Research: Polkadot and Kusama bring a multi-chain future closer to reality

Polkadot and Kusama are named after the Japanese artist Yayoi Kusama, who became famous through her trademark polkadot art and installations.

Over the past months we have seen layer 1 protocols outperform the rest of the market, with faster and cheaper alternatives to ETH gaining traction as they offer attractive liquidity incentives and lower transaction fees. Protocols like Solana, Avalanche, and Terra have all taken the spotlight for the future big layer 1’s that will evolve alongside ETH, and whilst these networks are all strong in their own right, the main drawback at the moment is the fragmentation and lack of interoperability between these various blockchains. Bridging between them is still often a technical, slow, expensive, or centralised process.

As DeFi TVL and NFT activity continues to surge and flow into newer networks, it’s important to understand the value proposition of a layer 0 protocol like Polkadot and Kusama. These are both networks that do not aim to compete with ETH or Solana, and instead focus on creating a foundation for which layer 1’s and 2’s can build and scale off each other whilst connecting across various other chains. DeFi TVL is already hitting significant levels of $200bn, so creating the ability for liquidity to truly move across the fragmented chains with low and sustainable fees will be a huge exponential factor.

What are Polkadot and Kusama?

Polkadot and Kusama are fundamentally different to other blockchains we have seen in the current market, and were created by Gavin Wood in 2016, one of the core founders of Ethereum. Like Ethereum has EVM, Polkadot and Kusama are built on a new blockchain framework called Substrate, which allows significant improvements for developers with new features such as the use of pallets and being able to upgrade without hard-forks. The Polkadot design of a layer 0 protocol is an example of real innovation, where the relaychain provides shared consensus and security to an entire network of unique and app-specific subchains which are called parachains. Parachains are layer 1’s that have their own native token and governance, which inherit the security of the entire DOT/KSM network whilst still having sovereignty and control. This sharded-chain design means that the network can scale without compromising speed or suffering from high gas fees, with parachains being able to connect and scale off each other to create a true multi-chain ecosystem. Currently there’s a limit of 100 parachains on both Polkadot and Kusama, so in order for sustainable and democratic distribution, the slots are allocated via the auction process, which we will go into more detail further below.

Kusama was originally intended to be a test-net with real world economic incentives and therefore was called the “canary network” of Polkadot, with both networks sharing the same code and design. The canary network concept is something we have not seen before in crypto, and it ensures maximum security and stability on the Dot network, whilst still providing the economic incentives to make Kusama an independent and fully functioning network by itself. As Kusama started to launch it was quickly realised that it would grow as a unique and innovative network in it’s own right, whilst still acting as a “proving ground” for the cutting edge tech that would eventually be released on Polkadot. It’s easier to understand their relationship when we instead consider Kusama as the “mainnet” and Polkadot as the “Prestige VIPnet”. Kusama will encourage a culture of innovation and experimentation, whilst Polkadot will remain the most enterprise friendly blockchain which prioritises stability and ‘bank like’ security.

For example, the first parachain now live is Karura, which is a layer 1 on Kusama that offers a complete platform of DeFi products like a DEX, liquid staking of KSM, yield farms, stablecoin minting, and all without smart contracts by using substrate pallets instead. Most importantly, due to the unique design of Substrate, Karura has EVM compatibility built in, and additionally it can host layer 2’s that want to build on top of it. The first parachain’s launched focus on the core infrastructure, such as creating DeFi primitives and user-friendly bridges to the main networks like ETH, SOL, ATOM, and BSC.

Polkadot auctions will likely start in the next 2–3 months, but we have a strong insight into how it may begin now that KSM has launched 5 parachains, which have already shown significant price action as well as a smooth rollout of new and innovative blockchain tech. Whilst it can be confusing to understand why a team would launch both on KSM and DOT, it’s important to remember that both networks will evolve independently and will be driven by their respective communities. Whilst a team’s priority may be building on Polkadot, they will still use Kusama to roll out all their cutting edge tech first. Polkadot will also have much higher barriers to entry and is slower to move in terms of governance and network upgrades, so KSM will foster a community focused on more innovate and experimental DeFi, NFT, and gaming protocols. Eventually Polkadot and Kusama will be bridged.

The success of the first Kusama auctions has also shown how profitable the returns can be when crowdloaning, the process in which teams gain support to acquire a parachain slot. The wider crypto community is now starting to realise that parachain auctions are a much better way to replace ICOs, by incentivising users to commit to longer term sustainable projects, and forcing developers to showcase the genuine value they add to the network. Instead of just trusting 1 team or project, by investing in the parachain auctions users are trusting the entire decentralised network as a whole instead, knowing that their loaned funds will be secured until the lease is over. One of the most important factors to note, is that the growth so far has been all organic, with projects focusing on sharing knowledge and information about the underlying tech, rather than marketing budgets that prioritise influencers.

Parachain Auctions & Crowd loan Process

Becoming a parachain means that you can plug and play into the security of the entire Kusama network, which allows developers to focus on their application specific design without compromising security. This is a significant improvement from building a layer 1 from scratch or on an expensive network like ETH, where protocols need to change their use to fit the network, due to high gas and scaling limitations. To become a parachain, a team must win a slot through the auction process, a democratic way of allocating the limited 100 slots. Teams can either use their own DOT or KSM, or alternatively turn to the community for support via a crowd loan.

The “crowd loan” process allows individual crypto holders to lend or bond their tokens to bidding projects, who in turn reward this support with tokens. If the team does not win a slot, then the DOT/KSM are returned at the end of the auction round. The bonded tokens are locked on the DOT/KSM networks for the leasing period (48 weeks on KSM, 2 years on DOT), and then returned to the users afterwards. The cost for the holder is the lost opportunity cost of staking rewards and locking up their tokens for 48 weeks, but they’re rewarded with an attractive allocation of the parachains native token. The cost for the project’s team is that they’re giving their token supply away, but they gain a parachain slot which allows them to build on the network and therefore have access to the entire ecosystem. The current parachain teams all have plans in place to continue to fund parachain slots after their first lease ends, mostly through the use of their protocol’s treasury.

Some teams have the capital to self-fund, but as we’ve seen on Kusama, all of the teams have offered a percent of their total token supply as rewards for supporting them in the auction process. For example, if you backed Moonriver in the first round of KSM auctions, you would have been rewarded with 14.5 MOVR tokens for every 1 KSM. MOVR is now currently trading at $410, meaning that you would have made $5945 per 1 KSM, and you still would get your KSM back in 48 weeks once the lease period is over. The majority of teams have a vesting schedule where 30% of rewards are released on launch, and the remaining are distributed over the rest of the parachain lease period.

The more KSM that is locked in auctions also means that there’s less KSM staked on the network, which in turn means that the return from staking increases to incentivise validators, creating even stronger game theory for users to decide if they want to lock their funds for 48 weeks to back a project. The fact that teams have to keep winning slots to maintain their space on the network also forces projects to perform and deliver, in order to keep winning the communities support and/or raise enough funds themselves to self-fund a slot.

An overview of the first 3 parachains on Kusama:

Karura — DeFi hub, Marketcap $103m

The first parachain winner managed to achieve backing of 500k KSM, equivalent to over $200m. Karura will be the foundation for DeFi on KSM, and offers a complete platform to trade, borrow, farm, and various other unique features all with relatively tiny gas fees. Karura will be one of the biggest DeFi protocols on Kusama because it has also launched the first collateral backed stablecoin kUSD, which users can mint by using KSM. Karura have already launched several innovative functions like “bring your own gas”, where users can pay for the transaction fees in whatever token they use, as well as implementing the first versions of liquid KSM staking. This is a significant boost for liquidity on KSM, where users can still use their tokens whilst securing the network and receiving staking rewards.

Moonriver — ETH on Kusama, Marketcap $590m

The 2nd parachain slot winner has strong support from the wider crypto community, bringing ETH to Kusama by offering a Ethereum smart contract platform where existing teams can launch their EVM/Solidity applications with relatively little change, whilst offering users a familiar experience by using Metamask and most importantly having gas fees that are cents rather than $100s. Moonriver already has partnerships with the key ETH teams like Sushiswap, AAVE, DODO, and will see these platforms launch and bring liquidity to the network over the coming weeks.

Shiden — Smartcontracts and Dapps, Marketcap $401m

The 3rd slot went to Shiden, another key piece of infrastructure for the Kusama network. Kusama doesn’t have smart contract functionality by design, so Shiden offers a full suite of smart contract options for developers using EVM, WASM, and Ink! languages. Shiden will also take advantage of using Metamask to offer a user-friendly experience, and will have bridges to networks like ETH, SOL, ATOM, and BSC. One of the most unique features of Shiden is the Dapps staking, where developers can earn rewards for people using their Dapps.

Now that users have seen how successful the first auctions were on Kusama, there’s significant anticipation building up for the start of Polkadot. The first 5 teams to win a slot on Kusama will also likely be the first teams to win slots on DOT. Considering the large amount of capital locked up on Kusama, it could be entirely possible that the first 5 slots manage to lockup a value of over $1bn DOT.

The game theory will play a significant factor, with the crowdloan lockup period being 2 years on Polkadot compared to 48 weeks on KSM. Although this may deter short term investors, it will likely benefit long term holders who want to achieve ICO level entries in the core eco-system projects. The returns from KSM will likely also be a big catalyst for the DOT auctions, with every crowdloan so far significantly outperforming the rewards that would have otherwise been made by staking KSM instead.

The future for Polkadot and Kusama is promising and ultimately layer 0’s are necessary for blockchain to achieve the scalability and interoperability that is currently not possible. Polkadot and Kusama not only bring innovation to the blockchain tech through substrate and parachains, but they also focus on creating and experimenting with new forms of on-chain governance. The ability to upgrade without hard-forks is another significant improvement that will allow blockchain innovation to happen at a much faster pace.

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Crypto Market Insights and Thought Leadership by Covario AG.