Parachain auction economics: Polkadot and Kusama, who is the better investment choice?


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If the amount of funds is relatively small, Kusama may be a better choice.

Original title: “The Economics of Parachain Auctions: Why Kusama might be a better investment choice? 》
Written by: PeachTree
Translation: Lucy

Polkadot, a concept mentioned by thousands of media, has strong expectations, a project valued at US$32 billion before it is fully formed.

The first thing I am curious about Polkadot is that it has a distant cousin worth $4 billion, Kusama, which can be seen as a mini version of Polkadot, or a test version.

I couldn’t help but start beeping inside my skull: “The gap between the two is not small… why?”

I think we need in-depth analysis to understand how relative prices are formed today. If all the players in the currency circle say that Polkadot and Kusama will indeed become an important part of the new digital economy, I also want to predict the investment risks and returns.

Choose Polkadot or Kusama?

pick one of two?

Why choose one of the two? Can’t I invest in two?

Of course I can save a bit of trouble and buy both. However, when a group of people with superior IQ builds a unique project like Polkadot, it is the meaning to truly understand its underlying construction logic and economic logic. In this way, when evaluating other projects in the Polkadot ecosystem, I may have a correct basic direction. In terms of investment, I may also find that Polkadot is superior to Kusama, or Kusama is stronger than Polkadot.

The value of each token is closely related to the basic principles and mechanisms of its unique design, which is the charm of cryptocurrency. We can find out the main pressure points and leverage points through detailed analysis to guide value creation.

Principle of operation

In other blockchain projects such as Ethereum, the project can simply create what they want on the blockchain. Polkadot and Kusama operate in different ways. They have a relay chain that links all the projects in the ecology. In order to obtain connection rights, the projects need to pay rent. I use an analogy to explain the business model:

Polkadot’s business model is like an airport. The airport leases the terminal space to airlines interested in participating in the airport’s economic ecology. The airport provides a hub for passengers to transit, operate efficiently and ensure safety.

Airlines have brought a variety of flight options, enhancing the function of the airport. If the airport is operated properly, there will be more and more airlines, which will further increase the value of the airport and then the airlines. In the end, everyone enjoys retirement in Hawaii.

Now suppose that I bought an island to build an airport, and plan to build a major large airport and a small airport. Small airports are used to carry local tourists, while major airports receive international tourists. Small airports are also used as testing grounds to formulate different pricing strategies for airlines, test new airlines, use new safety equipment, and so on.

In this way, we can make some new attempts in a less risky environment before deciding whether to reuse it to the main airport. Maybe we have launched a new pricing strategy, and it turns out that it is not optimal. Fortunately, only small markets have some economic losses.

Back to the airlines, they have to pay rent to the airport. After the lease expires, they need to compete with other airlines to regain a place.

Applied in the Polkadot ecology, the main airport = Polkadot, the smaller airport = Kusama, and the airline = Parachain. The busier the parachain, the more Polkadot and Kusama earn.

In this process, the most important thing is the auction. The auction determines which parachain will be connected to the relay chain and how much rent must be paid.

The importance of auctions is reflected in: ( 1) Value-added Polkadot and Kusama; (2) Investors can participate in profit; (3) Help us understand parachain and ecological behavior.

Cryptocurrency projects must first deposit rent in the form of corresponding DOT or KSM tokens before applying to become a parachain. The lease term depends on the demand of the project itself during the auction period. It can be as short as 6 months and as long as 2 years. The auction is held every 1-2 weeks.

If the item does not take a slot in one auction process, they may try again in the next process. Now, let us discuss how these auctions work economically.

Parachain auction economics

For a theoretical analysis, suppose we have a great project called Project X. The main chain can provide governance for our projects, strengthen security, and improve efficiency, so we decided to join the Polkadot and Kusama ecosystems.

We think that other good projects will also be connected to these two networks, so that we can use the functions of other projects in our own projects to provide users with more practicality. Suppose our market capitalization is about 100 million U.S. dollars, Polkadot’s market capitalization is 30 billion U.S. dollars, and Kusama is 4 billion U.S. dollars.

For the sake of simplicity, suppose we want to take a photo of a parachain slot with a one-year lease. Let’s do it for yourself . When we choose auction, we need to decide: (1) How do we pay? (2) How much loan do we need? How much interest is paid?

How do we buy tokens?

There are two options for Project X:

  1. Buy DOT or KSM tokens from the public trading market;
  2. Rent coins from DOT/KSM holders.

Option 1: Buy coins from the open trading market.

First of all, we are a start-up and don’t have much cash in hand. So we have to find venture capital, or go to the open market to raise funds.

Either way, you need to sell more project X tokens. The result of this operation is obvious: other conditions remain unchanged, the current holdings of each currency holder will be diluted, and the current value of the currency will decrease.

Selling the ownership share of the project to buy DOT and/or KSM tokens is not an ideal choice. We are all “biological fans” of our own projects, and we won’t spend a long time changing exogenous assets that we can’t control.

Furthermore, when we buy coins together with our opponents on the open market, the currency value of DOT coins or KSM will rise, hindering our own transactions. This wave of operations is a real pull.

Option 2: We borrow DOT or KSM tokens from the open market to participate in the auction.

To this end, we need to use economic stimulus token creditors to loan tokens and lock them for one year. This is similar to debt. We need to pay “interest” for the borrowed DOT/KSM tokens.

Although we have to pay interest by selling the tokens of project X, the difference between option two and option one is that the cost of option two is much lower, we don’t need to buy DOT or KSM tokens, we only need to pay “interest” to the borrower , Option 2 is more cost-effective for us.

Therefore, I guess that in the real auction process, all projects will probably choose the second option for financing, unless they are lucky to buy some DOT or KSM a few years ago.

How much loan do we need? How much interest is paid?

This question is too critical. Before answering the question, we first need to briefly understand the economics of DOT tokens. Let me talk about token economics as simply as possible:

Polkadot’s token economics shows that in its “ideal” state, the following conditions hold true:

  1. Under the blockchain network of the POS (Proof of Equity) mechanism, 50% of DOT tokens will be pledged through the normal equity pledge system. At this time, the interest rate obtained by the equity holder reaches 20%. Remember that under the POS mechanism, interest is paid in tokens, so it is also the inflation rate.
  2. 25-30% of DOT tokens are stored in parachains (these tokens will not earn interest from the DOT/KSM network)
  3. 20-25% of DOT tokens are freely traded (these tokens will not earn interest from the DOT/KSM network)

How did they arrive at these numbers? In general, the blockchain network of the POS mechanism hopes to have 60% to 75% pledged tokens. Because the more pledged tokens, the higher the security, but the less freely traded tokens, the worse the liquidity.

The special feature of DOT/KSM is that they have created a parachain structure, so it is necessary to allocate 60-65% of the equity between traditional stakeholders and parachains. Following the following logic, we can see why in an ideal state, compared to equity holders, the percentage allocated to parachains is lower:

If the percentage allocated to parachains is too high: the percentage allocated to parachains is more → the number of DOT tokens stored in parachains is more → parachains become more expensive → the demand for parachains to connect to Polkadot is reduced, and parachains Choose to connect to other blockchains. This is like the airport rent is too expensive, airlines transfer from JFK to another airport, which is not what we want.

Isn’t this delicate design worth keeping in a small book? Building a system with parallel chain deposits means:

  1. Parachain has real projects in operation.
  2. The security of the network is not only maintained by the rights holders, but also supported by the parachain.
  3. Because there is no need to pay the interest of the parallel chain deposit, Polkadot can pay more interest to ordinary stakeholders and attract them to join the Polkadot ecosystem. Therefore, without causing excessive inflation, Polkadot can attract more stakeholders to join.

In other blockchains without parachain design, raising interest rates for stakeholders will lead to one-to-one inflation, while Polkadot will not, because parachain token deposits will not get a dime from DOT/KSM Money interest! The creators of Polkadot have basically transferred some of the inflation burden to the parachain that needs to pay crowdfunding loans.

What method did they use to motivate the system to achieve a 50% stakeholder equilibrium to achieve this “ideal” state?

If the pledged tokens exceed 50%, they will sharply reduce the interest rate. Conversely, if the pledged tokens are below 50%, they will sharply increase the interest rate.

This is a chart of interest rates (green line, y-axis) VS pledged tokens (blue line, x-axis). Key point: If the percentage of equity holders exceeds 50%, interest rates will drop exponentially, and people will withdraw pledges to create liquidity for DOT/KSM tokens.

Parachain auction economics: Polkadot and Kusama, who is the better investment choice?

Why should I consider these? Because the cost of parachain loans needs to make up for the opportunity cost of traditional equity holders pledged on the Internet. The percentage of pledged DOT/KSM tokens determines the interest rate and therefore the cost of the parachain. I will explain further below.

Now that the token economics has been explained, we can finally answer the question: how much loan do we need and how much interest do we pay?

How much loan do we need?

Based on the ideal state, we know that approximately 30% of the tokens will be stored on the parachain. From this, calculate the meaning of the parachain under normal circumstances:

Parachain auction economics: Polkadot and Kusama, who is the better investment choice?

In my experience, a project needs to borrow about 3 million tokens to participate in DOT, and to participate in KSM, it needs to borrow about 26,000 tokens. This is equivalent to 96 million U.S. dollars in DOT and 13 million U.S. dollars in KSM, which is a bit high.

At present, it is difficult for DOT/KSM to reach the 30% “ideal” state, because the project is still in its infancy, and it is very expensive to borrow 96 million.

How much interest do we need to pay?

Let’s look at it from the perspective of DOT or KSM holders.

If I hold DOT or KSM, my options are as follows:

  1. Staking DOT or KSM tokens, under ideal conditions, can obtain an annualized interest rate of about 20% of the tokens each year.
  2. Lend my tokens to project X for one year and get interest on project X tokens.
  3. Store the DOT or KSM tokens in the wallet and wait for the transaction, and the income will be zero.

For DOT/KSM holders, option three is unreasonable in the short term because it has a return rate of 0%, so we exclude it. Therefore, option two must at least defeat option one to motivate coin holders to choose it.

Therefore, this is our answer: the “interest” we pay to crowdfunding creditors (paid in project X tokens) must at least exceed the 20% annual interest (paid in DOT or KSM tokens) obtained from the pledge.

It should be noted that a 20% interest rate is only possible when the percentage of pledged tokens is in the “ideal” state of 50%. If the pledge exceeds 50%, the interest rate and the borrowing cost of the parachain will drop sharply.

The core question becomes:

Today, how much dollars is the borrowing cost of a parachain worth? How would this dilute the hypothetical project X? What is the implied interest rate for crowdfunding?

The following is an explanation in an ideal state:

Parachain auction economics: Polkadot and Kusama, who is the better investment choice?

What if the pledge percentage is not ideal? The following is interest rate sensitivity:

Parachain auction economics: Polkadot and Kusama, who is the better investment choice?

What did we find?

I calculated that under ideal conditions, the total interest for DOT and KSM stakeholders is approximately US$3 billion and US$4 million. This is the opportunity cost for them not to pledge all of them, but to lend DOT/KSM tokens to parachains.

Assuming there are 100 parachains, we divide the total interest by 100 to calculate the average cost to be paid to equity holders for each project: DOT is 32 million U.S. dollars, and KSM is 4 million U.S. dollars.

Think about how expensive it is for a start-up company to pay this fee every year! For projects with a market value of 100 million US dollars today (such as our extraordinary project X), as a parachain on Polkadot, we depreciate currency inflation by 32% every year, and as a parachain on KSM, the depreciation rate is 4%.

My conclusion is that it is unlikely that an “ideal state” will appear in real life, because until now, unless cryptocurrency is more mature, it will inhibit the demand for parachain projects.

When the stakeholder’s pledge percentage on the Internet exceeds 50%, the ideal state is broken. As shown in the sensitivity chart, interest rates will drop sharply.

My intuition tells me that the equilibrium state reached will be slightly higher than 50%, between 50%-60%. This is because the total amount of pledged DOT tokens has reached 65%, and I don’t think there will be 15 % Of stakeholders withdrew their pledges and used DOT proceeds to participate in riskier parachain projects.

KSM currently has 55% pledged tokens. The stakeholders are also quite satisfied with the current 13% pledge interest rate. I guess the 13% interest rate connected to the parachain will satisfy them. At an interest rate of 13%, a project costs 20 million dollars to connect to DOT and 2 million dollars to connect to KSM. If you ask my opinion, I still think it is too expensive to connect to DOT.

Although based on logic, we already know that joining as a parachain means that we have to pay rental costs, and the price of project X will therefore be under downward pressure, and projects on DOT are more expensive than on KSM.

We have spent our noses and learned how to quantify this difficult inflation struggle. In this case, a project with a market value of 100 million US dollars will pay 20 million US dollars in interest expenses, that is, their currency inflation dilution exceeds 20% per year, and a 50 million US dollar project must offset 40% of the negative currency dilution. It’s ridiculous!

What else is worth mentioning? I think it is so much cheaper to connect to Kusama, which shocked me: Is Kusama “underrated”?

Competitive Analysis: DOT VS KSM

Why do DOT and KSM currency appreciate or depreciate?

People buy DOT/KSM tokens from outside → the cost of parachain rent rises → aspiring projects cannot afford to pay, and demand decreases → DOT or KSM token holders are no longer incentivized → DOT/KSM prices drop → rent costs drop , More project needs appear, and the cycle goes back and forth.

The supply of parachain slots on DOT and KSM on each network is fixed at 100, so demand is a variable of difference. The demand for projects to connect to the network is the real driving factor for the stability of DOT / KSM currency prices. Which of the two has more Project requirements?

KSM is a small airport next to the main airport of DOT. Let’s change the analogy now. Let’s talk about nightclubs instead of the airport.

In my opinion, KSM is a cheaper and busier nightclub, while DOT is a more luxurious and expensive nightclub. However, if cheap nightclubs have consistently higher traffic, why doesn’t it raise beverage prices to balance supply and demand? If luxury clubs do not have a full customer-earning ratio as compared to small clubs, they will not be able to raise prices further.

Let’s review what we just learned:

The above quantitative research shows that the economic cost of the project connected to Kusama is minimal compared to Polkadot.

Kusama’s connection cost is exactly 7 times cheaper. That’s right, just looking at the difference in market value, this is obvious. But now we know that the cost is calculated for each parachain. From the reality, that is, the currency value of a $100 million project will be diluted by about 20%. Unless the aspiring project initially has a high valuation, otherwise they will not connect to Kusama, but to connect to Polkadot, and they will lose real currency.

I think that under this mechanism, the demand for projects with smaller market capitalization will flock to Kusama. I originally wanted to try it first, but it may never be connected to Polkadot.

Does this mean that only smaller, lower-quality projects will be connected to Kusama, and better projects will only be connected to Polkadot? Not really.

The first-class Polkadot project will still be connected to the Kusama project, which is very cost-effective for high-value projects. Especially in the emerging experimental digital economy, the economic value of Kusama as a testing ground will offset its rental costs.

Compared with Polkadot, Kusama has the same functions and greatly reduces the cost, so it has obtained more project requirements. But how much more demand is there? Look at more numbers!

I found on Coingecko that in the Polkadot ecosystem, only about 20 public Polkadot projects have a market value of more than US$100 million, and about 30 projects are worth less than US$100 million.

Calculated at today’s price, the currency dilution ratio of 30/50 or 60% per year will exceed 20%. Let me cry again. We have not counted the projects that have not yet been listed, but this set of data can form a bell-shaped curve, which is still very Representative.

Therefore, in the short term, the Kusama ecosystem will have more asymmetric demand and supply-demand imbalance than the Polkadot system.

The 7 times market capitalization gap between the two is huge. Should I compare them?

With an estimated pledge rate of more than 55% and an inflation rate of 10%-13%, the project connected to Kusama today costs 2.5 million yuan per year. If the market value of Kusama doubles, the cost will increase to 5 million. If a currency dilution rate of 20% can be accepted, the cut-off market value is 5 million divided by 0.2 equal to 25 million.

At Coingecko, I found that only 14/50 or 28% of projects fail to meet this standard. Triple the price of Kusama can only exclude 18/50 or 36% of the project.

I think Kusama and Polkadot still have a lot of room for development before reaching a balance between supply and demand. Because now the project can offset the 20% currency dilution by raising the price of Kusama by 2-3 times.

If I have money constraints, I will bet on Kusama’s appreciation instead of Polkadot.

Where i might be wrong

  1. I hope my calculations above are all correct.
  2. I am not a technical expert, so the basis of my inference is based on the same function and effect of Kusama and Polkadot, which is very important for our Kusama needs assessment. My interpretation of the Polkadot market does not imply any point of view.
  3. Some projects may be “lost” to Polkadot, or upgrade to Polkadot, or get used to operating in Polkadot, and Kusama is no longer needed. My objection is that they will still use the Kusama ecosystem for a long time to test some new product features and update performance, and then go to Polkadot for reuse.
  4. Higher market value undoubtedly means higher security of proof of rights and interests. Therefore, some people may think that Polkadot’s higher security will bring more project requirements than Kusama. Of course, I agree that Polkadot is safer on this basis, but its cost is too high, not everyone can play it. Do you want to park your plane at the main airport, just snap your fingers, and you can magically have rent-paying venues?
  5. If the entire market value of the aspiring parachain is adjusted upwards and can afford Polkadot’s rent, then my argument is invalid. So far, this is not the case, but the situation will change in the future, when the entire market value of Polkadot and Kusama will be adjusted upwards.

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