Value Investing in Proof of Stake Blockchains

Comparing Proof of Stake and Masternode Coins from a Value Investor’s Perspective

Proof of Stake (POS) consensus mechanisms are a powerful way to manage incentives for the security and governance of blockchains. Given their advantages over Proof of Work (POW) consensus mechanisms in terms of throughput, energy efficiency, and – for certain use-cases – quality of governance, it seems likely that blockchain ecosystems built on POS consensus will form a large component of the blockchain economy, assuming such an economy emerges.

Those who believe in the emerging blockchain economy and are looking to invest in it, therefore, would be wise to look closely at blockchains built on POS protocols.

The employment of a small number of validators called Masternodes has emerged as a viable sub-section of POS consensus mechanisms (and therefore a potential investment opportunity for those who believe in the emergence of the blockchain economy).

Such systems are generally referred to as Masternode (MN) coins.

A detailed explanation of MN systems and ideas for how to approach investing in them can be found in another article in this series. With a goal of understanding how to approach investing in POS blockchains, in this article we’ll focus on some of the disadvantages of MN coins, and by extension, the advantages of so-called “pure” staking coins.

To that end, a quick review of the basics of POS is in order:

Staking, as it relates to blockchain, is the action of putting up a balance of tokens as a security deposit for the right to validate transactions in a POS consensus protocol. POS mining is the process of holding coins in an unlocked wallet and leaving them connected to the network 24/7. Such wallets become network nodes.

These nodes, with proven stake in the game, are considered secure enough to validate transactions for the network. The nodes which validate correctly (ie. according to the rules of the open-source protocol of the network) are rewarded with transaction fees and/or a portion of minted tokens in line with the coin’s inflation schedule.

Nodes that break the protocol’s rules, meanwhile, are penalized by having their staked tokens slashed. Penalties can be a small loss of staked tokens for light infractions, or loss of the entire stake for severe infractions.

Staking typically requires the holder to download the entire blockchain, deposit coins in an official wallet and hold them there for a minimum set number of blocks before earned rewards are confirmed and paid.

To calculate the payout, the most common factors are coin age and coin weight. Coin age refers to the amount of time each coin is locked with the wallet open and online.

Coin weight refers to the number of coins held in the open wallet. In order earn staking rewards in a POS system, there is often no required minimum amount of staked coins. However, in general the more coins staked and the longer they are staked, the higher the chance of earning POS mining rewards.

The Similarities and Differences between Masternode and Proof of Stake Coins

The main similarity between investing in MNs and staking in POS coins is that they are both considered a means of passive income in the cryptosphere. Additionally, in both cases holding a certain amount of coins generates rewards.

Due to this incentive model, there’s a tendency to think that Masternodes and POS coins are the same. However, there are some key differences, and understanding them can inform a wiser approach to investing.

In the case of “pure” POS protocols, the act of correctly staking coins according to the protocol is all that is required to secure the network. The reward for doing so is paid out without the need for providing additional services.

In the case of MN coins, the MNs provide extra service to the network, such as hosting and maintaining the entire blockchain, and enabling features like instant transactions (InstantSend) and Private transactions (PrivateSend), governance, and voting rights.

Masternode holders are rewarded for not just securing the network, therefore, but for enabling these extra services on the blockchain. In this way we can refer to MN coins as Proof of Service or Proof of Commitment, on top of being purely Proof of Stake.

While the MN system can further improve upon both the efficiency of a blockchain (by enabling a higher level of throughput) and the value-added services provided within blockchain ecosystem (by enabling features like PrivateSend and InstantSend), it is also prone to certain disadvantages.

Specifically, due to the high barrier to entry for purchasing and running a masternode, MN coins tend to lead to a concentration of wealth in a given blockchain ecosystem.

Concurrently, by collecting most or all of the inflation and transaction fee rewards of a blockchain, the small number of MN holders – already the elite by way of their ability to invest large sums in the first place – are ideally positioned to get even richer off the backs of small holders and everyone else who uses the blockchain.

The high incentive to obtain MNs early in a blockchain’s development, combined with some founders’ decision to attract early MN buyers by offering extremely high ROI (typically by setting a high rate of inflation), has pushed many MNs into the kind of unsustainable growth and collapse that is typically associated with a Ponzi scheme.

It could be said that the structure of certain MN coins makes them more susceptible for “pure” POS coins to the unsustainable growth that leads to price collapse and ultimately chain death.

Investing in MN coins, therefore, requires the investor to not only identify and avoid the higher instance of unsustainable networks, it also requires investors to commit a large amount of money to purchase the coins required to reach MN status (currently around $100,000 to buy a Dash MN).

On top of this, investors in MNs must have a rather high degree of technical understanding (or access to a trusted counterpart who does); setting up a MN is complex, typically requiring the use of a virtual private server and the capacity to remain online 24/7.

MNs are heavily penalized for not being online 24/7 (and may even lose their coveted MN status), while most staking coins simply calculate payouts by the amount of time the wallet is online.

Relative to MN coins, therefore, POS and Delegated Proof of Stake (DPOS) coins have the lowest barrier to entry for investors looking to generate passive income in the cryptocurrency landscape.

Those looking to invest in such coins should, of course, consider the usual factors when investing in any open-source crypto project. First and foremost, investors should determine whether the project has a viable use-case by examining the white paper and other marketing materials.

Determining whether or not the project can achieve its goals requires consideration of its structure and roadmap as laid out in the published materials.

Investors should also make a careful examination of the team behind the project, the level of github activity, the engagement of the supporting community, whether high-profile investors are involved, if the project will run into legal/compliance issues, and so on.

Blockchains built on POS consensus protocols (including MN projects) are very much economic experiments. As such, the design of the economy plays a central factor in the success or failure of the project.

As with Masternode coins, the inflation rate of the pure POS coin is again crucial for determining the feasibility of the project.

Just as with masternode coins, the inflation rate – the minting of new coins – is what pays for most of the rewards distributed to those doing the staking.

If the rate of inflation is too high, chances are the blockchain will experience unsustainable growth, leading to price explosion and subsequent collapse.

Governance is Critical

It’s unlikely that the consensus protocol for a blockchain with wide-ranging use-cases (ie. one that, unlike Bitcoin, employs smart contracts) will have been designed perfectly from inception.

A blockchain’s governance, therefore, plays a critical role in determining the success or failure of the economic experiment it is conducting; governance, after all, is one of the mechanisms for making adjustments to the system, should they be needed.

Ethereum, which is in the process of switching from POW to POS, presents a fascinating example of blockchain governance playing out in real-time. The proposed Casper upgrade is a switch to a protocol that will govern the new POS consensus on the Ethereum blockchain.

The Casper protocol is said algorithmically adjust the interest rate (inflation) of Ethereum depending on the number of active validators.

Under the Casper protocol there will be no imposed limit on the number of active validators.

Instead the number will be regulated economically by cutting the interest rate if there are too many validators and increasing the reward if there are too few.

In this way, the Casper protocol should, in theory, result in a secure network that also has a sustainable inflation rate that is adjusted by the growth and/or contraction of the network.

For value investors, this is the kind of thoughtful mechanism that should be sought out.

Summary

The rewards paid out to validators for staking coins in POS consensus protocol range from 2% to 10% ROI. Given the volatility of cryptocurrencies, investors in POS coins are wise to consider the long-term viability of the project rather than the advertised ROI.

On average, pure POS coins are likely to have longer term sustainability than MN coins and therefore could be a safer investment.

In addition to the usual due diligence, investors in POS coins should consider blockchain governance as a strongly contributing factor for the long-term viability of the project/investment.

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