Parallel Chain Auction Economics: Polkadot and Kusama, Who is the Better Investment Choice?
If the amount of funds is relatively small, Kusama may be a better choice.This article was published on Deep Tide TechFlow, author: PeachTree, translation: Lucy.
Polkadot, a concept mentioned by countless media outlets, has strong expectations, a project valued at $32 billion even before it is fully formed.
The first point of curiosity I have about Polkadot is that it has a distant cousin, Kusama, valued at $4 billion, which can be seen as a mini version or a test version of Polkadot.
I can't help but start thinking: "The gap between these two is quite large… Why is that?"
I believe a deeper analysis is needed to understand the principles behind the current relative pricing. If, as all crypto enthusiasts claim, Polkadot and Kusama are indeed going to become important components of the new digital economy, I also want to foresee the investment risks and returns involved.
Should I choose Polkadot or Kusama?
Choose One?
Why choose one? Can't I invest in both?
Of course, I could simplify things by buying both. However, when a group of exceptionally intelligent people builds a unique project like Polkadot, understanding its underlying construction logic and economic logic is what truly matters. This way, when evaluating other projects in the Polkadot ecosystem, I might have a correct foundational direction. In terms of investment, I might also discover some characteristics where Polkadot excels over Kusama, or vice versa.
The value of each token is closely related to its uniquely designed fundamental principles and mechanisms, which is the charm of cryptocurrency. We can identify the main pressure points and leverage points through detailed analysis, thereby guiding value creation.
Operating Principles
In other blockchain projects like Ethereum, projects can simply create whatever they want on the blockchain. Polkadot and Kusama operate differently. They have a relay chain that connects all projects in the ecosystem, and projects need to pay rent to gain connection rights. I use a metaphor to explain the business model:
Polkadot's business model is akin to an airport. The airport rents out terminal space to airlines that wish to participate in the airport's economic ecosystem. The airport provides a hub for passengers, ensuring efficient operations and safety.
Airlines bring various flight options, enhancing the airport's utility. If the airport operates well, more airlines will come, further increasing the airport's value, which in turn raises the value of the airlines, leading to a win-win situation where everyone enjoys retirement in Hawaii.
Now, let's assume I bought an island to build an airport, planning to construct a major large airport and a smaller airport. The smaller airport is for local tourists, while the major airport caters to international visitors. The smaller airport also serves as a testing ground for different pricing strategies for airlines, experimenting with new airlines, new safety equipment, and so on.
In this way, we can first try new things in a lower-risk environment before deciding whether to replicate them at the main airport. Perhaps we launched a new pricing strategy that turned out not to be optimal; that's fine, as only the smaller airport incurs some economic losses.
Returning to the airlines, they need to pay rent to the airport. Once the lease term expires, they must compete with other airlines to secure a spot again.
In the context of the Polkadot ecosystem, the main airport = Polkadot, the smaller airport = Kusama, airlines = parallel chains. The busier the parallel chains are, the more Polkadot and Kusama earn.
In this process, auctions are crucial. Auctions determine which parallel chains will connect to the relay chain and how much rent needs to be paid.
The importance of auctions is reflected in: (1) increasing the value of Polkadot and Kusama; (2) allowing investors to participate in profits; (3) helping us understand parallel chains and ecosystem behavior.
Crypto projects must first deposit rent in the form of the corresponding DOT or KSM tokens before applying to become a parallel chain. The lease term depends on the demand of the project during the auction period, ranging from as short as 6 months to as long as 2 years. Auctions are held every 1-2 weeks.
If a project fails to secure a slot in one auction process, they may try again in the next process. Now, let's discuss how these auctions function economically.
Parallel Chain Auction Economics
For theoretical analysis, let's assume we have a great project called Project X. The main chain can provide governance, enhance security, and improve efficiency for our project, so we decide to join the Polkadot and Kusama ecosystems.
We believe that other good projects will also connect to these two networks, allowing us to leverage the functionalities of other projects in our own project to provide more utility to users. Let's assume our market cap is about $100 million, Polkadot's market cap is $30 billion, and Kusama's is $4 billion.
For simplicity, let's assume we want to bid for a one-year lease on a parallel chain slot. Let's put this into practice: when we choose to bid, we need to decide: (1) how do we pay? (2) how much loan do we need? What interest do we pay?
How do we acquire tokens?
Project X has two options:
- Buy DOT or KSM tokens from the public trading market;
- Rent tokens from DOT/KSM holders.
Option One: Buy tokens from the public trading market.
First, we are a startup with limited cash. So we need to seek venture capital or raise funds in the public market.
Either way requires selling more tokens of Project X. The outcome of this operation is evident: all else being equal, the current holdings of each token holder will be diluted, and the token's market price will decrease.
Selling ownership stakes in the project to acquire DOT and/or KSM tokens is not an ideal choice. We are the "loyal fans" of our own project and wouldn't go through the trouble of exchanging for external assets we can't control.
Moreover, when we buy tokens in the public market alongside competitors, the price of DOT or KSM will rise, hindering our own transactions, which is indeed a poor strategy.
Option Two: We borrow DOT or KSM tokens from holders in the public market to participate in the auction.
To do this, we need to incentivize token holders to lend us tokens and lock them for a year, similar to a debt, for which we need to pay "interest" on the borrowed DOT/KSM tokens.
Although we will pay interest through the sale of Project X tokens, the difference between Option Two and Option One is that Option Two is much cheaper; we don't need to purchase DOT or KSM tokens, we just need to pay "interest" to the lenders, making Option Two more cost-effective for us.
Therefore, I suspect that in real auction processes, most projects will likely choose the second option to raise funds, unless they were fortunate enough to buy some DOT or KSM a few years ago.
How much loan do we need? What interest do we pay?
This question is crucial. Before answering it, we first need to briefly understand the economic principles of DOT tokens. Let me explain token economics as simply as possible:
Polkadot's token economics indicate that in its "ideal" state, the following conditions hold:
- In a POS (Proof of Stake) mechanism blockchain network, 50% of DOT tokens will be staked through the normal staking system, with stakeholders receiving an interest rate of 20%. Remember that in a POS mechanism, interest is paid in tokens, so it is also the inflation rate.
- 25-30% of DOT tokens are stored in parallel chains (these tokens do not earn interest from the DOT/KSM network).
- 20-25% of DOT tokens are in free trade (these tokens do not earn interest from the DOT/KSM network).
How did they arrive at these numbers? Generally speaking, POS mechanism blockchain networks aim for 60% to 75% of staked tokens. The more staked tokens there are, the higher the security, but the fewer freely traded tokens, the lower the liquidity.
The uniqueness of DOT/KSM lies in their creation of a parallel chain structure, thus requiring a distribution of 60-65% of the stake between traditional stakeholders and parallel chains. Following this logic, we can see why, in an ideal state, the percentage allocated to parallel chains is lower compared to stakeholders:
If the percentage allocated to parallel chains is too high: more allocation to parallel chains → more DOT tokens stored in parallel chains → parallel chains become more expensive → demand for parallel chains connecting to Polkadot decreases, leading parallel chains to choose to connect to other blockchains. This is akin to airport rents being too high, causing airlines to move from Kennedy International Airport to another airport, which is not what we want.
Isn't this ingenious design worth noting? Building a system with parallel chain token deposits means:
- Parallel chains operate with real projects.
- The network's security is maintained not only by stakeholders but also supported by parallel chains.
- Because there is no need to pay interest on parallel chain token deposits, Polkadot can offer higher interest to regular stakeholders, attracting them to join the Polkadot ecosystem, thus drawing more stakeholders without causing excessive inflation.
In other blockchains without parallel chain designs, increasing the interest rate for stakeholders would lead to one-to-one inflation, but Polkadot does not face this issue because parallel chain token deposits do not earn a dime in interest from DOT/KSM! The creators of Polkadot have essentially shifted some of the inflation burden onto parallel chains that need to pay for crowdfunding loans.
What method did they use to incentivize the system to achieve a 50% stakeholder equilibrium to realize this "ideal" state?
If the staked tokens exceed 50%, they will sharply reduce the interest rate; conversely, if the staked tokens are below 50%, they will sharply increase the interest rate.
This is the interest rate (green line, y-axis) vs. staked tokens (blue line, x-axis) chart. Key point: If the percentage of stakeholders exceeds 50%, the interest rate will drop significantly, prompting people to withdraw their stakes, creating liquidity for DOT/KSM tokens.
Why should I consider these? Because the cost of parallel chain loans needs to compensate for the opportunity cost of traditional stakeholders staking on the network. The percentage of staked DOT/KSM tokens determines the interest rate, and thus also determines the cost of parallel chains. I will explain further below.
Now that the token economics have been explained, we can finally answer the question: How much loan do we need, and what interest do we pay?
How much loan do we need?
Based on the ideal state, we know that about 30% of tokens will be stored in parallel chains. From this, we can infer what this generally means for parallel chains:
In my experience, a project needs to borrow about 3 million tokens to participate in DOT, while it needs to borrow about 26,000 tokens to participate in KSM. This amounts to $96 million in DOT and $13 million in KSM, which is indeed quite high.
Currently, it is challenging for DOT/KSM to reach the 30% "ideal" state because projects are still in their infancy, and borrowing $96 million is very expensive.
How much interest do we need to pay?
Let's look at this from the perspective of DOT or KSM holders.
If I hold DOT or KSM, my options are as follows:
- Stake DOT or KSM tokens, ideally earning about 20% annualized interest on tokens.
- Lend my tokens to Project X for a year and earn interest in Project X tokens.
- Keep DOT or KSM tokens in a wallet, waiting for trading, earning zero returns.
For DOT/KSM holders, Option Three is not reasonable in the short term, as its yield is 0%, so we can exclude it. Therefore, Option Two needs to at least outperform Option One to incentivize holders to choose it.
Thus, our answer is: the "interest" we pay to the crowdfunding lenders (in Project X tokens) must exceed the 20% annual interest earned from staking (in DOT or KSM tokens).
It is important to note that the 20% interest rate is only possible when the percentage of staked tokens is at the 50% "ideal" state. If staking exceeds 50%, the interest rate and the borrowing cost for parallel chains will drop sharply.
The core question becomes:
Today, how much is the borrowing cost of a parallel chain in dollars? How will this dilute the hypothetical Project X? What is the implied interest rate of the crowdfunding?
Below is an illustration of the ideal state:
What happens if the percentage of staked tokens is in a non-ideal state? Here is the interest rate sensitivity:
What have we discovered?
I calculated that in the ideal state, the total interest for DOT and KSM stakeholders is about $3 billion and $4 million, respectively. This represents the opportunity cost of not choosing to stake all their tokens but instead lending DOT/KSM tokens to parallel chains.
Assuming there are 100 parallel chains, we divide the total interest by 100 to find the average cost each project must pay to stakeholders: $32 million for DOT and $4 million for KSM.
Think about how expensive this cost is for a startup! For a project currently valued at $100 million (like our extraordinary Project X), joining as a parallel chain on Polkadot would mean an annual token inflation depreciation of 32%, while joining as a parallel chain on KSM would mean a depreciation rate of 4%.
I conclude that it is unlikely for the "ideal state" to occur in real life because, until now, unless cryptocurrencies mature further, it will suppress the demand for parallel chain projects.
When the percentage of staked tokens exceeds 50%, the ideal state is disrupted, as shown in the sensitivity chart, and interest rates will drop sharply.
My intuition tells me that the equilibrium state achieved will be slightly above 50%, between 50%-60%, because the total amount of staked DOT tokens has reached 65%, and I don't believe that 15% of stakeholders will withdraw their stakes to participate in riskier parallel chain projects with DOT's returns.
Currently, KSM has 55% of staked tokens. Stakeholders are quite satisfied with the current 13% staking interest rate. I suspect that a 13% interest rate for connecting to parallel chains would also satisfy them. At a 13% interest rate, a project would spend $20 million to connect to DOT and $2 million to connect to KSM. If you ask for my opinion, I still think connecting to DOT is too expensive.
Although logically, we already know that joining as a parallel chain means we have to pay rent costs, the price of Project X's tokens will thus bear downward pressure, and projects on DOT are indeed more expensive than those on KSM.
We have worked hard to learn how to quantify this difficult inflation struggle. In this case, a project valued at $100 million will pay $20 million in interest costs, meaning their annual token inflation dilution exceeds 20%, while a $5 million project must offset a 40% negative token value dilution, which is quite outrageous!
Is there anything else worth mentioning? I think it's surprising how much cheaper it is to connect to Kusama: is Kusama "undervalued"?
Competitive Analysis: DOT vs KSM
Why do the values of DOT and KSM rise or fall?
People buy DOT/KSM tokens externally → the cost of parallel chain rent rises → aspiring projects cannot afford it, leading to decreased demand → DOT or KSM holders are no longer incentivized → the price of DOT/KSM falls → rent costs decrease, leading to increased demand for more projects, and the cycle repeats.
The supply of parallel chain slots on each network for DOT and KSM is fixed at 100, so demand is the variable factor; the demand for projects connecting to the network is the real driver of the stability of DOT/KSM prices. Which of the two has more project demand?
KSM is like a smaller airport next to DOT's main airport; let's change the metaphor from airports to nightclubs.
In my view, KSM is a cheaper, busier nightclub, while DOT is a more luxurious, expensive nightclub. However, if the cheaper nightclub consistently has more foot traffic, why doesn't it raise drink prices to balance supply and demand? If the luxury club doesn't have the same occupancy rate as the smaller club, it cannot raise prices further.
Let's review what we've just learned:
The quantitative research above indicates that the economic cost required to connect to Kusama is negligible compared to Polkadot.
The connection cost to Kusama is seven times cheaper. Indeed, just looking at the market cap difference makes this clear. But now we know that costs are calculated per parallel chain, and in reality, a project valued at $100 million would see its token value diluted by about 20%. Unless an aspiring project has a very high initial valuation, they would lose real token value by connecting to Polkadot instead of Kusama.
I believe that under this mechanism, the demand from smaller market cap projects will flow towards Kusama; they may initially just want to try it out but may never connect to Polkadot afterward.
Does this mean that only smaller, lower-quality projects will connect to Kusama, while better projects will only connect to Polkadot? Not necessarily.
Top-tier Polkadot projects will still connect to Kusama projects, as this is highly cost-effective for high-value projects. Especially in the emerging experimental digital economy, Kusama's economic value as a testing ground will offset its rent costs.
Kusama has the same functionalities as Polkadot but at a significantly lower cost, thus attracting more project demand. But how much more demand is there? Let's look at more numbers!
I found on Coingecko that in the Polkadot ecosystem, only about 20 publicly listed Polkadot projects have a market cap exceeding $100 million, while about 30 projects are valued at less than $100 million.
At today's prices, a dilution ratio of 30/50 or 60% would exceed 20%. Allow me to lament again that we haven't counted the unlisted projects, but this set of data can form a bell curve, which is quite representative.
Therefore, in the short term, the Kusama ecosystem will exhibit more asymmetric demand and supply imbalance compared to the Polkadot system.
The sevenfold market cap difference between the two is indeed significant; should I compare them?
With an expected staking rate of over 55% and an inflation rate of 10%-13%, projects connecting to Kusama today spend $2.5 million annually. If Kusama's market cap doubles, the cost rises to $5 million. If one can accept a 20% token dilution rate, then the market cap threshold would be $5 million divided by 0.2, equaling $25 million.
On Coingecko, I found that only 14/50 or 28% of projects fail to meet this standard. Even tripling Kusama's price would only exclude 18/50 or 36% of projects.
I believe there is still significant room for growth for both Kusama and Polkadot before reaching supply-demand balance. Because now projects can offset a 20% token dilution by raising Kusama's price 2-3 times.
If I were short on funds, I would bet on Kusama appreciating rather than Polkadot.
Where I Might Be Wrong
- I hope all my calculations above are correct.
- I am not a technical expert, so my inferences are based on the assumption that Kusama and Polkadot function similarly, which is crucial for our assessment of Kusama's demand. My interpretation of the Polkadot market does not imply any opinions.
- Some projects may "flow" to Polkadot, either upgrading to Polkadot or becoming accustomed to operating on Polkadot, thus no longer needing Kusama. My counterargument is that they will still use the Kusama ecosystem long-term to test new product features and updates before reusing them on Polkadot.
- A higher market value undoubtedly means higher security for Proof of Stake. Therefore, some may argue that Polkadot's higher security will bring more project demand than Kusama. Of course, I agree that Polkadot is more secure on this basis, but it is too costly, and not everyone can afford it. Do you think you can just snap your fingers to magically have a rental payment space at the main airport?
- If the entire market cap of aspiring parallel chains adjusts upward and can afford Polkadot's rent, then my argument would not hold. So far, this has not been the case, but the situation may change in the future, at which point the entire market cap of both Polkadot and Kusama will adjust upward.
