As blockchain technology continues to evolve, new and established coins are increasingly looking for ways to use this development to reward their current coin holders and provide incentives to new customers to adopt their coin. Proof of Stake (PoS) or ‘Staking’, has arisen as a result of the energy intensive and increasingly difficult requirements necessary to undertake Proof of Work protocols used to validate coins like Bitcoin. This is also used extensively in Decentralised Finance or DeFi.
Staking is a way of earning interest or ‘rewards’ just for holding certain types of cryptocurrency and placing them in a smart contract, like Tezos, Cosmos or even Ethereum 2.0 when it launches. Staking allows a crypto holder ‘stake’ their crypto currency into a pool of crypto and earn interest or rewards. Staking is similar to depositing currency to a bank account and accumulating interest. It is an easy way of letting your crypto work for you in order to earn more crypto.
Instead of solving complex algorithms to earn coins as you might when you mine Bitcoin, participants nominate coins they own to be used as validators to guarantee the legitimacy of new transactions on a block chain. These new transactions can then be officially added to a blockchain. Essentially, the coins you stake act to validate the legitimacy of a new block on the blockchain. In return for validating a new block, participants receive new coins. If your crypto validates a new block that is later found out to be invalid, you may lose some of the coins you staked in what is known as a slashing event. The reward and penalty process differs between blockchains.
Staking your crypto increases the blockchain’s resistance to attacks and the ability to process transactions quickly. By staking your crypto, you’re adding another layer of protection to the network.
A big downside to staking, is that your crypto is not under your control while in a staking pool. Some pools also have a vesting period where you are unable to make trades for a prescribed period of time. If you’re a regular trader or looking to make a quick profit, staking probably isn’t for you. Staking encourages token holders to hold their coins long-term and actively participate in the blockchain.
There is also a risk of a ‘rug pull’, where a smart contract has vulnerabilities and the creators of the pool or a third party removes your crypto from the smart contract. Due to the nature of blockchain, such transactions are irreversible. This one of the risks of participating in DeFi, and also why there is an increased reward and substantial returns can be generated from staking.
Staking isn’t available on all blockchains (Bitcoin doesn’t allow it) and generally requires you to possess a certain amount of coins or level of investment before you can qualify. Some exchanges, like Coinbase, will allow you to contribute an amount to a staking pool. This allows casual investors to earn without having to use their own validator hardware or have a significant asset pool. Staking pools have a lower barrier to entry and low or free membership and can be both private or open to the public.
The ATO views any token holders who receive additional coins through staking as receiving assessable ordinary income equal to the money value of the tokens they receive, at the time were derived. For example, if you received $100 AUD worth of tokens through staking, that $100 would have to be included in your tax return as assessable income. It is often much more complicated, where the value of the tokens change substantially even within a day. Specialist tax software is usually required to accurately determine the tax on staking.
Coins and tokens earnt through staking will acquire a market value cost base and attract CGT on their disposal. Working out the market value on each acquisition is complex, let alone the CGT on a disposal.
If you participate in staking, have been subject to a rug pull or are developing a new blockchain project with staking functionality, you should seek advice from our Cryptocurrency Team.