Pre-Merge Proof-of-Stake Landscape
Aug 5, 2022
Despite the contagious effects of Luna and Three Arrows Capital (3AC) impacting various CeFi platforms and the current macro conditions pressuring risk-on assets such as crypto, the activity on smart contract platforms and Proof-of-Stake (PoS) protocols remains healthy. As such, Ethereum very recently hit a new ATH of 1.1m in daily active addresses, the overall total value locked (TVL) in DeFi is still hovering around an impressive USD 88.41b (stake and borrows included), while Uniswap keeps printing revenue to its LPs (9.12b weekly volume in CW30) and Ethereum (1.9m 7 day average fees).
The number of PoS blockchains has been steadily increasing over the last couple of years, and Ethereum’s highly anticipated move to PoS has generated even more awareness and controversies. The concept of PoS was introduced by Scott Nadal and Sunny King in 2012, and it was first adopted by the Peercoin blockchain in 2013. Staking basically is leveraging cryptocurrency as collateral to actively participate in securing the underlying blockchain and get rewarded native tokens for doing so.
PoS as part of the consensus mechanism is a way of protecting a decentralized network against Sybil attacks, an attack vector which works by creating multiple nodes. In PoS, votes are weighted by the amount of stake. In this sense, it does not matter how many nodes the attacker creates since stakes spread across many nodes yields very little voting weight. As an attacker would need to own an overwhelming quantity of tokens to stake, it significantly increases the cost of attacking a PoS network and mitigates the risk of a Sybil attack.
To incentivize validators to stake, the PoS protocol pays out a staking reward generated from the issuance of new tokens and transaction fees. As miners are obsolete in PoS due to less computational requirements, it is significantly less energy intensive than Proof-of-Work (PoW), enabling environmental, social and governance (ESG) cautious investments. As Vitalik Buterin states, PoS likely offers more security for the same cost, enables easier recovery of attacks and might be more decentralized, and censorship-resistant than PoW due to the reliance on ASICs (Application-Specific Integrated Circuit). On the flip side, PoS might lead to higher wealth concentration being a closed system that requires weak subjectivity. For investors, staking might be attractive since regular rewards can be generated akin to interest by depositing assets and making them productive. Similar to a time deposit or a withdrawal notice period, the assets are usually locked for a certain period of time. Hence, liquidity risk associated with having to lock up tokens is important to consider. Moreover, PoS induces risk of losing deposited assets due to slashing and might generate low returns due to bad validator performance.
Smart contract platforms and PoS protocols driving most activity and adoption are manifold and come with different flavors regarding their technology, degree of decentralization, monetary policy, security, or scalability. Smart contract platforms can be divided into Layer1, protocols such as Ethereum, Avalanche, or Solana, and Layer2 like Polygon. Layer2 protocols can be considered scaling solutions built on top of Layer1 networks specifically addressing scalability issues of the underlying blockchain. Below, follows a brief introduction of a selection of key protocols along our corresponding Fundamental articles:
Ethereum, launched in 2015, is the second-biggest cryptocurrency by market cap after Bitcoin. It was created to establish a global, decentralized computing platform which takes the security and openness of blockchains and extends those attributes to a vast range of applications. Ethereum was the first protocol to integrate smart contracts into a decentralized network with the introduction of the Ethereum Virtual Machine (EVM) and enabled the execution of any software code in a decentralized fashion.
Smart contracts running on Ethereum allow developers to build complex applications that should run exactly as programmed without downtime, censorship, fraud, or third-party interference, thus having the potential to disintermediate almost every industry. Popular innovations enabled by Ethereum include stablecoins, DeFi, NFTs, and many more.
Cardano was designed by Charles Hoskinson, former Ethereum CEO, in 2015 to be a next-gen evolution of Ethereum, with a blockchain aiming to enable a flexible, sustainable, and scalable platform for running smart contracts.
The Cardano blockchain is divided into two separate layers: the Cardano Settlement Layer (CSL) containing the ledger of accounts and balances and the Cardano Computing Layer (CCL) where distributed apps running on the blockchain are executed. This separation is expected to enable the network to process up to one million transactions per second in the future.
Cardano’s proprietary consensus algorithm “Ouroboros” was designed by experts in the fields of cryptography based on scientific and mathematical principles to prove its security.
Solana is a smart contract blockchain platform known for its transaction speed and efficiency. Since its launch in 2017, Solana has grown to become one of the largest cryptocurrencies in the world.
To differentiate itself, Solana introduces a combination of architectural design choices that attempt to offer faster transaction settlement times and an infrastructure which focuses on flexibility that should allow developers to write and launch customizable applications in multiple programming languages.
Solana runs a consensus mechanism called Tower BFT with PoS but which runs on a synchronized clock (Proof-of-History) to achieve fast speeds of 65’000 transactions per second (TPS) at low costs per transaction.
Polkadot was created by Dr. Gavin Wood, former Ethereum CTO and founder of the Web3 Foundation, in order to provide an infrastructure that allows individual blockchains to securely connect and exchange information and value.
The Polkadot network includes a main infrastructure for securing the network and message passing called the “relay chain” and many user-created parallel chains (or “parachains”). It also has a connecting layer, or “bridge” that allows value and data to be transferred between most blockchains — and is able to be used as a connection to non-blockchain databases.
The parachains are application-specific entire blockchains in and of themselves with their own logic and features. As they do most of the heavy lifting, the Polkadot network can process more than 1’000 transactions per second.
Avalanche is a blockchain platform that aims to address the blockchain trilemma of scalability, security, and decentralization thanks to its unique proof-of-stake mechanism which is based on repeatedly sampling small random sets of validators to reach consensus.
In addition, it mitigates the blockchain trilemma by consisting of three different blockchains, each specialized in a specific function like payments or smart contracts. Digital assets can be moved across each of these chains to accomplish different functions within the ecosystem.
Avalanche users are able to launch their own application-specific chains that can operate using their own sets of rules, similar to Polkadot’s parachains.
Previously known as Matic Network, Polygon significantly boosts Ethereum’s capacity by speeding up transactions and network scalability. In order to scale the Ethereum network, Polygon employs its own PoS chain and leverages its Commit Chain connectivity. technology.
Polygon also positioned itself as the “Swiss army knife for Ethereum” scaling as it works on the whole range of scaling solutions including modular data availability blockchain Avail, zk rollups Hermez, Miden, and Zero, privacy focus modular framework Edge, and hybrid optimistic-zk approach Nightfall. Along with that spectrum, Polygon aims to be one of Ethereum’s premier Layer-2 scaling solutions as hundreds of dApps already deployed iterations on Polygon to benefit from its increased throughput and decreased costs.
NEAR is a decentralized development platform which aims to offer developers an easy way to build scalable decentralized applications. It combines a horizontal scaling approach with a new consensus mechanism that splits the network into parallel shards and dynamically distributes the computation to increase the network's processing capacity. At the same time, it promotes itself as a certified carbon-neutral protocol thanks to its engagement in a variety of green projects.
The NEAR protocol facilitates interoperability via the Rainbow Bridge to Ethereum and it deployed Aurora, an Ethereum Virtual Machine (EVM) implementation that allows developers to launch dApps built for Ethereum on the NEAR network.
The Cosmos ecosystem is often referred to as the “internet of blockchains” by its founders. It aims to be a network of sovereign, interoperable blockchains, united by open-source tools that facilitate interoperability and transactions in the industry.
Each new independent blockchain (called “zone”) created within Cosmos is then tethered to the Cosmos Hub, which maintains a record of the state of each chain and vice versa. Each chain is able to carry out its essential functions on its own. This includes authenticating accounts and transactions, creating and distributing new tokens, and executing changes to its own blockchain.
Tezos is a proof-of-stake blockchain with on-chain governance and a built-in mechanism for incorporating future technological innovations and changes to its rules. Initiated in 2014, it aimed to reduce the chances its blockchain might “fork”, creating two separate cryptocurrencies with two distinct prices. This innovation led to the now well-known concept of on-chain governance.
Tezos technology was used in a recent experiment by different European central banks exploring the feasibility of launching a digital euro, a central bank digital currency.
Past performance and key metrics
Since the vast majority of on-chain user activity attracted by DeFi, NFTs, or staking occurs on smart contract networks, every transaction must be paid for with the native token that secures the protocol through PoS. As a result, these protocols have seen significant demand and therefore performed very well in 2021 and 2022 so far.
Avalanche, Near, and Solana which all launched in 2020 are clear outliers with regard to their one-year price performance, see Illustration 1. They managed to still be up over a one-year range even after the recent downtrend which was induced by various micro and macro conditions. Tezos’, Polkadot’s, and Cardano’s native tokens performed worst among the selected assets indicating a lacking ecosystem momentum.
Illustration 1: Relative one year USD performance of selected PoS chains
As Ethereum saw high blockspace demand and with that very high transaction fees, it exposed scalability issues and opened the gates to emerging smart contract platforms that captured large portions of the market. Thus, platforms like Solana, Near, and Avalanche experienced strong growth in daily on-chain transactions counts along with massive price appreciations up to >900%. As many of these projects launched in 2020, price action is concentrated in the last two years with dApps finding market fit and attracting on-chain traffic.
However, as most of these chains launched within the last couple of years with slightly delayed hype cycles, not all of them are highly correlated within a one-year time range, see Illustration 2. Looking at reduced timeframes between 30-90 days, we see that the whole spectrum is highly correlated. To quantify the correlation, the Pearson Correlation Coefficient is used to estimate the strength of the linear relationship between two price variables while +1 equals a perfect positive linear correlation, -1 equals a perfect negative linear correlation, and 0 equals no linear correlation.
Illustration 2: One year correlation matrix of selected PoS chains
There is now a thriving ecosystem of decentralized applications (dApps) available to users thanks to the ability to build software on top of decentralized networks. The most well-known are DeFi apps that aim to revolutionize TradFi by letting users swap tokens, borrow and lend money, or employ permissionless, on-chain asset management strategies in a decentralized fashion without intermediary and globally available 24/7. These protocols use smart contracts to automatically enforce positions and settle disputes without the need for paperwork or underwriting.
A proxy for adoption is the overall TVL within these dApps relative to the underlying protocol, see Illustration 3. Despite the fact that Ethereum’s TVL dominance took a hit in 2021, it has been slowly creeping up again and remains top for DeFi activity by a significant margin. Avalanche on the other hand, stands out in TVL as a rather new ecosystem that managed to capture impressive TVL and activity via incentivized ecosystem growth. For instance, Avalanche Rush which was introduced in 2021 has bolstered growth through a $180m incentive program. Interestingly, the three worst-performing assets seen in Illustration 1 correlate with rather low TVL, especially Tezos and Cardano, which indicates TVL is a proxy for price momentum.
Illustration 3: TVL of selected PoS chains
Table 1 below provides an overview of key metrics for the whole basket of highlighted protocols, ranging from monetary policy, revenue, and decentralization metrics. The rather high staking yields of Polkadot, Near, and Cosmos have to be seen in connection to the inflationary monetary policies of these chains, as paying staking yields from newly created coins creates inflation.
Transaction numbers and transaction fees driven by blockspace demand are a reliable sign of a robust and expanding network. On a smart contract platform, the cumulated transaction fees and network revenue are therefore directly correlated. The Price-to-Sales (P/S) ratio used in TradFi allows for a quantitative assessment of the network activity with regard to the market cap, yet it should be assessed in an isolated way for crypto to derive conclusions based on a comparative analysis.
Table 1: Key metrics of selected PoS chains sorted by market cap
As such, Polkadot stands out with a rather high P/S while Ethereum is leading the basket with its impressive 177.6. Heading into the Merge, Ethereum not only offers the most optimal P/S ratio, market cap, and inflation (post-merge) as a result of high demand and its burning feature, but also the highest validator count followed by Cardano, Solana, and Avalanche. The tokenomics of Avalanche, Solana, and Ethereum differ, but the underlying model shared by each of these networks has a burn mechanism to validate transactions. Ethereum being the oldest, with the most accumulated developer, user, and investor buy-in over time continues to be the most relevant smart contract platform. Despite the high cost of accessing the network, users and developers can expect that, given the size of its community and the amount of money invested in the network's smart contracts, Ethereum might probably continue to be the hub for application innovation and liquidity.
Conclusion and Outlook
Emerging smart contract platforms have grown their share of the DeFi market, yet Ethereum’s TVL still remains fairly untouched. Other emerging trends like metaverse, gaming, and NFTs might bring additional growth potential in smart contract platforms with an entirely new market of users, capital, and use cases. Approaching the Merge, Ethereum dominated most of the metrics discussed, and with its burning feature coupled with a sustainable blockspace demand, it is likely that deflationary periods post-merge occur more frequently. As more valuable dApps grow within these ecosystems, activity levels is expected to increase from here driving revenue for users exposed to their native tokens.
Disclosure: at time of writing, the author holds ETH, AVAX, MATIC, NEAR and XTZ