Introduction - What is Polkadot?
Polkadot is a
second-generation smart contract blockchain designed to solve many of the
scaling challenges that have impeded Ethereum since its introduction in 2015.
But the main
reason so many people are so excited about Polkadot against the alternatives is
that it operates in an entirely different manner to the individual rival
blockchains on the market today.
It uses
technology called sharding to link together multiple blockchains in a single
network. These links allow those chains to process transactions in parallel, as
well as exchanging data between them, while each trades on the security
guarantee of using the underlying Polkadot network.
In the Polkadot
whitepaper[1],
Dr Wood proposes theproject as “a scalable heterogenous multichain”, which he argues
overcomes many of
theshortcomings of discrete blockchains.
Unlike previous
blockchain implementations which have focused on providing a single chain of
varying degrees of generality over potential applications, Polkadot itself is
designed to provide no inherent application functionality at all. Rather,
Polkadot provides the bedrock…upon which a large number of validatable,
globally-coherent dynamic data structures may be hosted side-by-side.
In theory,
Polkadot allows any type of data — not just tokens or coins — to be sent
between any type of blockchain, ushering in the age of cross-compatibility and
interoperability in a fragmented space.
While Ethereum
2.0 will also bring in sharding to help it scale the number of transactions
currently flowing through it, Polkadot employs the technology in a slightly
different way.
Shards on the
Polkadot network are referred to as ‘parachains’. These parachains can execute
parallel transactions for improved speed, without each chain necessarily
connecting to every other chain.
The theory — now
being put into action — is that spreading transactions across these sharded
blockchains means that the ecosystem should be able to scale faster and more
cost-effectively than its blockchain competitors.
Polkadot vs Ethereum
It is impossible
not to compare Polkadot to Ethereum: Polkadot explicitly make the comparison
with Ethereum 2.0[2] and
this should come
as no surprise to avid market
watchers.
In the early
days of cryptocurrency, Ethereum attracted the best minds in distributed
computing and cryptography. Its original six-man founding team have created
some of the most influential and highly capitalised blockchain projects to
date.
Alongside
Vitalik Buterin, the de-facto figurehead for the ~$470bn market cap blockchain[3], this group includes:
●Charles Hoskinson,the founder of Cardano, currently the world’s sixth-largest
crypto project witha market valuation of $43bn[4];
●
Consensys founder
Joseph Lubin, whose enterprise blockchain software business created the
Metamask wallet and is valued at $3.2bn[5]; and
●
Polkadot founder, the
English computer scientist Dr Gavin Wood.
One of Dr Wood’s
most lauded creations[6]
is Solidity, the
programming language used for
writing smart contracts on Ethereum, Tron and Avalanche.
It is this technical prowess — and the status with which
he is revered in the crypto community — that has given Polkadot a huge
headstart. In the 18 months since its genesis block was launched, Polkadot has
already amassed a market cap of $27bn[7].
Despite this
relatively short incubation period,
there is clear appetite for a ‘blockchain of blockchains’, and Polkadot seems
to fit the bill.
The Polkadot ecosystem is, by any metric, awash with crypto cash. Wood
tweeted[8] on 17
October that
the blockchain’s treasury stood
at over $500m “ready to spend on your ideas for building, improving,educating and indeed
anything else that
the Polkadot governance believesvaluable”.
The project is
overseen and developed by the Swiss non-profit Web3 Foundation[9], which like many other blockchain
foundations provides grants[10] to
development teams
helping to build out its
ecosystem of decentralised apps, blockchain explorers, wallets, NFT marketplaces
and other tools.
The Polkadot Ecosystem
The RelayChain is the underlying
protocol that provides security for multiple sharded blockchains running in
parallel. Transactions from the parachains are confirmed on the Relay Chain
using a system of validators.
Parachains are individually-designed blockchains
that can be built to run according to their own specific rules and regulations.
Each has smart contract functionality and can mint their own tokens, rather
than relying on the underlying blockchain’s native currency as a means of
exchange. They can be public and open for anyone to access (like Tezos, Bitcoin
or Ethereum), or private, where a single organisation has control, for example
Hyperledger Fabric or R3’s Corda. As such, each can perform a variety of
functions, and can be designed for high transaction throughput use cases like
DeFi, NFTs or gaming, or more industrial verticals like central bank digital
currencies, supply chains or healthcare. Polkadot allows parachains to
communicate with one another if they wish, allowing cross-chain data and token
exchanges.
Parathreads are one step down in functionality from
parachains: these are effectively ‘pay as you go’ blockchains that still trade
on the security of the Relay Chain but don’t need to have a constant connection
with it.
The difference
between parachains and parathreads is largely economic; the latter avoids the
auction method of selection (see below) and instead comes with a fixed fee for
registration which Polkadot says[11] will
“realistically be
muchlowerthan the cost of acquiring a parachain slot”. Parathreads are not currently
live on the network. The only estimate from Polkadot is that it expects them to
launch “some months” after parachains, and that this extra functionality
will need to be enabled through an on-chain governance vote.
Bridges allow chains running on Polkadot to be
interoperable with external public blockchains like Bitcoin and Ethereum.
Polkadot
currently supports 100 parachains and early roadmaps suggest that it could
accommodate many thousands of parathreads in future[12]. While block times on
parathreads
will
likely be slower, both can still connect individually to the Relay Chain,
giving developers of these linked projects the flexibility to determine their
own rules on how they operate.
The network’s
native token is DOT. It is used as a stake in parachain auctions as well as for
making governance decisions on upgrades to the network.
According to
Gavin Wood[13], internal
benchmarking in August 2020 proved
Polkadot capable of processing 1,000 transactions per second, with the lofty
projection of as many as 1 million transactions per second once parachains are
enacted.
Auctioning off
To become one of
these highly-coveted parachains, blockchain projects must undergo an auction
process[14]
to win the right to
take up space and the
presumably cost-intensive nature of relying on the Polkadot’s Relay Chain
security. The project with the highest crowdloaned amount wins.
This crowdloan
system, where parties lock up a minimum of 5 DOT for two years while a project
runs as a parachain, does two interesting things. Firstly, it proves out the
economic value of a project before release, drawing in much more capital to a
project before it goes live than might be realised otherwise. This is
evident in the cap table of investors for some of the winners, which includes
crypto VC royalty like Sequoia Capital, Coinbase Ventures, Pantera and
Polychain Capital. Secondly, it gives developers the chance to showcase their
product long before launch, building out a large community of stakeholders
beyond the initial team.
DeFi and
stablecoin platform Acala was the first winner of a parachain auction, with
$1.3bn in DOT raised from over 81,000 wallets[15].
On 25 November,
the Ethereum-compatible smart contract project Moonbeam won[16] the second Polkadot auction,
with
more
than $1.4bn in DOT pledged. On 3 December, Japan’s dapp-focused Astar Network
took the top spot[17]
with 10.3m DOTpledged by
27,100 investors. ParallelFinance took the fourth parachain auction slot with 10.75m DOT
pledged[18]. At time of writing,
Clover
Finance and
EFinity are leading the race for the fifth and final auction slot in this
batch, with around 7.4 million DOT pledged to each project apiece[19].
Polkadot leases
out its parachain slots for 96 weeks (two years) at a time, with an option to
renew. The first batch of auction-winning projects, Acala, Moonbeam, Astar
Network, Parallel Finance and the final winner will operate on the network
until October 2023[20],
with their launch
date scheduled for 18 December
2021.
Nominated Proof of Stake
Polkadot uses a
Nominated Proof of Stake (NPos) consensus mechanism. The blockchain was
initially launched using an entirely centralised Proof of Authority setup,
where six validators run by the Web3 Foundation maintained the chain to ensure
its smooth running, and acted to attract a diverse subset of new validators.
Polkadot switched over to NPos as part of its latest update. This system allows
DOT holders to stake their token and help to secure the network, either by
running nodes as a validator and confirming transactions, as well as adding
blocks to the Relay Chain. Alternatively, for those holding fewer DOT, there is
the possibility to allocate their tokens to nominate up to 16 elected
validators. Staking rewards for this option are currently in the region of 6.5%
APY[21].
The minimum
number of DOT to be allowed to stake is not fixed, as it is with Ethereum (stakers
must have 32 ETH to make a deposit into the ETH2 smart contract[22]). Instead the figure is
flexible,
and
since inception has varied from 40 DOT as high as 350 DOT. As of 24 November
2021[23], the
minimum is 120
DOT (~$3,175), although
Polkadot says this is subject to change.
Both validators
and nominators are rewarded with DOT for helping to process transactions and
secure the network. The way the Polkadot network encourages good behaviour is
to punish both validators and nominators if a validator attacks the network,
attempts to run modified software or goes offline along with at least 10% of
other validators (which could be construed as a malicious attack)[24]. This is called ‘slashing’, and
means a
percentage of staked tokens are taken from validators — and the nominators that
elected them — and returned to the Polkadot treasury. It’s a sensible slice of
game theory which means that nominators will likely seek out validators with
the best reputation before staking tokens to nominate them.
Governance
Polkadot’s
governance model is on-chain and enacted autonomously, allowing the blockchain
to evolve without the need for contentious and lengthy battles between opposing
sides. As such, it is possible to upgrade the blockchain more seamlessly that
would otherwise be possible.
Changes to the
system are proposed and voted upon on-chain.
By contrast,
Ethereum governance occurs off-chain[25] through
numerous discussion
channels.
The Ethereum Foundation itself admits that:
Since so many people depend on
Ethereum'sstability,there is a very high coordination threshold for core changes, including
socialand
technical processes, to ensure any changes to Ethereum are secure andwidely supported by the
community.
The downside of such a method (compared to on-chain
governance) is that it can take much longer to agree on protocol upgrades. With
the speed of change in blockchain development lightning fast, delays of weeks
or months can be critical.
DOT
holders can submit proposals and/or vote on existing upgrades, or nominate
themselves to an on-chain Council, which represents more passive DOT holders in
much the same way as current political structures in democratic countries.
Valuation
Social signals
can give us a decent rough estimate of the retail popularity of any given
blockchain. For example, the size of the discussion group dedicated to a
particular crypto on Reddit. At 69,000 members[26],
r/Polkadot is not in the same
league as
longer-standing protocols like Bitcoin Cash’s (604,000 members in the
subreddit), but is comparable with the likes of Solana and Chainlink.
In terms of
institutional investment products, those dedicated to Polkadot remain limited
as of midway-through Q4 2021, but more are starting to appear.
Osprey Funds was
first to market with a Polkadot Trust in April 2021[27], albeit with a rather bold 2.5%
management fee. Valour then followed 21Shares to market with a Polkadot ETP in
spring of 2021[28]. And
while the
world’s largest digital asset
manager, Grayscale, filed with the SEC to open a Polkadot Trust[29] in January 2021, at time of
writing the
product had not yet made it to market.
Capital-rich
investors a little further ahead on the maturity curve are piling into DOT,
however.
Messari’s Q3
2021 analysis of crypto hedge funds[30] found Polkadot
the lead
investment by
quite some considerable margin.
As we head into
2022, it has become evident that the market is evolving from one where both
value and development is highly concentrated among a small number of players,
into a multi-chain world. While Ethereum was once the single blockchain that
underpinned decentralised finance markets, competitors are rising quickly to
snap at its heels.
And while
Ethereum still retains near-total dominance of the NFT market as the basis for
49 of the top 50 markets by daily trading volume[31], long-standing
issues
around its
scalability, very high transaction fees and slow confirmations has led to
alternatives grabbing market share. While some of these are Layer 2 additions
to Ethereum itself, like Arbitrum and Polygon, other chains are creeping into
the mix.
For example, the
top 10 DeFi protocols by Total Value Locked now looks very different to just
six months ago.
Source: DeFiLlama.com[32]
| Data
correct as of 9 December 2021
All of this has
happened remarkably quickly, as it tends to do in the fast-paced blockchain
space. Polkadot pitches itself as a solution to this fragmentation: with the
overarching aim from the Web3 Foundation of creating a decentralised web as the
next stage of evolution of the internet itself.
In the interim,
the addition of crowdloan-funded projects into an auction setup is innovative,
and has attracted the attention of not just crypto VC funders, but large communities
of users too.
While some have
suggested Polkadot enacts zero transaction fees, this is a little bit of a
misnomer: there are transaction fees but they remain reasonably low. One
estimate puts a simple balance transfer at around 0.015 DOT or $0.40.
Transactions
that take place on parachains don’t incur Relay Chain fees in DOT (because each
project may have its own token, or be tokenless). Projects may set their own
transaction fees — as parachain auction winner Acala has done[33].
What is true is
that unlike Ethereum, where gas prices need to be competitive to compensate
miners for including transactions in a block, Polkadot already gives newly
minted DOT to its validators and nominators, and these actors aren’t strictly
competing against one another on price. Transactions fees can be calculated
with reasonable certainty in advance, which is a major boon for businesses
trying to profit from large and growing DeFi markets.
In terms of valuation, it is still relatively early in
the story of Polkadot. As the chart below displays, the multichain bridge has a
long way to go to catch up with the kinds of dollar values being transacted
through rival networks. The original cryptocurrency, Bitcoin, leads in terms of
total transaction value, but the growth momentum has shifted to the kinds of
smart contract blockchains that can more easily allow decentralised apps to be
built and run on top of them, such as Ethereum (ETH) and Cardano (ADA).
Since the 26 May 2020 network launch, active accounts
have been growing steadily, but we have not yet seen the kind of parabolic
movement one might hope for from a network that is up and running at scale.
Venture capital and hedge funds are investing heavily in
both Polkadot itself, and as has been made obvious by the likes of parachain
auction winners Moonbeam and Acala, projects that will compete directly with
Ethereum-based DeFi and decentralised apps.
Conclusion
Polkadot is not
the first Proof of Stake blockchain. In the last four years, Proof of Stake
chains have taken over the charts and their representation in the top 20 coins
by market cap has tripled[34]. What
Polkadot does
promise is a way to usher in
the age of cross-compatibility: and that is a sell that VCs, hedge funds and
the wider crypto community are getting behind in their droves.
Given the rapid
growth of DeFi and NFT protocols in the last two years, investors are already
living in a multichain world, whether they realise it or not. Ethereum is not
the monolith that it once was, and the rise of clear competitors like Solana,
Avalanche and now Polkadot is testament to this point.
When the Polkadot genesis block was launched on 26 May
2020, it did so to considerable fanfare, led by a charismatic Ethereum
co-founder using all the tools at his disposal to make decentralised apps blockchain-agnostic.
DeFi is a massive growth market and is likely to continue
the trend into 2022. Polkadot has moved out of the theoretical phase and into
reality, and we have seen precisely how successful it has been in the early
crowdloan phase, with individual parachain auction projects raising billions of
dollars-worth of DOT for this prestigious position.
A lot of
Polkadot’s popularity is based on promise. And while even six months ago, there
were few live projects to point to, that state is changing.
There are only a handful of people in the world that can
build a successful blockchain network based on cutting-edge cryptography and
make it a success. Polkadot hinges on Gavin Wood and the kinds of teams
Polkadot is able to attract to its stable.
The community reaction to crowdfunding auctions has been
impressive to date, with hundreds of thousands of individuals and businesses
lending their support
At the same time, the number of blockchain projects
identifying themselves as a technological improvement on Ethereum has grown
sharply. That’s mainly due to the strength of the incumbent smart contract
blockchain, its dominance over DeFi and NFT markets, and the growth of its
market cap above $400bn, while at the same time users and developers identify and
encounter clear UI, UX and cost issues that have been ongoing since at least
2018.
There are clear long-standing problems with Ethereum.
Severe network congestion, unworkably high transaction fees, and off-chain
governance, which slows development to a crawl. Hence the rise of the
‘Ethereum-killer’ blockchain. A bet on Polkadot is a bet on a multichain smart
contract future, which has become not just a compelling argument, but the
dominant narrative facing crypto as a whole.
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