Considerations on decentralization, network security, projected value and consensus
By Joseph Todaro and James Todaro, MD
Bitcoin introduced the world to the liberating properties of a decentralized, censorship resistant sound money in 2009. In a little over a decade, bitcoin demonstrated the tremendous power of a marriage between a decentralized network and money. This marriage is what first caught our attention and personal investment in 2013.
The creation of sound, censorship resistant, global money has always been inextricably linked to privacy. Satoshi Nakamoto carefully maintained his/her own anonymity, and dedicated Section 10 of the Bitcoin white paper to privacy. Satoshi encouraged the use of new key pairs for every transaction in an attempt for greater privacy, but acknowledged that this was suboptimal. It was the best technological solution available at the time though.
In 2016, after years of research and development, Zooko Wilcox and his team iterated on bitcoin’s core design by integrating privacy at the protocol layer. In our opinion, Zcash has achieved a level of privacy that is unparalleled — entrenching itself as a vital piece of cryptography infrastructure.
Fast forward nearly 3 years to present day, the Zcash network faces a critical decision regarding the possible extension of its “Founder’s Reward.” A decision is to be made by October 2019 to expire, alter or extend the Founder’s Reward in the form of a network upgrade at the time of Zcash’s first halving in October 2020.
Herein, we advocate a continuation of the Founder’s Reward, albeit marked by a reduction from the current 20% allocation of mining rewards to a more modest 10% allocation. We believe this will afford the continued success of the Zcash network without undue burden on future development while simultaneously strengthening the ZEC currency itself with greater censorship resistance and community unity.
Censorship Resistance, Decentralization and Network Security
Financial privacy in a cryptocurrency carries regulatory risks. It should be no surprise that a global, censorship resistant network allowing for the private transfer of wealth may not be embraced by governments and banks. Fear of money laundering, black market activities and terrorism are already becoming common regulatory talking points regarding cryptocurrencies. With the strongest privacy solution, Zcash could become a primary target of these attacks as adoption expands and ZEC increasingly captures value.
We are already seeing initial responses to the privacy component of the Zcash network by US regulated exchanges (e.g. Coinbase) that limit Zcash transactions to transparent “t-addresses.” Governments (e.g. Japan) have pressured exchanges to prevent the purchase and exchange of untraceable, privacy focused cryptocurrencies and, just recently, Coinbase UK delisted ZEC from its exchange among speculation regarding banking regulations.
The prohibition of privacy-centric cryptocurrencies will only continue to tighten with adoption. To withstand this pressure, Zcash’s greatest strengths are its decentralization and network security.
The decision to weaken decentralization or network security jeopardizes the longevity of Zcash and could render it a technical milestone in a footnote on the history of digital currencies.
As we explain in the subsequent sections, the Founder’s Reward weakens both decentralization and network security. It should be minimized and should not sustain a bloated budget — a practice that is rampant in early stage companies flush with funding.
Bitcoin has survived because it has no central point of failure. This is evident as history has shown that all of bitcoin’s predecessors were rapidly dismantled by government regulation and indictments (e.g. E-gold). Decentralization allowed bitcoin to persist and, some would argue, even forced governments to adapt more lenient regulations.
A large foundation with continual, algorithmically driven funding over 4 years is an attack vector. While the implications of an underfunded Zcash Foundation have been addressed in other proposals, the ramifications of an “overfunded” foundation have been largely unexplored.
The Zcash network must strive to operate as closely as possible to the proven network effects that have allowed bitcoin to flourish. The Zcash Foundation and Electric Coin Company (ECC) are central points of failure vulnerable to regulatory action.
We do believe the continued development of Zcash is important and merits funding. Moreover, Zooko and his development team have proven themselves to be incredibly competent and the “best fit” for continuing development on the Zcash network beyond the year 2020. For the sake of decentralization though, we implore the community to understand that every extra dollar allocated to the Founder’s Reward comes at the cost of widening this attack vector.
Perhaps as important as minimizing central points of failure is chain security. Proof-of-Work blockchains are largely secured by two fundamental components: the social contract of the network’s users and the economic incentives of mining. Bitcoin allocates 100% of the coinbase rewards to miners — making bitcoin the most secure and resilient PoW chain by many orders of magnitude. Currently, Zcash miners earn only 80% of the mining rewards.
At an annual new issuance rate of ~36%, Zcash has a proportionately greater miner’s reward-to-market cap ratio than bitcoin has today. This could lead one to argue that the Zcash network is presently “over-secured” in relation to its market cap. We believe that a proportionately greater block reward in a young cryptocurrency serves a dual purpose though: rapid decentralized distribution of coins and increased security during the vulnerable early years.
While an attack on Zcash may not be a profitable move, one could imagine that if the cost is low enough, a government or institution could see an opportunity to harm the Zcash network with an early attack. For this reason, we believe that the Zcash network is not, in fact, over-secured from this standpoint, especially given the controversial nature of privacy.
Over the next 5 years, we could see Zcash move from an experimental blockchain project to an established means of privately storing wealth and transferring value. With this expansion of economic utility, pressure will come from regulators and institutions alike as they lose the ability to monitor and control the movement of wealth. Aggressive regulatory attack is a likely outcome. With this understanding, it is imperative that network security is maximized through mining rewards. We believe a continuation of the full 20% Founder’s Reward unnecessarily weakens security of the Zcash network and departs too greatly from the proven bitcoin mining reward model.
Projected Value of Founder’s Reward
As of August 2019, the cumulative Founder’s Reward is estimated to be 1.4M ZEC, which, if sold on the corresponding days it was received, aggregates to 250M USD. This breaks down to a Founder’s Reward averaging 90M USD annually since the launch of Zcash in October 2016.
At today’s low ZEC price of 55 USD, the Founder’s Reward still amounts to 80k USD daily or 30M USD annually.
Current State of the Market
Sentiment in the altcoin market is low, and it’s even lower for the Zcash community. ZEC has been one of the worst performing large cap assets in 2019. Below are a few statistics highlighting ZEC’s subpar performance.
ZEC YTD performance is down 1% (USD denomination, Figure 1)
- The average YTD performance of the top 20 large cap altcoins is up 99%
- Competitor privacy-centric coins, Dash and Monero, are up 31% and 89%, respectively
ZEC is down 94% from ATH (USD denomination, Figure 2)
- The average large cap altcoin publicly traded since 2017 or earlier is only down 83% from ATH
ZEC is down 66% YTD (BTC denomination, Figure 3)
In summary, ZEC has vastly underperformed most large cap altcoins in 2019, including privacy coins Dash and Monero, as well as bitcoin. Sentiment and interest in Zcash are likely near an all-time low.
We followed advancements in zero-knowledge proofs long before the Zcash network was launched in 2016. We are invested in ZEC. We staunchly believe that privacy is fundamental to cryptocurrencies and have a positive outlook for Zcash. We point out the above statistics not to dishearten the Zcash community and ZEC investors, but rather to highlight that the despondent state of Zcash may affect the community’s projections on the future value of ZEC.
In the cryptocurrency sector, 5 years is not an insignificant amount of time. It is nearly half the lifespan of bitcoin. Entire market cycles in cryptocurrency last less than 5 years, with the most recent cycle, peak-to-peak, lasting about 4 years (Q4 2013 — Q4 2017). Looking forward, it is probable that a bull market will come to pass before the second halving of Zcash in Q4 2024, especially considering that we are already over 1.5 years out from the end of the last bull market in January 2018. We believe that it would be a mistake to make projections on the USD value of the Founder’s Reward based on the speculation that the exchange price of ZEC will remain in the vicinity of 50 USD over the next 5 years.
Moreover, bitcoin’s history has shown us that a decrease in the USD value of mining rewards after halvings are short lived. Actually, USD denominated rewards are often magnitudes higher merely a year or two after halving events (Figure 4).
A magnitude peak increase of 10x for ZEC from present value after the halving would result in a Founder’s Reward averaging an estimated 75M USD annually for an aggregate sum of 300M USD from the years 2020–2024 if the Founder’s Reward is extended at its current rate of 20%. Mind you, this conservative scenario would result in a peak price of ZEC of only ~600 USD — still far from its former ATH of 920 USD.
If, however, we reduce the Founder’s Reward to 10% of the miner’s reward, there would still be a projected 37M USD annually and an aggregate sum of 150M USD. We have yet to see a budget proposal from the Zcash Foundation that necessitates more funding than this, nor do we think more funding than this is fiscally responsible.
First, it is our understanding that after the halving in 2020, the new “Founder’s Reward” will be entirely allocated to funding research and development as well as any other direct efforts to advance the Zcash network. That is, funding will no longer be allocated to early investors in Zcash. This alone should increase funds available for the Zcash Foundation and ECC to continue operations after 2020.
Secondly, at risk of ad nauseam, we want to stress that every dollar allocated toward the Founder’s Reward decreases decentralization, chain security, and ultimately, censorship resistance. While the efforts by the Zcash Foundation and ECC this past year — specifically in research and development — deserve applause, we find recent expense reports released by the Zcash Foundation and ECC concerning.
In late 2018 and early 2019, most blockchain and cryptocurrency companies dramatically downsized operations. While operating at a loss, the Zcash Foundation and ECC, increased operations and expenses during this time. We are concerned that this spending behavior is reminiscent of that of state departments and governments. That is, a nation state will be spiraling into debt, yet state departments rapidly exhaust resources near spending deadlines in order to justify budget renewals/increases and avoid spending cuts.
It is the community’s responsibility to ensure that this behavior does not plague the Zcash Foundation and ECC at the expense of network decentralization and security. Decreasing the Founder’s Reward to 10% would be a step in the right direction.
The importance of the social contract cannot be understated in decentralized projects. Technology can be replicated, communities cannot. Each cryptocurrency has a certain set of rules. Altering these rules can fracture a community, especially a community that’s had a few years to coalesce around the social contract. It is incredibly important to establish a sustainable social contract as early as possible for decentralized projects.
The social contract for Zcash was a Founder’s Reward of 20% for 4 years, but failed to definitively address the Founder’s Reward after the first halving. Just recently, as the first halving approaches, Zooko and the Zcash Foundation proposed extending the Founder’s Reward at its current rate.
For reasons well-articulated in the proposal by Placeholder, we agree that Zcash will benefit from a continued source of funding dedicated toward development and other necessities of a young, evolving cryptocurrency. However, we believe that this social contract should set a sustainable precedent. If the social contract is such that the Founder’s Reward is simply extended at its current rate of 20%, then the precedent for future halvings will be set for a continuous extension of the Founder’s Reward at this rate. Most of the community would agree though that an indefinite 20% reward is inappropriate.
By decreasing the Founder’s Reward to 10%, the precedent is set that the Founder’s Reward is not indefinite and will decrease faster than simply the rate of halving. This social contract will restore the community’s faith in the decentralization of Zcash in respect to the following points.
- Zcash Foundation compromised to reach the greatest community consensus possible
- The Founder’s Reward will continue to decline over the next decade if this same approach is taken in the second halving in 2024
- Greater clarity on a sustainable social contract regarding the Founder’s Reward
Lastly, it is indeed possible that the majority of the community may vote for a simple extension of the Founder’s Reward at 20%, as proposed by the Zcash Foundation. However, a simple majority may not be the optimal choice. What about the remaining 20%, 30% or 49% of the Zcash community who supported decreasing the Founder’s Reward? What about all those who were initially excited about Zcash in 2016 but became estranged when the Zcash Foundation and ECC created the Founder’s Reward? By decreasing the Founder’s Reward to 10%, there is a good chance that minority voters will feel validated even if extending the Founder’s Reward was not their first choice. Perhaps some of the harshest critics of Zcash will see a decreasing Founder’s Reward as a path toward the level of decentralization and chain security of bitcoin and rekindle their interest in Zcash.
The founding Zcash team has accomplished a tremendous feat by integrating privacy with decentralized money. With the upcoming expiration of the Founder’s Reward, the community is now responsible for deciding the most appropriate path forward to ensure continued development, strengthened security, and ultimately user growth and value capture of Zcash.
In an environment where governments and banks are increasingly hostile to privacy-centric cryptocurrencies, decentralization and network security need to be strengthened as opposed to weakened. An extended Founder’s Reward comes at the cost of decentralization and chain security, and should be minimized as much as possible.
As early Zcash investors and fervent supporters, we believe that Zcash will undergo significant price appreciation over the coming 5 years mitigating today’s concerns regarding development funding. Although speculative, bitcoin’s history has demonstrated that miner’s rewards denominated in USD increase after halvings — easily absorbing the decreased output of the native asset. We see no reason that Zcash will significantly deviate from this trajectory provided a reasonable decision is made regarding the Founder’s Reward.
Finally, we believe that a decrease in the Founder’s Reward from 20% to 10% will unite the Zcash community by offering a compromise between terminating the Founder’s Reward altogether and extending the full 20% reward. This compromise may rekindle interest from parties who were originally alienated by the initial, unilateral decision of a large Founder’s Reward. The outcome would be a stronger community, increased network security and decentralization, and greater adoption for the Zcash network.
The managing partners of Blocktown Capital do not endorse or recommend any investment action in Zcash or ZEC. This document should not be regarded as investment advice. The managing partners of Blocktown Capital own ZEC. These views are those solely of the managing partners of Blocktown Capital and do not represent the views of the Zcash Foundation or Electric Coin Company — although we hope they will agree with this proposed course of action.