Polkadot: Parachains and opportunities for DOT tokenholders

Crypto

This year’s crypto bear market could be considered a rather mild one, given that Bitcoin has still seen a 57 percent increase year-to-date, while emerging sectors and use cases like Ethereum’s Layer 2 solutions and liquid staking options experienced significant growth. Unfortunately, this has overshadowed some important developments by other crypto projects.

Many are preparing for a new market cycle by improving their networks, collaborating with other initiatives, adding value for tokenholders and tackling issues like interoperability and scalability. Polkadot, for instance, is one such project – offering a multi-chain ecosystem, with customisable blockchains and shared security for its users.

DOT (Polkadot’s native token) tokenholders can actively engage in governance decisions, auctions (more below) and staking to help secure the Polkadot network.

So how does it work?

Founded by Ethereum co-founder Gavin Wood, Polkadot is a blockchain network that connects different blockchains together. Users can build their own custom chains or create their own decentralised applications and solutions, all operating under a broader network. This is achieved by Polkadot’s unique architecture: It’s mainchain, dubbed “The Relay Chain”, and parachains, which are essentially separate chains that run in parallel with the main network.

Parachains are designed to be highly customisable and can serve specific use cases or applications. They all connect to the Relay Chain, which handles the consensus, communication and shared security between them.

Polkadot uses a modified Proof-of-Stake system called nominated Proof-of-Stake (NPOS), where tokenholders can vote for validators and only those with enough votes can start validating transactions. This gives tokenholders the authority to select and nominate validators to represent them. Tokenholders who stake their DOT tokens collectively secure Polkadot’s Relay Chain and earn rewards, which in turn, provides security for all parachains connected to it. As of now, approximately 48 percent of Polkadot’s circulating supply is staked, amounting to roughly USD 2.64 billion in value.

Value proposition?

Polkadot offers some unique advantages for tokenholders compared to established chains like Ethereum. For instance, while Layer 2 solutions on Ethereum have reduced network congestion, they operate in isolation, meaning users are still required to pay Layer 1 transaction fees if they want to transfer assets between them. In contrast, Polkadot’s parachains can communicate directly with one another, offering no additional fees and a more user-friendly form of asset transfer.

For now, Polkadot can only support a limited number of Parachains (100), so Parachain slots are awarded through competitive “Parachain slot auctions” where projects bid and lease slots for a set period. To bid at an auction, projects agree to lock up (or bond) a portion of DOT tokens for the duration of the lease.

To boost their chance of winning a slot, projects often run crowd loan campaigns by asking the community and DOT tokenholders for contributions. The higher the bid, the higher the odds of winning.

Crowd loans also benefit tokenholders as they encourage projects to offer incentives to bond their DOT tokens. These incentives often come in the form of a project’s own tokens and distributed on a vesting schedule. Crowd loads are also highly secure, as the funds are locked on the Relay Chain, meaning founders cannot execute any exit scams with the funds. If a project secures a Parachain slot, the DOTs are bonded until the end of the lease; if the bid fails, the DOTs are returned to the contributor’s wallet.

Tokenholders have the option to earn rewards through either staking DOT tokens or participating in auctions. However, when tokens are bonded for an auction, they become temporarily unavailable for other activities like staking or participating in on-chain governance.

Ecosystem growth

Polkadot’s ecosystem has expanded into various sectors, and while this is good for diversity, the overall activity within this ecosystem has not shown a lot of activity in 2023. This may be a result of the current bear market, leading to low activity volumes on various applications and networks.

However, Polkadot’s ecosystem of 47 parachains spans into several important sectors each with their own sector-specific applications and communities. Thanks to the compatibility of networks like Kusama and the Substrate framework, various applications can also interact with Polkadot. For now, there are over 300 projects that are part of the broader Polkadot ecosystem, with the most popular sectors being DeFi, Exchanges, and NFTs.

Polkadot ecosystem by category

Source: Sygnum Bank analysis

Polkadot also revealed its much-anticipated Polkadot 2.0 upgrade, which aims to improve scalability, interoperability and network performance. ParityTech, the developer team behind Polkadot, also partnered with ZodiaCustody, a joint venture by Standard Chartered, SBI Holdings and Northern Trust, to provide institutional investors with access to DOT and liquid staking on the Polkadot Network. Stablecoin issuer Circle also launched its USDC coin on Polkadot, allowing users to mint, redeem and transfer USDC directly within the Polkadot ecosystem.

Token supply model

Polkadot has an inflationary token supply model with a 10 percent fixed annual inflation rate and no capped supply. However, adjustments to the inflation rate can be made through governance referendums. Eight percent of the newly issued DOT tokens are then distributed to validators and tokenholders as rewards for securing the network, while the remaining two percent of tokens are sent to the Polkadot Treasury.

The Polkadot Treasury serves as a financial reserve for the network. These funds are then used on activities to generate value for the ecosystem. The allocation of these funds is governed by the Polkadot Council (who approve the spend proposals), the community and DOT tokenholders. The Council can, however, be voted out by the token majority in case of any adversarial actions. Polkadot also employs a burning mechanism in the Polkadot Treasury, but this is to encourage the full usage of the Treasury itself. Treasury funds must be spent within the spend period (24 days), and if the Treasury ends without spending all its funds, 1 percent of the remaining funds is burned.

Summary

Throughout 2023, the popularity of Bitcoin and Ethereum, as well as the general bearish market sentiment has somewhat taken the spotlight away from the technological progress of crypto projects like Polkadot, which may suggest that Polkadot still has room to fully realise its growth potential.

However, Polkadot’s true test lies in its ability to efficiently connect with external blockchains beyond its own ecosystem. Initiatives like Interlay and ChainBridge are addressing this challenge, but it is still a work in progress. If Polkadot succeeds, though, its multi-chain ecosystem has the potential to see future growth, provided it maintains flexibility, successfully executes its upgrades, and sustains monthly user growth.

END

Disclaimer: This information was prepared by Sygnum Bank AG. This information may contain forward looking statements and may be subject to change. The opinions expressed herein are those of Sygnum Bank AG, its affilitates, and partners at the time of writing. This is for informational purposes only and contains general material. It does not constitute any advice or recommendation, an offer or invitation by or on behalf of Sygnum Bank AG to purchase or sell assets or securities. It is not intended to be used as a general guide to investing, and it should be used for informational purposes only. When making an investment decision, you should either conduct your own research and analysis or seek advice from an expert to make a calculated decision. The information and analysis contained here have been compiled from sources believed to be reliable. However, Sygnum Bank AG makes no representation as to its reliability or completeness and disclaims all liability for losses arising from the use of this information.

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