Polkadot: From Layer 0 to Hero (Cryptocurrency: DOT-USD)
This article originally appeared in Try Technically Crypto.
Polkadot (DOT-USD) is one of the most exciting projects in the blockchain space right now. This “blockchain of blockchains” promises to create a secure and scalable ecosystem where multiple “parachains” can interact with each other via a “central relay chain”.
The beauty of this approach is that one can create a highly specialized blockchain for particular use cases, but allow those use cases to be part of an environment where they can easily interact with each other, and all benefit from a common security protocol.
Polkadot was founded in 2017 by Ethereum co-founder and CTO Gavin Wood. Polkadot has yet to be fully released and currently only has a handful of projects on its blockchain, but many more are testing Polkadot through its blockchain cousin, Kusama.
The first thing we need to understand about Polkadot is how this multi-chain ecosystem works.
At the center of the system we have the relay chain, which is responsible for the security and connection of the parachains. Parachains can be launched by anyone who rents a “slot” on the Polkadot ecosystem. Each parachain is like a “fragment” of the original chain. Finally, we have bridges, which connect all the parachains.
In terms of operation and consensus mechanism, Polkadot uses a designated proof-of-stake. In this particular case, there are 4 different entities involved in the consensus mechanism. Validators, Nominators, Assemblers and Fishers.
The table above explains the process quite well. First, we have validators, which validate blocks through the usual PoS system. However, we also have nominators, who can donate their capital, in this case DOT, to what they consider to be trustworthy validators. Nominators, like validators, stake the DOT. Assemblers act as miners/validators for parachains. They submit parachain blocks to validators and receive rewards in the form of transaction fees. Finally U.S have anglers, who are independent “bounty hunters” who are rewarded for reporting bad behavior. Assemblers and all full parachain nodes can play the fisherman role.
The goal of this system is to combine the security of a large and robust blockchain backed by many validators and a large amount of staked DOTs, but also to give parachains the flexibility to operate independently, thereby reducing costs and other inefficiencies.
The main advantages of Polkadot are indeed security and scalability. Consensus mechanisms work best with a large number of validators and a high-value underlying coin. Everyone knows that altcoins with small market caps and fewer miners/validators are much more susceptible to attack. In the end, a system with thousands of different blockchains will not be feasible. Polkadot solves this problem with shared security.
When a parachain connects to Polkadot, the relay chain’s validator is set to become the securer of that parachain’s state transitions. The parachain will only have the overhead of having to run a few assembly nodes to keep validators informed of the latest state transitions and proofs/witnesses. Validators will then check them for the parachains they are assigned to. This way, new parachains instantly benefit from Polkadot’s global security even if they’ve just been launched.
Source: Polkadot Wiki
The level of security will not be affected by adding additional parachains to the network. The important variable here is the number of DOTs staked by honest validators.
Polkadot’s parachains also solve scalability issues by allowing transactions to run on separate parachains. Polkadot can do 1000 tps already and aims to be able to do 1 million tps in the future.
There are three uses for Polkadot’s native currency, DOT: Governance, Staking and Bonding.
Everything in Polkadot is decided on-chain, and owning DOT gives you the right to vote. Staking is essential to keep the network safe and running smoothly, and it offers monetary rewards. Finally, DOTs are needed for bonding.
Bonding is the process by which parachains become part of the Polkadot ecosystem. To use Polkadot, projects must bid, DOT, for a parachain spot in an auction. The winner of the auction has their DOT “stuck” for the duration of the lease. The bound DOT cannot be used for anything else at this point. DOTs are released after the lease, so the only real cost involved here is the opportunity cost. In addition, there is an element of crowdfunding in this process. Point holders can lend their currency to different projects, in exchange for anything, although most likely an amount of the project’s native token.
For now, Polkadot plans to have 100 parachains, although hypothetically the amount could be unlimited.
DOT is also used to pay fees on the relay chain. There are no DOT fees in the separate parachains, but to connect to the Polkadot relay chain parachains, you have to pay a DOT fee. Charges are calculated based on “weight”, “length” and an optional “tip”. Fees on Polkadot are subject to change as frequently as every 24 hours, as fees are adjusted based on the fill level of the previous block.
Finally, let’s talk about inflation. DOT does not have a theoretical supply limit at this time, and inflation could vary depending on the amount of DOT wagered. On the other hand, DOT is taken out of circulation through bonds and fees. Polkadot’s inflation rate is designed to stabilize around 10%.
TAM with polka dots
As mentioned in the whitepaper, Polkadot is not intended to be a currency per se, so we shouldn’t think of it that way. On the contrary, DOTs represent the property of the Polkadot network and should reflect the value it holds.
After all, Polkadot is the vehicle through which investors can access new projects, crowdfunding them. It therefore stands to reason that the value of DOT will increase with the market capitalization and the locked value of the projects it holds within it.
There are currently thirteen active projects on Polkadot:
Acala, Moonbeam, Clover, Astar and Parallel are among the oldest. We also have Statemint, but it is a “generic asset parachain” that has been proposed to act as a “common good” for other parachains.
Polkadot is currently the 11th largest channel by locked value, with a TVL of $2.4 billion. Interestingly, Polkadot has one of the highest market cap to TVL ratios. It’s a bit like saying that Polkadot has a high P/E. On the one hand, you could say that Polkadot is expensive, but it’s also proof that investors believe there is embedded potential and are willing to pay that premium.
That said, what could be a potential TVL for Polkadot in 5 years? A simplistic analysis would be that with 100 parachains, it could be at least 7 times more valuable. Probably a lot more, since these projects are relatively new. The value of DeFi has grown rapidly over the past few years, and currently $280 billion is locked in the space. DeFi could easily more than double over the next 4 years.
And Polkadot is not limited to DeFi, it is versatile and could easily find a niche in the NFT market. Efinity is an example of a project on Polkadot that would enable NFT interoperability.
However, the price could be even higher, as it does not necessarily follow the fundamentals. Months ago, during the bull market, DOT had fewer parachains and less TVL and yet its token was trading at much higher prices.
Is it a good time to buy Polkadot?
Polkadot is down over 50% from its ATH, and I expect that level to be broken, so I would recommend buying now.
From a fundamental perspective, Polkadot has a technology and a system that solves the blockchain trilemma. Security, scalability and decentralization cannot perfectly coexist. More centralized blockchains like Solana (SOL-USD) can be more scalable and fast, but also give up security in the process.
Polkadot, however, scores well on all of these. The network is highly decentralized, with all governance done on-chain. The relay chain provides security for all other blockchains, but high levels of tps can also be achieved through the operation of parachains.
Polkadot has the ability to rival Ethereum (ETH-USD), making it a crypto investment. DOT also offers owners great staking rewards, and even the opportunity to participate in parachain crowdfunding, which is also something to consider.
Finally, it should be mentioned that I think we are in a bull market for the altcoin, and this should also really help the price of DOT to appreciate.
That said, Polkadot is an ambitious project, aiming to compete with Ethereum, and that’s a tall order. Polkadot’s cross-chain connectivity appeal works best if many projects are built on Polkadot, but so far there are a limited number. It is still early.
Meanwhile, Ethereum is a well-established blockchain, and it is taking steps in the right direction to become a more scalable and efficient blockchain. Moreover, there are also many layer 2 solutions that enhance the appeal of Ethereum, such as Polygon (MATIC-USD).
Additionally, Polkadot depends on a few projects, some of which haven’t been doing so well over the past few months. Stafi, a DeFi protocol on Polkadot, lost 78% of its TVL from February to March.
Ultimately, given the nature of how Polkadot does things, which involves auctioning off limited time slots, growth could be much slower than in the “wild west” of the Ethereum blockchain.
Overall, Polkadot offers a smart and comprehensive solution to the crypto trilemma. Polkadot has one of, if not the best balance of security, scalability, and decentralization of any coin I’ve reviewed, making it a solid buy.