This article will give you a basic rundown of two separate concepts, staking Solana and liquidity pools. These concepts are critical to understand if you want to succeed in DEFI (decentralized finance).
Getting into Crypto and Defi can seem scary and confusing, but this article will help break down these two core concepts and give you an idea of where to start and what to trust.
To understand why one might stake their Solana, it’s essential to understand the proof of stake concept. Unlike some other cryptos that have proof of work verification methods, Solana is based on the proof of stake method.
Proof of stake is a method of blockchain verification that is faster, more secure, and less risky than proof of work, where only one minter is chosen at a time to validate the blockchain. The chosen minter must first lock up some of their coins as collateral. If validated correctly, they are rewarded; if they validate fraudulent transactions, they are punished by losing a portion of their initial collateral.
What is Staking?
Staking is the process of delegating your crypto assets to support a blockchain network and confirm transactions.
Think of staking as a long-term investment. When you invest money into a company long-term, you invest in it because you believe in the company’s future. As the company grows, you are rewarded with dividends and as the stock rises.
When you stake your Solana, think of it as you’re investing directly into the future of Solana. As the crypto rises in value, your investment appreciates, but you are also getting rewards for having your Solana staked.
How Does Staking Work?
Solana uses randomly selected nodes to validate the next block in the chain to be minted. Though these nodes are chosen randomly, the amount of Solana held by the node has a linear correlation with the likelihood of being selected to validate.
A validator node is in charge of validating all of the transactions within a given block before adding to the chain. The incentive for validators is that once the block is validated, they receive all of the transaction fees associated with that given block as a reward.
These validators rely heavily on having large amounts of Solana to increase their likelihood of being selected. The more they are selected, the more rewards they receive.
This is where you come in. You are the delegator; you choose where to delegate (AKA stake) your coins. When you trust your Solana to a validator, you receive some of their reward as an incentive. The longer you stake your Solana, the more these rewards accumulate.
Validators who structure their systems to process transactions quicker earn more rewards because they keep the network running as quickly and smoothly as possible. Because of this, validators take on the costs to run and maintain their systems. These costs are then passed down to the delegators as commission fees.
These commission fees are a small percentage taken from the rewards you get for stalking your Solana. These commission fees vary between validators. The more stake a validator has impacted, the likelihood they will be selected. Validators are always competing for the lowest commission rates to earn your business.
Is it Safe to Stake Solana?
Staking is a shared risk, shared reward structure. Built into the blockchain itself is the security system.
If a node does validate fraudulent transactions within a block, they lose a portion of their original stake. The system ensures that the total amount staked exceeds the full amount rewarded. This process is in place to discourage validators from validating fraudulent transactions because there is nothing to gain. That being said, it never hurts to do your own research into where you chose to stake.
What is a Liquidity Pool?
Decentralized financing and lending protocols rely on enough liquid funds locked in to run effectively and meet users’ exchange demands. These entities rely heavily on the need for liquidity assets. That is where liquidity pools come in.
Liquidity pools are large pools of money in the form of cryptocurrency. They are used as an exchange matrix, you give it one type of token, and you get an equal value of another token in exchange.
When a user exchanges these currencies, there is a small fee for the exchange service. This is where the money is made. The more exchanges occur, the more revenue is generated for the liquidity pool.
Because liquidity pools need large amounts of liquid assets and try to maintain an even ratio of whatever coins they are exchanging, they reward anyone willing to stake their crypto in the liquidity pool for its use.
How Do Liquidity Pools Work?
Some of the technicalities surrounding liquidity pools can get highly complex. I will explain the core concepts in fairly basic and understandable terms but know there is much more depth to explore.
One does not necessarily need deep technical knowledge to use a liquidity pool. Understanding the basics helps you navigate and make informed decisions. Here are two important concepts to understand, Smart Contracts and Automatic Market Makers.
At its simplest, a smart contract is a piece of code that follows “If this, then that.” Smart contracts have two essential characteristics: they cannot be changed and are visible to anyone. There is no backing out or disputing a smart contract, and it is all triggered thanks to the code automatically. Its goal is to be a contract without human error or disruption. This means smart contracts are highly versatile and dependable in the crypto world.
An automated market maker is an algorithm established to adjust the price of two goods based on their ratio and total supply to keep the value ratio at a perfect 50/50.
A liquidity pool is essentially a complex set of smart contracts that create a constant product automated market. It allows you to independently exchange one coin for an equal value of another coin. These pools are established by staking two equal amounts of the same coin; once set up, there is no limit to how large a pool can get or how many people can stake in a pool.
The size of the stake doesn’t matter. The only limitation is they must stake equal amounts of both coins. When you choose to stake in a liquidity pool, you receive rewards every time someone uses it. These rewards come from a small fee attached to each exchange. The size of the pool, how volatile the crypto is, and how much you staked all factors into how much of these fees you receive.
Is it Safe to Put Solana into a Liquidity Pool?
Unlike staking, when you put your crypto in a liquidity pool, if the price of that coin changes in the market, the price of your coin does not change. This is called impermanent loss. When you deposit tokens into a liquidity pool and its price changes a few days later, the amount of money lost due to that change is your impermanent loss.
It is called impermanent because it is not permanent until you remove your coin from the liquidity pool. This is the reason it matters how volatile the coin you stake is. Suppose you’re staking a highly volatile coin. In that case, the rewards tend to be higher because there is a higher likelihood of loss.
Another possible threat to your staked investment is called a rug pull. Essentially the developer of the crypto token quickly sells their large amount of tokens for profit, causing the value of everyone else’s staked investment to plummet.
Rug pulls can happen quite often and are typically seen with unaudited, sketchier coins that may not have any real purpose or value. Using a service like RadRugs can help reduce the chance of participating in a rug.