Cold staking is a method of securing and validating transactions on certain proof-of-stake blockchains. This method allows cryptocurrency holders to earn staking rewards without needing to actively participate in consensus or keep their funds in a hot wallet connected to the internet.
In traditional staking protocols, funds must be kept in an internet-connected wallet so the funds can actively sign and validate new blocks on the blockchain. However, this exposes users to potential attacks or theft of assets. Cold staking instead allows users to keep the majority of their holdings safely offline or in “cold” storage, while still earning staking yields through delegating consensus responsibilities.
But before diving into cold staking specifically, it helps to understand the proof-of-stake consensus mechanisms it builds on top of. Check out our article on masternodes and staking to learn more about the concept.
Introducing Proof-of-Stake
Proof-of-stake (PoS) has emerged as an alternative to proof-of-work consensus for blockchain networks. Unlike Bitcoin’s computationally intensive puzzle-solving, PoS is based on allocating influence proportional to the economic stakes held on-chain. It aims to provide security in a far more energy-efficient manner.
Network validators are therefore determined based on the number of native protocol tokens they have locked as collateral. Their chance of being selected to add the next block is directly tied to their holdings.
Hot Staking Wallets vs Cold Staking
Hot wallets refer to cryptocurrency wallets connected online to perform operations like transacting and participating in network staking. However, keeping funds hot carries security downsides:
- Vulnerability to theft via hacks/malware
- Forced slashing penalties if protocol rules violated
- Temptation to panic sell in bear markets
- Hardware failure risks with consistently online systems
Cold staking offers a solution – it allows funds to be kept offline in cold storage, while still contributing to consensus through delegated staking pools. The bulk holdings avoid online risks while staking rights are temporarily delegated to validators handling operations online.
Delegated Proof-of-Stake
Cold staking leverages delegated proof-of-stake (DPoS) architecture. In DPoS, token holders delegate consensus participation rights to validator nodes tasked with maintaining always-online infrastructure and directly handling things like:
- Block proposal duties
- Transaction ordering/confirmation
- Signature verification on blocks
Meanwhile, delegators stake tokens to various validators to passively earn a share of the staking rewards.
This separation between stake owners (delegators) and operational entities (validators) is the key to offline staking. The holders delegate consensus rights to the validators, authorizing them to actively maintain the network according to delegated stake weight, facilitating the ability to keep holdings offline.
Offline signing allows delegators to submit periodic approval votes to endorse their validator’s activity from cold storage. Here’s how it works at a protocol level:
- Hot validator initiates an approval request containing recent chain data hashes
- Request forwarded to delegator for offline signature endorsing validator in next epoch
- Signed approval returned to validator via communication relay
- Validator aggregates approvals to meet threshold stake levels
This means the private keys controlling the delegator’s funds never need to expose themselves online. The public key serves solely as an authorization token representing the delegated stake weight. Bridging the communication between the online validator and offline holder to transmit signature requests and responses is achieved through one of two main interoperability architectures:
- Cross-Chain Relays
- Off-Chain Oracles
Cross-chain relay schemes leverage secondary companion chains running parallel to the main chain to facilitate message passing to offline delegators across ledgers. Off-chain oracles operate through sets of nodes external to the main chain dynamically fed with data.
Benefits of Cold Staking
Cold staking was conceived as a solution to a common security issue for proof-of-stake investors — the need to keep cryptocurrency holdings online 24/7 for staking participation. Maintaining funds in a hot wallet carries inherent risks, including:
- Exposure to potential attacks/hacks
- Forced slashing if protocol rules are inadvertently violated
- Increased temptation for panic selling in price dips
- Security vulnerabilities on the user end with malware, crashes, etc.
With cold staking, the bulk of holdings can instead be kept offline (in “cold” storage via hardware wallet for example), while a smaller “active” wallet held online is used to actually handle staking duties.
Some key advantages this architecture provides include:
- Greatly enhanced security — main balance is air-gapped offline
- Avoidance of staking conflicts or slashing risks
- Support for virtually any storage setup, from hardware wallets to paper wallets
- Flexibility to independently manage cold and hot wallet components
- Easier exit/entry to staking participation as desired
In short, cold staking combines the security of cold storage with the earning potential of hot staking — the best of both worlds. Only a minimal viable balance needs kept online, just enough to handle staking operations. The rest of the holdings kept offline reap compounding benefits over time without ever facing internet-based risks.
Key Differences from Masternodes
Some crypto projects offer masternode architectures alongside or instead of cold staking models for securing their blockchain and providing operational utility. But masternodes have some key differences, including:
- Large upfront collateral requirements, imposing high capital lockup
- Consensus participation is more centralized among masternode operators
- Generally, masternodes must be maintained on constantly-running dedicated server instances
- Associated legal/regulatory risks and disclosure duties
Meanwhile, running a cold staking node has minimal barriers to entry and flexibly accommodates nearly any storage arrangement desired. For example, the same cold funds could be held in a rotation of hardware wallets to eliminate single points of failure risk without needing constant availability.
In return for their heightened operation demands, masternodes generally offer significantly higher percentage yields on invested collateral. But weighing total opportunity cost and risk considerations, cold staking tends to provide superior security, accessibility, and decentralization.
Best Practices for Maximizing Cold Staking Rewards
Once comfortable with the mechanisms of cold staking, investors still have multiple variables within their control that can amplify yields and returns. For instance:
Choosing Reliable Validators/Delegates
The hot wallet side of the arrangement relies heavily on validators tasked with block creation duties, so prudent selection is critical. Those with consistent infrastructure uptime and a strong history of proposal/voting alignments tend to offer better annualized returns.
Balancing Risks
While delegating to multiple validators provides risk diversification, it also spreads stakes thin and allows none to maximize importance. Similarly, excessive dividing/switching creates churn hampering yield optimization — finding an optimal balance is key.
Adjusting Collateralization
Depending on ratio thresholds coded into the underlying platform architecture, varying the percentage of overall holdings placed into cold storage versus the hot wallet can impact rewards due to weighting mechanisms.
Advancing Decentralization
Delegating to less prominent validators allows their importance and influence to grow, fueling further decentralization for the mutual benefit of the overall ecosystem. Prioritizing smaller validators boosts resilience.
Conclusion
In closing, cold staking empowers cryptocurrency owners to maximize security without sacrificing earning potential or network validation duties. This innovative approach to consensus participation has rapidly gained traction across nearly all major staking-compatible blockchains thanks to the unique advantages over hot-only staking. And continued refinement of cryptography and infrastructure is only making the mechanisms safer and more accessible over time.
By splitting holdings across cold and hot wallet environments, investors can securely compound wealth through passive crypto income while protecting the bulk of their capital from potential risks. Following sound cold storage and delegation best practices further optimizes reliable returns. For these reasons, cold staking is quickly emerging as the premier consensus architecture amongst proof-of-stake protocols.
