Masternodes (MNs) are often marketed as a stable and reliable source of passive income; a safer and more sensible way to invest in the volatile crypto markets.
This article aims to explain the true value brought by MNs with a view to making informed investments in them in the current market. To that end, a quick review is in order:
In the world of crypto, a masternode has come to refer to a computer that processes transactions on a blockchain and is rewarded with a portion of the blockchain’s expanding token supply for doing so.
Blockchains which employ MN systems require people (nodes) to hold a number of tokens in an official wallet as a precondition for setting up the MN.
This ensures that MN holders have a stake in the network, which is said to improve the network’s security. It also means that, particularly in the early stages of the coin, the buy pressure is high.
Blockchains that employ MN systems can be considered to be achieving consensus through the Proof of Stake (POS) model, which arose as an alternative to the Proof of Work (POW) model employed by first generation blockchains such as Bitcoin.
There are three main reasons usually cited for MN systems being a good way to run a blockchain:
1. They enable certain features that are harder to achieve than through POW consensus.
Masternode systems generally use the nodes to provide services like instant pay, private send, direct send, etc. These services are possible because the MNs are assumed to be trusted to validate transactions correctly.
By eliminating the need to wait for the usual 51% of the network to agree (as is the case with traditional POW consensus mechanisms) MN systems can run at a drastically higher rate of throughput.
2. They use fewer resources to achieve consensus.
MN based systems are claimed to be able to secure the network more efficiently than POW systems. The POW consensus mechanism requires validators to “waste” computing power as a way to prove they have skin in the game.
The argument is that MN holders, as large stakeholders in the network, are already sufficiently discouraged from cheating because doing so would render their investment less valuable, or indeed useless. MN blockchains, it is argued, can therefore process transactions reliably at much lower computational cost.
Critics here point out that the inefficiency of reaching consensus in POW systems is worth it to maintain decentralization.
MN coins are criticized as skewing towards centralization because:
a) The cost of setting up a MN can be prohibitively high (in the case of Dash, the biggest and most dominant MN coin, it’s currently just under $100,000 to buy the 1000 Dash needed to setup a MN) thus making them only available to the financial elite.
b) The limited number of MNs gives a dangerous amount of power to their owners, especially in MN systems that have implemented a cap on their number.
In both cases, the argument is that if only a select elite have the means to run the MNs that validate transactions, the management of the blockchain will be susceptible to human manipulation, even becoming politicized. This brings us to the last point:
3. They are potentially a good way to govern a blockchain’s growth and evolution.
MN coins offer alternative governance mechanisms that may prove effective in the long-term. There has already been an explosion in MN systems, with each new experiment employing slightly different governance mechanisms.
Some MN systems allow anyone holding enough tokens to run a MN, others limit the number of MNs and elect delegates to govern the blockchain.
Most MN systems set aside a portion of newly minted tokens and sometimes also previously reserved treasury tokens as a war-chest to fund the development of the blockchain. The allocation of these resources is typically decided by MN holders and other token holders, and directed to tasks like marketing campaigns and the payment of blockchain developers.
Critics of the MN governing systems point out that, in the name of improving efficiency, they reintroduce the very thing the blockchain revolution was seeking to eliminate: centralization. Supporters of POW systems like Bitcoin say that its resistance to change is a feature, not a bug.
How to Invest
People have been debating the merits of POS mechanisms relative to POW for years. Only time will tell how the debate evolves.
Moving forward into 2019 and beyond, those who understand the pros and cons of MN systems and wish to invest in them, must first and foremost conduct the usual due-diligence necessary for any crypto investment.
This means looking at the team, the github activity, the white paper, the level of community support, whether high-profile investors are involved, whether there is a pre-mine, and so on.
In addition to the usual due-diligence, for MN systems in particular it is essential to look at how the governance process is setup, the dollar amount needed to purchase the required tokens for staking, what level of rewards are given to MN holders (the ROI), and what stage the project is in.
Taking all that into consideration, we can divide investing in MNs into two basic strategies:
Strategy One: The Greater Fool Theory (Not Recommended)
Critics of masternode systems accuse them of being ponzi schemes, with those who got in early profiting at the expense of the later waves of investors. Indeed, a large portion of MN coins are clearly trying to attract uneducated investors by offering high ROI numbers for MN holders.
With dollar signs in their eyes, investors pile on: “Even if the coin dumps,” they think, “I’m still getting an ROI of 100% or more, so what’s the risk?”
The problem is that the higher the rewards offered to MN holders, the higher the rate of inflation of the coin. In most cases, the payouts are clearly unsustainable. Many MN coins have therefore pumped tremendously, only to run out of steam, crash 90% or more, and ultimately be abandoned by developers.
It’s also important to note that for “Greater Fool” MNs, the rewards offered by running the actual node are small in comparison to the ROI provided by price appreciation as the coin goes through its initial pumping stage. This means you don’t actually have to purchase a MN to benefit from Greater Fool MNs, you just have to purchase some tokens.
Greater Fool Masternode Case Study: Crave Coin
Crave Coin, which was was advertised to offer more that 75% ROI for MN holders, was in the initial stages, valued at pennies. If you had purchased the 5,000 CRAVE required to obtain a MN on Jun 1, 2017 at $0.16/CRAVE, the total investment would have been just $800.
A little over six months later, at its peak, those 5000 CRAVE were worth over $60,000, a gain of over 6500% (75X). The additional CRAVE earned during those six months by running the MN, meanwhile, would have added a trivial amount relative to the total gains.
Of course, the problem with actually investing using the greater fool strategy – in addition to it being morally dubious – is that it’s extremely risky. First of all, in this case, since the trend has already been identified, it is unlikely to repeat.
Secondly, as we’ll see, there is good reason to believe that the next alt-season, if it comes, will not float all boats as happened last time around. This brings us to the recommended strategy for investing in MNs:
Strategy Two: Value-Investing in Masternodes
With the majority of altcoins having seen a 90% correction from their all-time-highs, many traders who rely on technical analysis are signaling the start of their accumulation phase in anticipation of the next alt-season bull-run.
In the last run, total crypto market-cap went from less than $100 billion to over $750 billion in under six months, with Bitcoin dominance dropping to less than 35% at the peak of the run.
Now that we are again sitting at around $100 billion market cap and Bitcoin is again more than 50% dominant, the theory is that now is the time to start thinking about getting back into alts.
If you believe in alt-season, the question is: which alts?
In the last alt-season, buy pressure was so great that you could put your money into practically anything and still be disappointed at merely 2X gains. This time last year, crypto had gone mainstream: Bitcoin was making daily headlines and you could chat crypto with your taxi driver.
ICO marketing was directed squarely at retail investors who scarcely knew what they were getting into. In fact, as evidenced by the large majority of crypto hedge funds that were hastily set up in the second half of 2017 but are now showing 50 percent losses or greater, it could be argued that hardly anyone knew what they were getting into.
Supposing we do see another swing towards altcoins, it is likely that this time investors will have to be smarter about what coins they choose because the overall level of understanding of crypto is now much higher. The crypto-space has matured a lot in the last year.
Investors, having gone through the last cycle are now more intelligent (if they are still here), with access to more reliable and trusted information. Meanwhile, the masses already know about crypto, and – thanks to the 90% drop from the all-time-highs of early 2018 – the general sentiment is that much of it is a scam, so there’s a much lower chance of seeing another retail boom.
All of this means that this time around, you’re going to have to choose your investments much more carefully. Should you choose to invest in a MN, therefore, there are two basic approaches from a value-investor perspective:
1. The conservative approach:
Invest in a trusted MN system that has a proven track-record, is evolving progressively, and is now available at a favorable price.
With this approach you would choose from, for example, the top 5 MN coins (Dash, Ark, PIVX, ZCoin, Horizen), all of which have currently made almost full retracements from their all-time-highs back to their pre-run-up valuations.
The theory here is that if alt-season comes again, all of these “respected” MN coins are likely to do well. If alt-season doesn’t happen, at least these MN coins are less likely to disappear completely and you’ll get your steady 10-15% ROI while waiting out crypto winter.
2. The venture approach:
Look for added value services beyond the usual features provided by the first generation MNs.
The usual features are private send and instant send. The next generation of MN systems, sometimes referred to as Service Networks, put MNs to work offering additional services. Horizen, as an example, says its MNs will operate side chains that enable anyone to build privacy-based applications.
Another example is Swarm, which proposes to use its MNs as investment professionals who manage a portion of the Swarm Fund on behalf of the rest of the more passive token holders who merely vote on which MN (investment professional) to support.
The point here is that, as MN coins are experimental blockchain-based governance systems, the ones that are adding value for network users are likely to offer the greatest investment return over the long-term.
Beware of high ROI promises
No matter the approach you take, a rule of thumb for MN coins is that anything higher than 30% ROI as rewards for MNs is likely to inflate the money-supply of the network more than is sustainable by reasonable network growth projections.
Many projects advertise ROI of 100% or more. These should be avoided.
Investing in masternodes is, like all crypto investing, a high-risk endeavor. That being said, if you’re a crypto-believer, the innovative approach to blockchain governance employed by some MN coins, combined with the potential for steady passive income through MN rewards (at realistic levels) means that – particularly given the almost full retracement in the overall altcoin market cap since the start of the last bullrun – now might be a good time to get off the sidelines and into MNs.