Network Analysis Series Part 4: Examining the Solana Network
Authors: Lukas Bruell, Chris Smalley, River Fields
In the final installment of our four-part series, we analyze the Solana Network, focusing on its network design, gas implementation, token supply management, incentivization mechanisms for validators, and the economics of the system. Parts one, two, and three, which analyzed Ethereum, Avalanche, and NEAR individually (in a similar fashion), can be found with the following links: Ethereum, Avalanche, NEAR.
If you are already familiar with Solana’s background, please feel free to skip through to your desired topic.
An Overview of the Solana Network
Launched in March 2020 (with the idea having first emerged in a whitepaper published in November 2017 by co-founder Anatoly Yakovenko), Solana is a general-purpose layer-1 blockchain with a unique architecture designed to provide a blockchain network that is scalable with high-throughput and low transaction costs. Solana achieves its fast transaction speeds and native scalability through its innovative hybrid consensus mechanism that augments Proof of Stake (PoS) with its Proof of History (PoH) scheme, where transactions are automatically ordered through a unique timestamping mechanism.
Proof of History can be thought of as a cryptographic clock where transactions are timestamped with a hash that indicates when a block was created, providing a way to ensure an event took place at a given point in time. Under PoH, individual transactions are chained together as opposed to being grouped into batches of blocks and then linked together on a blockchain. On Solana, this chained list of individual transactions creates a verifiable historical record of all transactions on the network. Proof of History empowers Solana nodes to focus their attention on validating transactions and adding new blocks as the process of transaction ordering is inherently covered by the network.
The chart below indicates a few core differences between PoH (as it jointly works with Proof-of-Stake to provide an enhanced consensus mechanism on Solana) versus Proof-of-Work and Proof-of-Stake consensus mechanisms on other blockchain networks.
Source: Zebpay
Currently, the Solana ecosystem’s strongest narrative is NFTs according to recently collected data and market sentiment, with Solana boasting the third-largest NFT ecosystem based on transaction volume. Solana attracts creators to launch their NFT projects on the platform and users to participate in NFT collections through offering a unique set of advantages for both parties including high transactions speeds, low transaction fees, native scalability, and interoperability amongst other blockchain networks, providing an environment well-suited for a growing NFT ecosystem. The growth of NFTs on Solana has subsequently sparked innovation and experimentation on the network resulting in the development of intriguing new narratives. NFT-DeFi represents a compelling new area of interest within Solana’s NFT ecosystem, where core principles of DeFi are blended together with the gamification of NFTs.
On Solana, clusters are sets of validators that work together to maintain a ledger, helping validate transactions and secure the network. These clusters can coexist with each other, and in the instance two clusters are created on the same genesis block they will strive to converge; otherwise, clusters ignore the existence of each other.
SOL is the native utility token of the Solana network and is the 10th largest cryptocurrency with a market capitalization of over $6B at the time of writing this piece. SOL is used to cover transaction fees, to compensate validators helping secure the network, and to vote on governance proposals (where a given validator’s voting power is determined based on the amount of SOL they have staked).
Below are two charts providing key metrics regarding the Solana ecosystem and the network’s performance from Q1 2022 to Q1 2023.
Source: Messari
Source: Messari
Solana Economics
Network Supply — validators
Solana implements a Proof-of-Stake (PoS) consensus mechanism, incentivizing stake delegators and validators to help secure the network in exchange for SOL token rewards. The network has three primary objectives for utilizing this scheme:
1) Align the incentives of validators within clusters through all parties having skin-in-the-game
2) Deter nothing-at-stake problems on the network (situations where validators have nothing to lose by validating multiple versions of a block which can potentially lead to challenges reaching consensus on the network and ultimately impact the network’s security and integrity)
3) Reward validators for their work in helping validate/process transactions and provide network security
Any SOL holders can stake their tokens (delegate) to validator nodes to help process transactions and add new blocks to the blockchain and provide security to the network. In doing so, stakers receive token rewards for risking their assets to maintain the network. Indeed, by staking SOL to validators, stakers run the risk of having their SOL slashed in the instance of misbehavior from the designated validator node.
To become a validator and participate in network consensus, a user must create a vote account with a rent-exempt reserve (the specific amount of SOL needed to maintain the validator’s vote account) of 0.02685864 SOL. Validators would also need to submit a voting transaction for each block they confirm as valid on the network, costing them up to 1.1 SOL per day.
Delegators and validators receive staking rewards once per epoch (about every two days). The staking rewards accrued within a given epoch are then distributed in the first block of the next epoch. The staking yield (the interest earned from staked SOL), while represented as an annual figure, repeatedly changes per epoch as the network’s inflation rate and the total amount staked vary continuously. The staking yield is determined based on the network’s current inflation rate, a given validator’s uptime, the validator’s commission fee, and the percentage of SOL staked on the network. Below is the formula used for calculation:
Source: Solana Docs
A portion of delegators’ staking rewards is paid to validators (commission rate) to compensate them for their services to the network. When token rewards are issued, the commission fee is deposited into the given validator’s account and then the remaining rewards are deposited in all of the staked accounts delegated to that validator. Rewards distributed to delegators are divided proportionally based on the amount of SOL they have staked to a validator.
Token rewards and slashing align the incentives of stake delegators and validators to help maintain the network’s security and ensure efficient network performance.
Now, let’s move on to discuss token issuance on Solana.
Solana Token Issuance
SOL is an inflationary token with no hard card supply. On March 16th, 2020, 500,000,000 SOLs were created in the Genesis block. At the time of writing, there is a total supply of 549,569,926 SOL, with a circulating supply of 398,188,898 and a non-circulating supply of 151,381,028, according to Solana Explorer.
Over the past year, Solana has introduced a significantly higher amount of SOL tokens into circulation than it has removed through burning. Specifically, approximately 84.68x more SOL has been created than destroyed (burned) with about $652.1m worth of SOL introduced into circulation through token rewards and $7.7m burned or removed from circulation ($15.4m accumulated in total transactions fees with 50% of all transaction fees burned based on the network’s burning mechanism), leading to a long-term imbalance as token issuance far exceeds burning.
To achieve equilibrium, Solana currently requires a significant increase in its average daily active users (DAUs). Currently, there are about 172,741 DAUs, with an average transaction fee of $0.25 per user. Solana would then need to increase its DAUs to approximately 7,186,146, a 41.6x increase.
As previously indicated in the Avalanche and NEAR network analyses, it is not expected for the transaction fees per user to remain constant but instead to actually increase as the network becomes more congested and users become more inclined to include higher priority fees. Similarly, as more people use the network, it is likely more complex transactions would take place on Solana, also leading to higher transaction fees for users.
Solana’s token issuance rate is scheduled to decrease over time until reaching its long-term rate of 1.5% annually, as discussed below. While Solana would need to significantly increase its DAUs to reach a state of equilibrium on the network between token issuance and burning, the aforementioned critical factors indicate it would not actually need to have 7,186,146 daily active users but less to realize a state of equilibrium on the network.
Solana introduces new SOL into the ecosystem through token issuance based on the network’s predetermined “dis-inflationary inflation schedule” — where the inflation rate begins at its highest value and then gradually decreases over time until reaching its long-term, sustainable inflation rate. Here are the parameters of Solana’s inflation schedule (introduced by the Solana Foundation):
● Initial Inflation Rate: 8%
● Dis-Inflation Rate: — 15%
● Long-term Inflation Rate: 1.5%
In February 2021, Solana set SOL’s initial inflation rate at 8%, decreasing annually by 15% until reaching its ideal long-term inflation rate of 1.5% by 2031 (expectedly).
The graph below indicates some of the implications of Solana’s proposed inflation schedule. However, it does not take into account token destructive events such as fee burning or slashing and thus indicates an upper limit of SOL issued from the network’s inflation schedule.
Source: Solana Docs
Network Demand
Fees
Transaction fees are paid to process transactions on the network, and the leading validator node within a given cluster is responsible for validating and executing the transaction. Transaction fees provide critical benefits to Solana’s economic design by rewarding validators for their contribution to the network, deterring network spam by introducing real costs associated with executing tasks and supporting the long-term viability of the network through collecting SOL for every transaction.
Blockchain networks generally depend on reward issuance to validators to secure the network in the short term and then leverage transaction fees for long-term network security. Solana implements this methodology:
● 50% of transaction fees are burned (removed from circulation) with the remaining SOL going to the leader validator-node responsible for executing the given transaction
● Solana distributes token rewards to network validators based on the predetermined inflation schedule discussed above
Source: Solana Compass
The diagram above indicates how fees are utilized on the Solana network. A fixed portion of every transaction fee (50%) is burned to support the economic value of SOL, helping add to the security/sustainability of the network. The base fee refers to the general fee a user must pay to execute a transaction on Solana. A prioritization fee (discussed in greater detail below) is an additional optional fee that users can pay to increase the execution speed of their transaction, and a vote fee is merely a transaction fee paid by validators for every block they confirm on the network (the fee of up to 1.1 SOL per day discussed earlier in this piece).
Solana transaction fees are calculated based on a base fee per signature and the amount of computation required to process a given transaction (measured using “compute units”). Every transaction is granted a maximum number of compute units to process it (“compute budget”), and after that value has been met an error will be returned (indicating the transaction has failed).
Similar to Ethereum and Avalanche, Solana also introduced a prioritization fee that users pay to execute their transactions faster. This fee is calculated by multiplying the maximum compute units for the transaction by the price (measured in Lamports) to execute each instruction within the given transaction. Lamport is a denomination of SOL where 1 Lamport is equivalent to 0.000000001 SOL (or 1 SOL is equal to 1 billion Lamports).
In the next section, we examine Solana’s prioritization fee in greater detail and explore its impact on the system and economic designs of the network.
Key Economic Takeaway — Priority Fee Implementation
One of Solana’s most important upgrades last year was the implementation of priority fees, where users could pay an extra fee to avoid network congestion and prioritize their transactions over others within the queue. The additional boost can be particularly helpful for users involved in high network traffic scenarios such as users aiming to secure a mint of a highly-anticipated and coveted NFT project.
At present, Solana priority fees have been warmly received by ecosystem projects and users of the network. One of Solana’s prominent exchange aggregators (Jupiter Aggregator) enabled the feature within its platform. Similarly, by the end of Q1 2023, nearly 50% of all transaction fees on the network included an additional priority fee. While the additional fee increases the total costs for users, it should be noted that the final cost is still a fraction of a cent making it a negligible expense.
Source: Dune Analytics
The trade-off for faster transaction execution at the expense of higher gas fees on the Solana network differs significantly compared to Ethereum, where congestion around one part of the network makes the platform more expensive for all users. Solana, however, enables multiple transactions to be processed at once, effectively bypassing this issue. A recent CoinDesk article on the topic clearly illustrated this point with the following example: If a Solana-based exchange became congested as many traders were attempting to make a swap, the dApp would likely experience users paying higher fees to ensure their transactions were executed. This high traffic would not affect a fully separate NFT mint happening simultaneously on the network, for example. In contrast, on Ethereum, it would. These users would similarly be forced to pay higher fees to ensure their mint was successful.
Priority fees follow the same rules as base fees on Solana with 50% distributed to the validator who processes the transaction and the remaining 50% burned — potentially helping sustain/promote the value of SOL tokens.
Key Economic Takeaway — Data Analysis
In addition to examining Solana’s priority fee implementation (playing a critical role in the networks’ economic design), we conducted an OLS registration analysis of key metrics related to the network and found that burned tokens and validator fees are strongly significant (with a coefficient of 0.47) with regard to influencing token price. The results from our analysis suggest that a one unit increase in burned tokens or supplied side fees would increase the price by 0.47 units.
