Masternodes: An Introduction

In peer-to-peer systems, full nodes play a vital role in protecting the integrity and efficiency of the network. On the Bitcoin blockchain, full nodes are defined as a running instance of a Bitcoin daemon such as a Bitcoin core reference client or other alternative implementations.[1] Essentially, full nodes are computers or servers that a) download the entire Bitcoin ledger b) fully validate all blocks and transactions against Bitcoin’s core consensus rules and c) provide services to other network participants. Such services include validating and relaying blocks and transactions, transmitting historical blocks to synchronizing nodes that were previously offline, and filtering transactions and blocks for lightweight nodes, also known as SPV (simple payment validation) nodes.

Unlike lightweight nodes, which only download the headers of blocks and rely on third-parties to validate the blockchain, full nodes are (fully) trustless in that they check all blocks against Bitcoin’s core consensus rules without exception. Thus full nodes serve as backbone of security for the blockchain, auditing the work of miners and the information relayed by other network participants. Yet the increasing costs and technical difficulties associated with running a full node effectively, in conjunction with the fact that there are zero built-in economic rewards for running a full node (besides the enlightened self-interest of participants who want to help the network) has resulted in diminishing incentives for full node operators. This is reflected in the number of Bitcoin full nodes in operation. From December 2016 to February 2017, the number of Bitcoin full nodes declined from 250,000 to under 6,000, although there has been an uptick since then (see Bitnodes’ data).

Many have written about the potentially perilous effects of the decline in Bitcoin full nodes, from increasing block propagation times to centralization. The centralization point is worth focusing on for a moment. The problem stems from the fact that many lightweight nodes are essentially programmed to trust and follow the majority of mining power, which itself has been de-facto centralized due to the high initial investment and specialized hardware needed for efficient mining. A steady decrease in the amount of full nodes puts more power in the hands of mining pools, which are already highly centralized. Fear of the vulnerabilities of centralization has prompted developers in the space to better educate the public and cryptocurrency enthusiasts on the topic, from encouraging laymen to run full nodes to calling for developers to seek long-term solutions.

In the midst of all this debate and discussion, we focus on a different approach to the Bitcoin full node system which has been trialed and implemented: economically incentivizing full nodes.

ENTER MASTERNODES: A SECOND TIER OF INCENTIVIZED INFRASTRUCTURE

DASH, a fork of Bitcoin released as XCoin (XCO) in January 2014 (then Darkcoin and finally Dash), was the first cryptocurrency project to utilize masternodes. Since then, masternodes have become increasingly popular, especially among privacy-focused coins. You can find lists of coins with masternodes and the associated costs and set-up information in curated lists such as this, this, and this.

Masternodes can be thought of as a second tier of incentivized infrastructure. They are full nodes that provide services and validations on the blockchain that miners do not, but unlike Bitcoin full nodes, masternode operators are rewarded economically, just like miners in a proof-of-work system. Masternodes are also called “bonded validator systems” — they require a bond or collateral in order to operate, and they provide validating services to the network. The exact “bond” required for operating a masternode varies across projects, but is usually set at a significant amount in order to ensure the masternodes perform their tasks correctly. If masternodes validate blocks incorrectly, for instance their bond is slashed. The high staking requirement also mitigates the risk that one party controls a majority of masternodes at once.

An example may be more illustrative. The specific stipulations will differ across projects, but we are using DASH as it was the first masternode system.

In the DASH framework, a masternode requires 1,000 DASH, a dedicated IP address and the ability to run the client 24 hours a day without more than 1 hour of connection loss per day. The 1,000 DASH masternode bond, which now amounts to a breezy $1.08 mil., is trustlessly held in escrow in a special Dash address. Each masternode fulfills unique functions on the DASH blockchain, namely instant transactions (InstantSend), off-chain anonymization (PrivateSend), and decentralized governance (DGBB).

In exchange for staking 1,000 DASH and running a dedicated full node, masternode operators are collectively rewarded by 45% of block reward on every block, equal to miners. The remaining 10% of the block reward is allocated to a treasury fund, which is used to improve the DASH protocol in ways determined by collective voting by masternode operators. Masternode operators are also paid fees from users who utilize a masternode’s services such as InstantSend, PrivateSend, or DGBB. Rewards and fees are paid in the network’s native token DASH.

There are currently around 4,000 DASH masternodes, staking approximately 18% of the total DASH supply and operating at an annual rate of return around 11%. This ROI remains subject to changing variables, increasing as transactions on the network grow, and decreasing as more masternodes are set up. Since masternode returns are inversely related to the total amount of masternodes, there exists a long-term equilibrium dynamic in which high ROIs attract more masternode operators which results in higher coin price (as the tradable supply of the coin decreases), and eventually a downward pressure on masternode returns. More data on various masternode ROIs can be found here.

PROS AND CONS FOR INVESTORS, USERS, AND NETWORKS

Masternodes are an interesting development with advantages and drawbacks. On one hand, incentivizing investors to provide services to the network means greater participation, and faster confirmation times. More risk-averse investors who nonetheless want to participate in the hot cryptocurrency ecosystem can look into masternodes as a way to earn a solid passive interest in addition to the appreciation of the underlying token itself. That being said, setting up a masternode remains technically difficult, making it an unlikely choice for everyday investors.

Furthermore, operating a masternode is stable, or more precisely, one-off in cost: it does not require renewed investment in specialized hardware like proof-of-work miners or a competitive savings balance like proof-of-stake stakers. Operators need only to maintain a flat amount of currency to participate. If the initial stake required for a masternode is prohibitively expensive (like DASH currently), users can look into a masternode pool where multiple parties pool their stake to meet the minimum requirement and share dividends, although users are cautioned to trust any such services at their own risk.

For users of a blockchain network, masternodes may signal enhanced stability and network loyalty, as there is a layer of the infrastructure incentivized by the large initial staking investment to stick around and do its job correctly. Various coins have different designs for dismantling a masternode and recovering staking collateral, but most payouts happen only periodically, which means that pulling out the collateral jeopardizes the most recent payout. Contrast this with miners, who can frictionlessly switch work across blockchains in response to changing rewards. Building a network of stable and loyal participants is quite important in the cryptocurrency space, where investment and development are rife with fickle speculation, pump and dumps, and other short termism.

The most interesting thing about a masternode system is perhaps its implications on the economic dynamics of a network. The built-in incentive to hold coins as a staking collateral suppresses velocity, which is defined as total transaction volume divided by average network value, and can be understood as the turnover rate of an asset or the amount of times an asset changes hand within a network. While assets require some velocity to achieve full intrinsic value, velocity that increases linearly with transactions exerts a downward pressure on network value. In token economic terms, this means that protocols that do not incentivize users to hold their native tokens for more than ultra-short periods will likely fail to maintain long-term token price appreciation, while protocols that incentivize holding or staking (in the case of a masternode system) can capture more value for token-holders. Multicoin’s post on token velocity cogently explains this point. The collateral requirement also creates a natural disincentive for masternodes to sell, which in certain cases may prevent against large drops in the network’s token price.

That being said, not all of the economic dynamics of masternodes are benign. Cases like DASH, where the minimum staking collateral has become prohibitively expensive, may create networks where only high net-worth individuals or entities control masternodes, as setting up a masternodes becomes too expensive for new entrants, and old entrants are pressured to liquidate their collateral once it becomes a high percentage of their net worth. In time, this may negatively impact decentralization. A system like Dash can also create an ecosystem in which a sizable portion of DASH tokens are held by masternode operators, something which may create larger short-term volatility in token price given the decrease of tradable supply.

MASTERNODES AND PRIVACY

Chain Intelligence has been looking into privacy coins for some time, and we are very interested in the exciting technical developments related to privacy-oriented projects. That is why we find it particularly interesting how masternodes figure into the infrastructure of many privacy coins, such as DASH, PIVX (a fork of DASH), ZenCash, etc. In the following section, we will discuss DASH’s masternode systems in relation to its privacy-enhancing functions.

DASH’s alleged improvements over Bitcoin is its ability to secure the anonymity and fungibility of assets and transactions, and faster payment confirmation times. As we explained in a previous article, Bitcoin provides pseudonymous privacy — that is, users can preserve their privacy as long as their pseudonym is not linked to their real-world identities. That being said, given that all transactions on the Bitcoin blockchain are transparently logged on the public ledger (with each block containing the sender address, receiver address and amount), researchers have developed ways to link an entire constellation of addresses and transactions to one pseudonymous actor (companies like Chainalysis do just that). If that actor’s real identity is compromised, e.g. at a point-of-exchange such as a merchant or a centralized cryptocurrency trading platform where a user must reveal/validate real-world identity, then one’s entire transaction history and on-chain assets become open to scrutiny and surveillance, severely compromising the user’s security and privacy.

DASH aims to solve this problem through its PrivateSend function, which uses a decentralized coin-mixing service modified from CoinJoin to shield transactions from linkability. The basic idea is that by pooling multiple transactions into a joint payment, you mask the inputs and outputs of individual transactions.

CoinJoin basic idea example: two transactions are joined into one while inputs and outputs are unchanged.

Yet CoinJoin has been repeatedly criticized for being vulnerable to exposing users’ transaction information. For one, the easiest way to create a CoinJoin transaction is through a dedicated server, a single point of failure from a privacy and fungibility perspective. Attackers could retroactively de-anonymize transactions by matching revealing input amounts with output amounts, or by working backwards from a point where the user sends his/her money to an entity that knows the user’s identity, like an exchange.

DASH claims its “extended version of CoinJoin” leverages decentralization, chaining approach, denominations, and passive ahead-of-time mixing to correct for such vulnerabilities. Each PrivateSend transaction requires at least three participants and uses common denominations (0.1, 1, 10, and 100 DASH) to avoid revealing input/output increments. Once 3 or more users initiate a PrivateSend transaction, their input, output, and amount are broadcast to a randomly selected masternode, which mixes their transactions. In order to further obscure transaction trails, PrivateSend employs a chained approach where transactions pass through multiple masternodes for up to 8 mixing rounds.

While PrivateSend offers marked improvements over basic CoinJoin, some have raised the possibility of such a system being subject to a Masternode Snooping Attack. Since masternodes are privy to all input and output addresses of to-be-mixed coins, masternodes can theoretically trace funds within its mixing cycle. Attackers increase their chances of tracing funds from beginning to end with each additional masternode they control. There are also concerns that since many masternodes are hosted on cloud-hosting services, such centralized servers could give up mixing logs if pressured by governments or related entities.

Dash’s reply is that given multiple chains of mixing and the high collateral required to operate a malicious masternode, it would be prohibitively expensive for attackers to control enough masternodes to even secure any probability of success in such a snooping attack.

CONCLUSION

Masternodes have been around since DASH’s implementation in 2014, yet they are only starting to receive popular attention amongst investors and crypto enthusiasts. This Google trends chart shows that we are at peak search interest of the past two years:

Much of the content generated on masternodes is either highly technical in nature or marketing masternodes (inaccurately) as a fool-proof method of generating passive income on cryptocurrency assets. As masternodes become more popularized and set-up becomes easier for non-technical investors, we believe it is important to think hard about the complicated token-economic dynamics and privacy implications of masternode systems.

References:

https://github.com/dashpay/dash/wiki/Whitepaper

https://medium.com/@lopp/bitcoin-nodes-how-many-is-enough-9b8e8f6fd2cf

https://www.investitin.com/masternode/

https://www.technologyreview.com/s/608716/bitcoin-transactions-arent-as-anonymous-as-everyone-hoped/

http://cdn.anonymousbitcoinbook.com/darkcoin/darksend-paper/Atlas_Darksend-Analysis-v001.pdf

[1] https://medium.com/@lopp/bitcoin-nodes-how-many-is-enough-9b8e8f6fd2cf


About Chain Intelligence — Based in New York City, Chain Intelligence is a technical consulting group dedicated to quality blockchain research pertaining to consensus protocols, token dynamics, product architecture, and technical viability.