Participating in the day-to-day operations of a blockchain network may help you get a higher return on your investment, but it can be risky. Here’s what you need to know.
The trade-off between risk and reward is an essential concept in finance. When it comes to passive income, a greater potential return typically means a higher degree of danger when compared to comparable alternatives. Given this relationship, investors should not only choose which cryptocurrencies to stake based on the stated annual percentage yield (APY). A higher staking yield almost certainly implies that there are several elements contributing to a higher level of risk. Here are two main factors to consider.
1. Crypto market risk
The first and most apparent danger with cryptocurrencies, like any investment asset, is market risk. Every market is susceptible to volatility, and individual assets and securities are far more so. Expect short-term price fluctuations to vary greatly since any asset’s value is just a reflection of what investors are ready to offer or buy it for at a specific moment in time.
The cryptocurrency market, which is barely over a decade old, is highly volatile. The cryptocurrency industry has been extremely volatile since Bitcoin started the party in 2009. In 2022, for example, Ethereum’s price fell nearly 70%. Over the first half of the year, Ethereum has seen a drop of nearly 70%.
Staking is an excellent strategy to improve your investment returns, but a cryptocurrency’s price fluctuations can exceed the yield and result in a loss.
2. Liquidity and lockup period risk
The unpredictability of the cryptocurrency market adds to the second category of risk: liquidity.
A commodity is “liquid” if it may be readily purchased or sold. Cryptocurrencies are some of the most liquid assets on the market, since crypto exchanges are open 24 hours a day, seven days a week, 365 days a year. However, staking your tokens reduces liquidity somewhat.
It’s never a good idea to try to sell your cryptocurrencies all at once. Staking presents several advantages, such as tax breaks and the potential for higher returns on investment, in addition to reducing volatility. You should carefully consider whether it’s worth risking your money for any given cryptocurrency because some cryptos have lockup periods. If you want to stake Ethereum during its proof-of-stake transition, for example, you’ll need to agree to a one-year or two-year lockup period if you invest. If you need the cash within a specific period of time, avoid cryptocurrencies with a lockup period. Keep in mind that if market risk arises and the value of your holdings drops, you may be unable to sell tokens until the lockup expires.
Another thing to keep in mind is the liquidity of newer or smaller crypto projects. A new network might have a high yield to pique people’s interest, but lack of investor interest may make it hard to sell or convert your rewards into other more popular cryptocurrencies like Bitcoin or Ethereum. Before purchasing and staking a new or small cryptocurrency, look at how much trading volume it has.