation of cryptos that investors can stake that have attracted hundreds of millions of dollars in investments. While staking is a great way to earn in crypto space, it carries its risks, and if you are not aware of them, they can cost you a lot, especially if you are a large investor — one of the most significant risks that you face in crypto. Simply put, slashing means forfeiting your crypto holding of staked cryptos in case you break the staking rules of the concerned project. The goal is to ensure that all staking nodes adhere to the rules and keep the project safe. Unfortunately, if you are not fully conversant with the rules, it can cost you a lot since you would nearly lose your hard-earned money, with no option of getting them back. The essence of this guide is to help you manage the risks that come with staking, especially the risk of losing your coins. To make it easier for you, the guide delves deeper into proof-of-stake and the various aspects to it that can make you a better investor.


PoW v PoS

To understand how to manage the risks that come with staking, it is imperative to comprehend Proof of Stake as compared to Proof-of-work. Proof-of-Stake is a consensus algorithm whereby new blocks are chosen through a distributed consensus. In contrast, Proof-of-Work id is a consensus algorithm whereby new blocks come into existence through computational work that takes both time and energy. Bitcoin, the largest cryptocurrency is the best example of a Proof-of-Work consensus. Miners expend energy and time on computations that generate a new block of Bitcoin. Besides their differing approach to the generation of a new block, the two consensus algorithms have several other differences. One such difference is in how they protect themselves from malicious attacks.

Proof-of-Work blockchains protect themselves from malicious attacks by making it almost impossible to raise the amount of power needed to control the network. For one to take over a Proof-of-Work blockchain, one would need to generate computational power that is equal to 51% of the entire network. This is not only expensive but also impractical for specific cryptocurrencies such as Bitcoin. On the other hand, Proof-of-Stake blockchains protect themselves from malicious attacks by making it economically mute to attack the network. To strike a PoS network, one would need to take ownership of 51% of the cryptos in the network. Not only is this expensive, but the price drop that would follow would diminish the whole essence of committing resources to such an endeavour. The other difference between the two consensus algorithms is in the way they reward those who generate new blocks. In a Proof-of-Work blockchain, the first person to solve the computational problem is awarded new coins. In Proof-of-Stake blockchains, those who stake their coins and participate in the process of creating new blocks are rewarded with a transaction fee.

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The PoS Advantage

While PoW is still the most dominant consensus algorithm in the crypto market, PoS is gaining acceptance fast. So fast that Ethereum, the second-largest cryptocurrency by market capitalization is in the process of shifting to PoS. Several benefits make PoS attractive as the future of consensus in the blockchain. Some of them are as below:


Energy Efficiency

While PoW is highly secure, it is also largely energy inefficient. Not only is this harmful to the environment, but it also creates risks of centralization. For instance, Bitcoin mining is currently concentrated in China due to the country’s low energy costs. In a situation where crypto gets adopted widely as a means of exchange and value storage, such a scenario is not tenable. PoS avoid this situation because no work is put in the process of generating new blocks. This energy efficiency makes PoS the tenable option as the future of blockchain consensus.


Speed

The second benefit of PoS is that it is fast. Since no complex problems are being solved to bring up new blocks, transactions are processed faster in PoS. This also means that the network can scale more quickly, making it practical for large scale applications such as global payments at scale. The poS consensus is also less efficient overall because it does not require a supercomputer for it to function. This is unlike PoW, which continuously requires more sophisticated computers for it to work. For context, in the early days of Bitcoin, it was possible to mine using a laptop. However, as the computations became more complex, it required more complicated equipment. Today, only highly sophisticated and specialized equipment can be used for this purpose. All these make PoS, a more practical consensus method.


PoS Main functionalities

PoS has multiple functionalities that allow it to function effectively. Some of these functionalities are as below:


Slashing

Slashing is functionality that aims to ensure that all those staking coins to keep the network do not act in a manner that may harm the network. When a validator node acts in a way that compromises the smooth running of the network, they lose 5-20% of their staked cryptos. The tokens are then redistributed to other stakeholders or banned. Some of the factors that can lead to slashing are as below:


Downtime

Downtime means that a node is not signing transactions. Depending on the rules on how much downtime can be tolerated, once a node meets this parameter, it automatically loses its validator status and the staked tokens. It can simply happen due to power outage. Thus, it’s important to backup nodes; i.e., when one is down, another one starts working immediately.


Double-signing

This entails signing one block twice. In most cases, this is usually the act of an adversary trying to attack the network. However, it can also happen with a valid node due to a poorly set infrastructure that makes the node double sign a block. To protect the network, nodes that keep double signing lose their privileges, including forfeiture of the tokens staked.


Minting

Unlike staking, where investors buy tokens then stake them to protect the network, minting takes an entirely different approach. Under this system, validators are chosen randomly by the network to verify transactions and keep the network secure. One can think of them as miners in a PoW network. For their work, the validators are rewarded with fees and new tokens. Minting tends to have better rewards than staking as one earns both the staking rewards and other incentives for keeping the network secure.


Bonding

Bonding is a proof-of-stake approach whereby network users set aside a part of their stake as a way of influencing the generation of new blocks. Such users lock a segment of their tokens for a pre-specified period, in return for a stake in the next block. When it comes to voting on the direction of the protocol, their voting power is directly proportional to the amount that they have locked up. Like other aspects of proof-of-stake, Bonded Proof-of-Stake has its drawbacks. One of them is that the user cannot spend their crypto while they are still in the bond. This can be detrimental to the investor staking their tokens if prices drop. However, there are exceptions to the rule. For instance, for someone looking to stake Algorand, they can bond their tokens, and spend them at any time they wish.


What is slashing?

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As discussed above, slashing is a PoS functionality that entails the loss of staked cryptos for nodes that do not do their part in ensuring the smooth running of the network. Due to their highly punitive nature, blockchains that use slashing to punish bad actors tend to run the majority of the time smoothly. That’s because those staking tokens have a lot to lose and as such have the motivation to act in a manner that safeguards their interests. Some of the significant PoS blockchains that use slashing as a tool to guarantee network efficiency are listed below. The list includes  projects that you can find on Atomic Wallet, those being listed there soon, and major non-listed projects that slash.

Cosmos (Supported)

Harmony (Not supported)

Icon (Coming soon)

IRIS (Not supported)

LivePeer (Not supported)

Terra (Not supported)

It is also noteworthy that the wallet is decentralized and uses cross-chain atomic swaps. As such, you can exchange these tokens for any other crypto without leaving the safety of your wallet.


Slashing Risks and How to Minimize Them

The biggest risk that comes with slashing is the loss of your staked tokens. Cryptocurrencies are investments just like any other, and when someone puts in the capital, they expect growth. The risk of losing one’s entire holding through a wrong staking move is too high. The good news is that there are multiple ways to minimize the risk of slashing, while at the same time making money through staking. For someone who is risk-averse and would want to avoid the risk of slashing altogether, the best approach would be to go for projects that do not slash at all. Some of the biggest proof-of-stake projects that do not slash are: 

Cosmos

Tron

Band

Neo

Komodo

VeChain

Tezos

Aion  (Not supported by Atomic Wallet)

Algorand

Polkadot

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Most of them are available on Atomic Wallet, and you can stake them on the wallet without having to worry about losing your staked tokens through slashing. However, if you would rather take the risk and stake a project that has slashing, there are ways to minimize the risks while also enjoying the rewards. One way to minimize risk is to look at the threshold that has to be met before slashing happens. For a lower risk level, one can go for a project that is tolerant enough to the point that the only for slashing to happen is if one is incompetent. For instance, ICON only slashes if downtime on a staking node is above 15%. That’s quite lenient considering that for a staking node to have a downtime of over 15%, it would mean that the node has serious configuration issues. That’s an issue that would be easily noticeable way before slashing happens.


To Stake Safely – Choose a Trustworthy Validator

Any digital system is vulnerable to hacking, and blockchain is no exception. In the case of staking, technical problems can lead to downtime for individual validators, which will affect the overall network performance. 

Why is it important to delegate only to a reliable validator? The first and most obvious reason is that your income will depend on it. In the event of long downtime, part of the reward will be lost not only to the validator himself but also to the stakers who delegated the coins to this baker. Another reason is the possible security threats. If the validator nodes will be caught for fraud attempts, everyone will be fined, including the delegates. And if the attack is successful, the delegates will suffer because of an insecure validator. The main idea of all this is to conduct own analysis and due diligence.

(Bohdan Opryshko, COO at Everstake).


Staking perspectives and takeaways

Staking is a great way to earn in crypto space. Regardless of the perspective that a PoS project takes, you get to make some money through fees, and other staking rewards. Besides the rewards, staking is a crucial component to the Proof-of-Stake consensus mechanism, which is the future of blockchain technology. It is energy efficient and allows for the development of highly scalable networks, good enough to handle the needs of the DeFi revolution that is just taking shape.


FAQs about Staking


What is staking?

Staking is the process of actively taking part in validating transactions in a proof-of-stake blockchain.


Is staking safe?

Staking is safe, especially when doing it from a cold storage wallet like Atomic Wallet. You get to retain full control over your private keys, and you can withdraw your tokens at any time.


Conclusion

Staking is an excellent way to make a passive income in crypto. However, one needs to be aware of the risks and how to manage them. One of the dangers that one can encounter is slashing, which entails the loss of staked tokens for not fulfilling the network validation requirements. The good news is that it is a manageable risk by choosing projects that have a high threshold on what could lead to the execution of slashing.

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