Polkadot: Networking For Blockchains

Summary

• The Polkadot blockchain aims to provide interoperability and security to other blockchains, helping to solve issues like scalability.
• In a multi-blockchain world, interoperability could be a potentially valuable function. If a small number of blockchains becomes dominant this value proposition will be significantly weakened though.
• Polkadot is currently the leading interoperability blockchain, but its value is uncertain and dependent on how the blockchain ecosystem evolves in the future.

Polkadot (DOT-USD) is a third generation blockchain which aims to provide security and interoperability to other blockchains. If the smart contract market is fragmented across a number of blockchains, which are focused on specific use cases, Polkadot could become an integral part of the blockchain economy. I believe DOT offers significant upside from current prices, but is a risky investment due to the early stage of the project and the uncertain demand for Polkadot's functionality.

First generation - payments

Second generation - smart contracts

Third generation - scalability and interoperability

Figure 1: Blockchain Technology Generations

(Source: Created by author using data from coingecko)

Interoperability

Potential blockchain applications include the Internet of Things (IoT), finance, governance, identity management, web decentralization and asset-tracking, but adoption is currently low and one of the main reasons is that there are still fatal flaws with existing blockchains. They suffer from a lack of extensibility, scalability and interoperability and there is a need for open and closed networks to have trust-free access to each other.

While there are a number of proposed solutions to these issues, including second layer solutions and network upgrades, interoperability blockchains are one promising solution. Interoperability becomes necessary if there is not one dominant blockchain and a proliferation of successful blockchains will increase the need for cross-communication over time.

The main problems addressed by interoperability blockchains include:

• Scalability - Most blockchains still struggle to process a reasonable number of transactions without utilizing excessive resources (processing, bandwidth and storage).
• Isolatability - Different parties and applications can have divergent needs that must be addressed under the same framework.
• Security - It can be financially feasible although not necessarily profitable to launch an attack on smaller blockchains due to a lack of resources securing the blockchain. An interoperability blockchain can provide security to smaller blockchains, lowering the barriers to entry to creating a secure public blockchain.

Interoperability can provide functionality like:

• Transfer of assets from one chain to another.
• Locking of assets on chain A based on an event on chain B. This could be used to create financial products like derivatives.
• Either two transfers happen or no transfer happens (atomic swap). This could be used as a replacement for escrow.
• Cross-chain payments like the payment of a dividend to Chain A based on ownership of an asset held on chain B.

Existing approaches to interoperability can be broke into:

• Systems which drop or reduce the notion of a globally coherent state machine.
• Systems which attempt to provide a globally coherent singleton machine through homogeneous shards.
• Systems which target only heterogeneity.

Polkadot

Polkadot is a blockchain protocol that unites a network of heterogeneous blockchains, allowing them to operate together at scale. Polkadot aims to address interoperability, scalability, speed, security, privacy, developability and governance, but is probably most focused on providing the core requirements for the settlement layer of a blockchain stack (security, scalability and decentralization). Polkadot's goal is to become comparable to how TCP/IP is the communication layer of the internet.

Polkadot enables use cases like:

• Development of a State Machine (smart contract, payment, supply chain, etc.) without worrying about the consensus mechanism and economic model
• Atomic swaps of tokens/coins across blockchains (public and private)
• Decentralized exchanges without any central infrastructure attached
• Calling smart contracts from other blockchains
• Communication with IoT devices from any blockchain

The project is led by Gavin Wood, one of the founders and main developers of Ethereum, giving the project credibility from its inception. The Polkadot blockchain has been under development for a number of years and its mainnet was launched in 2020. As part of the development process an unaudited and unrefined release of Polkadot called Kusama was created to test the network's technology and economic incentives in a real-world environment. The Kusama blockchain can also be used by developers to test ideas.

Polkadot unites a network of heterogeneous blockchain shards, called parachains. These chains connect to and are secured by the Polkadot relay chain. This allows blockchains to pool their security together so that the individual chains can leverage the collective security without having to scale to build security. Shards can also connect with external networks via bridges. Using multiple interconnected chains helps to spread transactions across more nodes, which should decrease the cost of executing smart contracts and improve scaling and decentralization.

Gavin Wood has claimed that Polkadot is capable of up to 1 million transactions per second. The functionality of the Polkadot blockchain has been kept to a minimum, primarily providing security and interoperability. Instead of smart contracts, other blockchains (parachains) run on the Polkadot platform. Polkadot's cross-chain composability and message passing allows any type of data to be sent between shards, opening the door for a wave of innovation.

The project's roadmap involves phased upgrades to a fully decentralized infrastructure with all planned governance in place. The first phase is proof-of-authority, which involves assembling validators for the network. The project recently launched its second phase, which is known as nominated proof-of-stake. This refers to an initial go-live of the network's consensus model. Assuming all goes well, the next step will involve implementation of the network's governance model.

Relay Chain

The Polkadot relay chain is responsible for network security, consensus and cross-chain interoperability. The relay chain is similar to a blockchain like Ethereum in that it is state-based with states mapping addresses to account information such as balance and number of transactions. Messages do not pass through the relay chain, only proofs of post and channel operations (open, close, etc.) go into the relay chain. This enhances scalability by keeping data on the edges of the system.

Polkadot has implemented flat transaction fees, regardless of the number of transactions, to help avoid scaling issues although this increases the possibility of spamming and it is not yet clear how this problem will be resolved.

Parachains

Parachains are sovereign blockchains (like heterogeneous shards), which can have their own tokens and optimize functionality for specific use cases. Early blockchains had limited throughput and lacked runtime specialization making them impractical to scale for many real-world use cases. Sharding allows transactions to be processed in parallel, increasing throughput. In addition, nested relay chains can increase the number of shards that can be added to the network. To connect to the relay chain, parachains can pay as they go or lease a slot for continuous connectivity.

Bridges

In order to interact with chains that want to use their own finalization process (e.g. Bitcoin), Polkadot has bridge parachains that offer two-way compatibility. Bridges are special blockchains that allow Polkadot to connect to and communicate with blockchains with smart contract capabilities without affecting their native protocol.

Figure 2: Polkadot Blockchain

(Source: Polkadot)

Scaling can be provided by second-order relay chains as well as sharded parachains. Polkadot's structure almost has a fractal quality to it, which helps provide scalability.

Figure 3: Polkadot Architecture

(Source: Created by author)

Network Participants

The Polkadot consensus roles are validators, collators, nominators and fisherman.

Validators - Validators finalize new blocks on the relay chain and secure the relay chain by staking DOT and validating proofs from collators.

Collators - Maintain parachains by collecting parachain transactions from users and producing proofs for validators. Collators maintain a full node at their respective parachain and perform a similar function to miners in current PoW blockchains. Collators are full nodes of parachains and the relay chain and as such are a key component of message passing.

Nominators - Secure the relay chain by selecting trustworthy validators and staking DOT. Nominators receive a pro-rata reward or penalty depending on whether the validator nominated by them performs the desired function.

Fisherman - Monitor the network and report bad behavior to validators. Collators and any parachain full node can perform the fisherman role. Fisherman are incentivized to identify and prove malicious behavior among bonded network participants.

Figure 4: Polkadot Network Participants

(Source: Polkadot)

Polkadot achieves consensus through an asynchronous Byzantine Fault Tolerant (BFT) algorithm. Polkadot utilizes the GRANDPA finality gadget to give stronger and quicker guarantees on the finality of blocks (cannot be reverted after agreement has taken place). Polkadot also utilizes a hybrid consensus mechanism where the finality gadget is separate from the block production mechanism. This allows block production to happen independent of the slower finality process.

Modern blockchain implementations like the Parity Ethereum client can process in excess of 3,000 transactions per second when running on performant consumer hardware. Despite this, current real-world blockchain networks are practically limited to around 30 transactions per second, a level far too low for widespread adoption. This limitation is primarily due to the current synchronous consensus mechanisms requiring wide timing margins of safety on the expected processing time, which is exacerbated by the desire to support slower implementations. By decoupling the consensus process from the state-transition mechanism scalability can be dramatically improved.

DOT is the native token of Polkadot. There is a circulating supply of 960 million DOT and a max supply of 1.04 billion DOT. The DOT token serves three distinct purposes: governance, staking and bonding. Polkadot utilizes on-chain governance with voting rights based on the amount of DOT held. New parachains are added by bonding tokens and outdated or non-useful parachains are removed by removing bonded tokens. Polkadot offers staking for DOT with a current yield of 12%.

Polkadot has been designed with upgradability in mind, which should help to avoid the difficult and contentious upgrades other blockchains have faced. This is achieved through a forkless upgrade process using a transparent on-chain governance system. All DOT holders are able to propose a change to the protocol or vote on existing proposals and they can elect council members who represent passive stakeholders.

Polkadot governance roles include council members and a technical committee. Council members are elected to represent passive stakeholders in two primary governance roles: proposing referenda and vetoing dangerous or malicious referenda. The technical committee is composed of teams actively building Polkadot. They can propose emergency referenda, together with the council, for fast-tracked voting and implementation.

One problem with current blockchains is that all data that transacts across the network is public, limiting adoption by organizations that need to keep certain information private. An issue that could become more prevalent as regulations like GDPR continue to be introduced. The private transaction technology that Parity developed for Ethereum can also be implemented on Polkadot for parachains, making running a permissioned chain on top of Polkadot relatively easy. This allows for the private transfer of data without losing the benefits of interoperability.

For application platforms, developability is one of the most important features to attract developers and Polkadot provides this with the Substrate framework. The Substrate framework provides consensus, networking and webassembly runtime. Substrate is like a web application framework, but for building distributed or decentralized systems such as cryptocurrencies. Polkadot was built with Substrate and projects built with Substrate are able to run natively on Polkadot.

Competitors

There are 3 broad categories of competing interoperability blockchains:

• Generic communication protocols aimed at developers - Cosmos and Polkadot
• DeFi products aimed at displacing fiat exchanges and banks - ICON and Wanchain
• TCP/IP for blockchain generic bridging protocol - Aion

Cosmos

Cosmos aims to become an internet of blockchains, providing interoperability and scalability to other blockchains. Polkadot and Cosmos are both protocols that provide an interface for different state machines to communicate with each other. There are fundamental differences in how Cosmos and Polkadot achieve this though.

Figure 5: Cosmos Provides Interoperability Between Blockchains

(Source: Created by author)

Cosmos utilizes a bridge-hub model where bridges connect Tendermint chains to a hub. The system can have multiple hubs, the primary one being the Cosmos Hub. The Hub maintains a multi-token ledger of token balances (non-transfer messages are relayed but their state is not stored in the Hub). Each hub is connected to a group of exterior chains called zones.

Each zone must maintain its own state and is responsible for securing the chain with a sufficiently staked and decentralized validator set. As zones do not share state, a re-organization of one zone does not impact other zones, meaning the recipient of each message must trust the security of the sender. This appears to be a significant weakness of Cosmos relative to Polkadot as it does not provide pooled security benefits. Cosmos does plan to provide pooled security in future upgrades though. Zones send messages and tokens to each other via the hub using a protocol called Inter-Blockchain Communication (IBC).

Figure 6: Example Cosmos Ecosystem

(Source: blockgeeks)

Cosmos uses the Byzantine fault tolerant Tendermint algorithm for consensus with PoS as its validator set selection method. Tendermint is implemented via Tendermint Core, which is an application-agnostic consensus engine. Tendermint can handle 10,000 transactions per second for 250 byte transactions. Tendermint has fork-accountability which stops attacks such as long-range-nothing-at-stake double spends and censorship.

ATOM is the native token of the Cosmos blockchain and is used for staking, but is not really used for transactions. In Cosmos, if a staker does not vote in a governance referendum, the validators assume their voting power. Because of this, many validators in Cosmos have zero commission in order to acquire more control over the protocol. In Polkadot, governance and staking are completely disjoint; nominating a validator does not assign any governance voting rights to the validator. Cosmos uses on-chain governance and the actual enactment of governance decisions is carried out via a protocol fork, much like other blockchains.

Polkadot offers advantages across security, governance, upgradability and developer tools which I believe makes it a clearly superior interoperability blockchain to Cosmos, a fact that is reflected in Polkadot's significantly larger market capitalization. This does not imply that Cosmos cannot be successful in its own right though and ATOM may be a relatively attractive investment at this point.

Avalanche

Avalanche is an open-source platform for launching highly decentralized applications and interoperable blockchains. Avalanche is focused on financial applications and aims to build the internet of finance. Ava Labs is developing Avalanche and has backing from credible investors like Andreesen Horowitz. Avalanche claims to be capable of handling 4,500 transactions per second with sub-second transaction times and low fees. While the project touts high scalability Avalanche recently had a bug where the network became congested as transaction volume scaled.

Avalanche consists of subnets (blockchains) that form an interoperable network. There is no limit to the number of Subnets Avalanche can have and the goal is to eventually have thousands of interoperable subnets. Similar to Polkadot, Avalanche allows developers to create their own application specific blockchain. Avalanche utilizes the Avalanche Consensus protocol and PoS. In the Avalanche Consensus protocol each node randomly samples other nodes and then updates based on the results. This allows rapid consensus with lower communication overhead.

Avalanche, Cosmos and Polkadot all have quite similar aims, but differ in implementation. There are strengths and weaknesses to each approach and at this stage it is not clear which platform will gain the most widespread adoption. From a technology perspective Avalanche appears to be the strongest competitor to Polkadot but it is a more recent project that Polkadot or Cosmos and as a result currently has less developer activity.

Cardano

Cardano is a smart contract platform that is currently under development and which includes interoperability upgrades in its roadmap. The Basho era of Cardano aims to improve the scalability and interoperability of the network, although it is unclear when this update will occur. Cardano will also provide interoperability with permissioned systems.

Cardano's primary focus is providing a platform for smart contracts, not interoperability. While it plans to provide for communication with other blockchains and legacy systems it is probably not realistic to expect it to do this as well as a purpose built blockchain like Polkadot. In addition, Polkadot provides other advantages like a developer toolkit for building blockchains and pooled security.

AION

Aion is a blockchain platform created to provide interoperability while remaining capable of handling its own applications. Aion supports custom blockchain architectures and achieves communication using one-way bridges between chains.

Bridges validate cross-chain transactions across the network. They sign and broadcast the transaction as valid only if the source blockchain has sealed it and paid the forwarding fees. Aion allows bridges to set their own fees with the goal of creating a market for bridges. The intention is that larger chains will have direct bridges between one another and smaller chains will connect by the transaction taking multiple hops (this is handled by the Aion protocol). Two-way bridges are handled by having two individual bridges, one in each direction. Bridges do not have shared security.

ICON

ICON achieves interoperability using a hub-and-spoke model and has been modelled after existing financial exchanges. ICON appears to be targeting payments and other financial products like loans rather than providing for general interoperability. Given the narrow focus of ICON it does not appear to be a genuine competitor to Polkadot.

Wanchain

Wanchain is also heavily modelled after fiat exchanges and seems to be more focused on providing banking services such as loans than on providing interoperability. Wanchain aims to build a distributed bank and provide a new, distributed infrastructure for digital assets. With Wanchain, any institution or individual can set up and provide services such as loan origination, asset exchanges, credit payments and transaction settlements based on digital assets. Wanchain is a fully-featured smart contract platform which is based on Solidity and the EVM. Similar to ICON, the narrow focus of Wanchain means it is not a serious threat to Polkadot.

Ethereum

Polkadot and Ethereum are addressing two different use cases but there is overlap in their projects and similarities in their approaches. In some ways Polkadot's architecture will be similar to Ethereum 2.0 with Polkadot having a relay chain with parachains and Ethereum 2.0 having a beacon chain with shards. Polkadot allows users to build a blockchain and utilize the security of the Polkadot blockchain. In comparison Ethereum allows users to build dApps on the Ethereum smart contract platform. Building a full parachain versus an application on top of an existing blockchain are generally likely to be two different use cases.

While Polkadot is often touted as a competitor to Ethereum it is actually more of a complement. Polkadot was designed as a stable base layer for other consensus systems to build upon and as such does not actually have smart contract functionality. This may foster competition for Ethereum but it does not make Polkadot a direct competitor.

Valuation

Polkadot is difficult to value for a number of reasons. In addition to the immense difficulties with valuing a smart contract platform like Ethereum, Polkadot introduces new issues, as it is merely acting as a security layer and as a bridge between blockchains. Polkadot's value is highly dependent on how fragmented the blockchain market is in the future and to what extent communication between blockchains is valuable.

Polkadot will most likely be valuable in a future where there are a large number of competing private and public blockchains that need to communicate with each other and with legacy systems. Polkadot may even help to create this future by mitigating the winner take most effects of blockchain security, allowing smaller chains to securely gain traction in the market.

Bitcoin's dominance continues to decline slowly, pointing toward a multi-chain future. Ethereum is currently the most widely used smart contract platform and most private enterprise projects are also built on Ethereum. There are competing smart contract platforms like Cardano which are reaching maturity though and they may win market share with their enhanced features, particularly if Ethereum has problems with the roll-out of Ethereum 2.0.

Figure 9: Bitcoin Dominance

(Source: coinmarketcap)

Polkadot utilizes DOT for staking and in addition parachains needs to stake DOT to get attached to the Polkadot relay chain to enjoy the benefits of pooled security. Demand for DOT could be driven largely by competition for parachains slots. At this stage it is difficult to know how much demand there will be though.

Assuming that value accrues at the bottom of the blockchain technology stack and that Polkadot is a type of middleware it would be reasonable for Polkadot to be worth less than blockchains like Ethereum and Bitcoin and in line with other middleware, like Chainlink. The web3 foundation actually defines Polkadot as belonging in a Meta Protocol base layer, which could potentially make it as valuable or even more valuable than Ethereum. This would depend on to what extent other chains end up building on Polkadot and to what extent Polkadot becomes the default for blockchain networking.

Figure 10: Blockchain Technology Stack

(Source: Created by author)

I believe it is likely that Polkadot will be a central part of the blockchain ecosystem in the future and therefore think it is reasonable for Polkadot's market capitalization to be in line with other high potential projects like Cardano and Chainlink. Although, as a type of middleware above the settlement layer in the blockchain technology stack, I tend to believe Polkadot will ultimately be less valuable than platforms like Ethereum.

Figure 11: Interoperability Blockchain Price Index

(Source: coingecko)

Analyst’s Disclosure: I am/we are long DOT-USD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.