Blockchains in 2018, Addressing the Challenges. Spotlight: Polkadot & Substrate

2018 has been a rough year for crypto in general. This is felt even stronger after the meteoric rise of 2017, which carried many people away, me not being exception of course. A year ago everyone was making retirement plans, browsing through Bali mansions on Airbnb, and picking a color for the Balenciaga sneakers and so on… or so I heard from a close friend of mine.

All of these dreams crashing is a good thing (at least this is how many counsel themselves). The carnage of the market and being as many call it #rekt, is a perfect time to look make a reality check of the technology and its fundamentals, not being consumed by speculation and price charts.

Having taken a fresh cold-hearted look on the blockchain space, one realizes, surprisingly to many, that there are still a lot of unaddressed challenges, which need to be fixed first before we can speak of the project valuations we saw a year ago as being fundamentally sane.

In this post I will cover the issues I see today from technological, business and legal perspective, look at possible solutions for those and zoom-in on Polkadot Network, as I believe it currently has the best shot to provide these solutions.

Table of Contents

  1. Technological Challenges
  2. Business Challenges
  3. Legal Challenges
  4. Overcoming the Technological Challenges
  5. Spotlight: Polkadot
  6. Conslusion

1. Technological Challenges

a) Scalability and siloed chains

One of the biggest challenges of blockchains in their current stage is their scalability. Blockchains today are clunky and not yet fit for neither enterprise-grade dapps nor mainstream adoption. Be it a hyped-up ICOs like Status or Bancor last year or a new crypto collectible game like Cryptokitties, several times already we have hit the wall when it comes to blockchain throughput.

In addition, most of the existing blockchains are siloed, which negatively impacts their security and decentralization (especially the smaller projects). Thus, when it comes to setting up newer chains with an own native token, it’s often hard to get these initially off the ground in a truly secure and decentralized way.

b) Privacy

In the era of data hegemony, data itself is the biggest source of revenue for finance, media and tech companies along with countless other industries. Therefore, the need to breach user’s personal data has become irresistible, resulting industry giants like Facebook to do the exact thing. One solution is blockchain but it itself in some extent worsens the problem since the flow of monetary value and script executions can be witnessed by others (although the identification of transaction participants are unexposed but nevertheless possible to trace).

c) Governance

In decentralized systems due to the absence of a centralized decision-maker to rely on, the topic of governance is more complex. It is the first time we can create economic systems from scratch via programmable money with monetary and fiscal policies encoded into it. With the power to create these, comes however the responsibility, complex nature of cryptoeconomics and interdisciplinary requirements to get it right.

2. Business Challenges

a) Disintermediation and vested interest

Blockchains are a lot about disintermediation. It is thus natural to assume that the parties being disintermediated are not fond of this. In most cases these are the rent-seekers along almost any industry’s value chain. This leads to opposition among the large stakeholders within most of the industries and opposition to innovation with any given company, since some of the new blockchain-powered business models can cannibalize existing ones. With Internet we took traditional business models and made them accessible through the web, with Web3, however, we are able to redefine the business models and build them in most cases from scratch.

I have experienced personally as well as with my current company the pushback of big corporates when it comes to innovation, where senior stakeholders are not willing to take the risk of trying new things out. This often has to do in my opinion with faulty incentives at the board level where stability and being risk averse is incentivized.

In the future of Web3, just like it was with the internet in late 90s — early 00s, only those companies would survive, which would be able to adjust and adapt their business models and take the risk.

b) Tokens as incentive machine

This part is probably the most interdisciplinary since, it finds itself on the verge of technology, game theory and mechanism design as well as behavioral economics, finance and business. Especially when it comes to utility tokens, we have a lack of practical examples and empirical data to prove that the incentives designed by the token designers actually work in real life. In most cases an own token for a every dapp causes unnecessary friction compared to legacy systems. Thus there is risk of most of the ICO-fueled utility tokens designs not to work as expected or more probably be phased out and be not too necessary.

c) Inflated expectations and greed

As with almost any disruptive technology, there come inflated expectations. Since its interdisciplinary nature, it is not so easy to understand the underlying tech without committing sufficient time into it. In this environment, blockchain acquired characteristics of buzzword and was thrown around a lot in the enterprise sphere. In such cases the promise and image of blockchains goes ahead of its tech progress.

Having seen the meteoric rise in crypto-asset valuations in 2017, a lot of people have joined the space out of FOMO and greed without wish to contribute to the space in a meaningful way. This partially was supported the rise of bolted-on tokens, in theory designed for cryptoeconomic incentives but in reality being there just to fundraise.

3. Legal Challenges

a) Fragmented legal frameworks

The nature of decentralized systems is global and thus transcends individual jurisdictions. The decentralized nature of the network makes it close to impossible to regulate. It is impossible for governments to regulate Bitcoin or Ethereum on protocol level, however there is a lot of fragmented regulation taking place on individual level.

b) On- and off-chain settlement for security tokens and/or tokenized securities

Security tokens (also the tokenized security) space is expected to grow exponentially in coming years solely based on the addressable market and the benefits tokens provide over traditional financial instruments. The key regulatory challenge of the security token space is directly tied to the topic of settlement. In other words how does one ensure the transfer of e.g. a physical asset like Painting X once the transfer of the “Painting X non-fungible token” is recorded on-chain?

One of the challenges here is the absence of regulated custody solutions. This is a double-edged sword however, since when the custodians will be developed, fitting the current legal frameworks, the gap between tokenized and non-tokenized securities would close, diminishing the original benefits tokens possessed.

c) Lack of incentives to change the existing regulation

Building on top of previous point, there is currently a lack of incentives combined with lack of technology understanding of legal stakeholders to develop new crypto-native regulations not to diminish the benefits of tokenization with complex compliance processes.

d) ICOs as innovation tool vs “bad apples”

ICOs have become a great tool of innovation, the way (in most of the cases) for the open source projects to finance themselves. A way to disrupt capital raising. The ease of capital raise via a decentralized network has however its downsides which are two-fold. Firstly, scams, both deliberate and non-deliberate can relatively easily raise a lot of money, thus harming the ecosystem. And secondly there is a danger of purely ICO utility tokens in the long term. This means that the token’s main goal was the fundraising, and the utility within the ecosystem was created artificially. This weak or complete absent cryptoeconomics can lead to a price crash in the long term. Most of these bad apples will attract the eye of regulator, potentially leading to over-regulation and also harming the legitimate teams and projects.

4. Overcoming the Technological Challenges

Scalability

Firstly let’s dig into scalability issue. There are many “new” blockchains coming up claiming a much higher TPS than existing ones. I like to think of the problem as “centralization slider bar”, one can pull the slider of centralization towards the right, thus enabling higher TPS with a trade-off of making the system more centralized. This does not, however, solve the problem, since we want systems to be both scalable and decentralized.

There are several second layer solutions currently in development addressing the scalability issue. Lightning for Bitcoin, Raiden Network and Plasma and Plasma Cash for Ethereum, sharding etc. Despite the great efforts of the respective teams, the problem, might lie a bit deeper. This has to do with general purpose blockchains. Ethereum is an example of one.

Scalability is an issue in the “winner takes it all” type of scenario, where there is just one or a few major general purpose blockchains allowing dapps to be run on top. I however believe in the future of many chains of application-specific nature, or in other words where dapps run its own blockchains, interconnected via cross-chain protocols such as Polkadot, Cosmos or Interledger.

This would allow blockchains to scale up and also foster innovation by allowing easy creation of newer application-specific chains using simple “toolkits”. Parity Substrate is a leading example of one.

This is also extremely relevant in the future of many chains, where each application would have its own token. Thus, in order to avoid friction and thus improve adoption, seamless cross-chain transactions are needed.

CZ, the CEO of Binance, compares the evolution of blockchains to the way chips space developed, where customized ASIC chips have come to dominate computing over general purpose ones.

Privacy

There are several privacy-oriented technologies like zk-SNARKs (implemented originally by Zcash), zk-STARKs, etc. The idea of privacy on the blockchain is to cover up not only the senders and receivers but also the transactions themselves. In some cases and in some industries there is also a need to keep the smart contracts private as well as the underlying data but still be able to run computations on top of it.

This could be achieved by interoperability protocols enabling communication between a public blockchains as well as either private one or a privacy-enabled one. Here, out of various cross-chain protocols, Polkadot is the most promising. Cosmos is focuses on value transfers across chains, while Polkadot also supports transferring of data and smart contract interoperability.

Governance

We have established that the governance of decentralized systems is extremely complex. The knee-jerk approach when designing a new system from scratch would be to lean towards full democracy. As we have learned from TheDAO however, in democratic process, very few actors are taking part in governance unless financially incentivized to do so. So it is not a simple.

Forks have proven to be successful way of governing, where blockchain communities split according to their vision of the protocol (ETH/ETC, BTC/BCH, and now the controversial BTCABC/BTCSV, etc.). These however also do not always solve the problem. One of the yet unsolved issues is the smart contract exploit which froze funds in several ICO wallets, Polkadot’s token sale wallet included.

We can try to solve governance by applying cryptoeconomics, using game theory and mechanism design to design incentives in such a way to incentivize governance.

In most cases we can only extrapolate that the cryptoeconomics of the tokens we design would indeed have the designed incentives once the dapp or the protocol goes live. This is extremely complex subject and I have barely scratched the surface if it.

5. Spotlight: Polkadot & Substrate

In its core, Polkadot is bringing together various consensus algorithm and allowing these to interoperate. Unlike other interoperability projects such as Cosmos, it’s not just about the transfer of value between chains but also transferring data and smart contracts being able to interoperate, the concept being currently one of its kind in the space. The concept of interoperable application-specific blockchains would help Polkadot to become the scalable platform for building dapps and enabling the vision of Web3.

The project is however evolving and not standing still. The best way to cater to the future of many blockchains is to provide an easy-to-use framework to build own blockchains and decentralized governance. Parity Substrate ergonomic blockchain framework is key in this case (read more here). Any blockchain technology can be built on top of it, as long as a proof of validity can be produced for its transactions. Polkadot is currently the first project to be live on testnet among the Web 3.0 projects.

What makes Polkadot so attractive to build own blockchains (parachains) and brings scalability is the notion of pooled security or pooled consensus. There is no need for developers to create a community of miners or validators to ensure the blockchain’s security since the existing pool of validators and nominators takes care of it. This allows developers to focus on their own blockchain development without taking care about the p2p consensus, effectively bootstrapping the security. This allows Polkadot to be less wasteful compared to PoW and even the sum of various PoS consensus algorithms.

The scalability issue is thus solved not only with having the transactions spread amongst the application-specific chain and having each of the blockchains contribute to the overall security, but also because it’s possible for any parachain to have its own parachains and so on.

Another key of interoperability and thus scalability of already existing independent blockchains is the concept of bridges, connecting the chains like Bitcoin and Ethereum to Polkadot, allowing Ethereum smart contracts for example to forward messages into the external world and/or other blockchains.

On the governance side of things, Polkadot also supports DAOs, funded from the inflation of the DOT-base and there would be proposals, which will be voted on by the stakeholders within the network. DOT holders are able to take one of several roles within the network like validator, collator, nominator or fisherman. Apart from that, DOT holders have complete control over the protocol, adding or removing parachains, as well as managing exceptional events such as protocol upgrades and fixes. Due to game-theoretic and mechanism design aspects of the network, good actors are incentivized with DOTs, while bad actors could face losing their stake.

6. Conclusion

The year-long bear market has given us a great opportunity to catch our breath, sober up and critically assess where we are today and how far away the Web3 vision is. Blockchains as of today are facing multiple challenges and limitations. These have technological, business, legal and cross-disciplinary characteristics. The general perceptions shift within the space is away from general purpose blockchains and towards application-specific ones. This provides the much needed flexibility to the projects, ability to focus on our blockchain’s business logic and rationale.

However with making our blockchain more performant and more flexible, we still have the issue of them being siloed and network effects are nowhere to be seen. This is the combination of application-specific blockchains and their interoperability that makes it possible in my opinion to address the existing challenges as well as foster adoption, both from developers as well as end-users.

There are currently two lighthouse projects in the space of interoperability, Cosmos and Polkadot. Both of them are in their early stages and are yet to launch their mainnet in 2019. I am excited to follow how these two projects move forward and would advise the same to anyone believing there is more to crypto than just speculation.

About the author

As a blockchain analyst at ASTRATUM, I am involved in a wide spectrum of activities, analyzing blockchain ventures and ICOs, applying cryptoeconomics and mechanism design to engineer tokens, conducting due diligence, developing blockchain strategies as well trading and investing into crypto-assets.

I am passionate about:

- Novel business models like masternodes, staking, validating/delegating

- Crypto-asset analytics and valuation

- Crypto-asset management

- Token engineering and mechanism design (game theory view)

- Smart contract platform research and analysis

- ICO/STO consulting

- Blockchain “deeptech” research

ASTRATUM is a Berlin-based blockchain venture studio, developing blockchain strategies, solutions and ventures. Besides corporate innovation in mobility, fintech 2.0 and real estate, we develop together with partners our own ventures. We are a founding member of German Blockchain Association.

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Gleb Dudka

Gleb Dudka

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Blockchain Analyst & Researcher | Staking and Generalized Mining | Infrastructure Provision. VC @GreenfieldOne, ex @StakingRewards, Deutsche Telekom