The True Costs of Polkadot Crowdloans

Published in

Coinmonks

9 min readJan 3, 2022

Now is a very exciting time for Polkadot (DOT). Parachain slot auctions are underway and crowdloans are a novel way to democratize access to blockchain startups at their earliest stages. Incredibly, this comes at little nominal risks as you are guaranteed to get your DOT tokens back.

Although, this is a novel and incredible opportunity. It’s wise to be clear of the true cost of participating in a crowdloan.

What is Polkadot?

Polkadot is a L1 (arguably L0) blockchain aiming to find its niche not only as an “ethereum killer” but also as the network that holds together an “internet of blockchains”. It was founded by Gavin Wood, co-founder and former CTO of Ethereum. To this day Polkadot has developed one of the most innovative and ambitious blockchain networks out there, but with so many moving parts, including parachains, the Kusama “canary” network, and delegated staking, the user experience has been a bit daunting and difficult to understand.

These different innovations however, all serve important roles in securing and scaling the network, in a decentralized and trustworthy way. For example, parachains connect to the core relay chain and allow up to roughly 100 separate blockchain networks to process in parallel. These are all, in turn, backed by the core relay chain of the Polkadot network securing each of these networks and even allowing cross network interactions between parachains. They’re incredibly innovative and you can read more about them here.

To learn more about Polkadot in general, you can explore their website and whitepapers. For a quicker synopsis though, it’s also worth checking out the polkadot recap in the following video by The Coin Bureau. The video goes through a pretty concise and engaging explanation of the network.

In this article, I want to focus on parachains specifically because the parachain slot operators are selected though an auction.

It is this auctioning mechanism that opens up a whole new world of opportunity in the form of crowdloans.

What are Polkadot crowdloans?

A parachain slot operator is selected using an auctioning mechanism. It actually follows a pretty exotic auction process called a “candle auction”, but for simplicity’s sake, you can assume it goes to the highest bidder. Auction winners will have their DOT locked up for the entire lease period of the parachain slot (96 weeks).

Projects bidding for the auction can raise funds themselves, but more likely they will collect at least some of their DOT using crowdloans. Crowdloans are a built-in mechanism in Polkadot which allows DOT holders to “loan” their DOT to an auction bidder. If their bidder wins, the loaned DOT will be locked up for 96 weeks, and returned to them at the end of the lease period. The entire transaction is done securely on-chain and the Polkadot network handles the transaction so that the crowdloan participant never has to trust or transfer DOT to the bidder.

I will repeat this since this might save someone from a scam.

YOU NEVER HAVE TO TRANSFER YOUR DOT OR PROVIDE A WALLET PASSPHRASE PARTICIPATE IN A CROWDLOAN

Crowdloan participants don’t just loan the DOT out of the goodness of their heart. As I will talk about further down, even though you get your DOT back, you’re still paying for this. Thus, projects requesting crowdloans need to offer something in return in order to entice people to loan them the DOT. This usually comes in the form of tokens for the project.

This way, crowdloans democratize an incredible opportunity.

It allows anyone to act as small scale venture capitalists, offering a little bit of capital to early stage projects with the hopes that the project will succeed and the tokens they get in return will appreciate into bustling networks on Polkadot. Even sweeter is the fact that you know, no matter how the project does, you’ll get your DOT back after two years. So in the worst case scenario, it feels like a lossless lottery ticket!

Hidden Cost 1: Opportunity Cost

Nominally speaking, this euphoric glee is justified. You will get your DOT back after two years. I’m not going to tell you that there’s hidden fees or an evil little script surreptitiously draining your DOT a fraction of a penny at a time like some knockoff Superman villain.

Instead, I will point you towards an Economics 101 concept known as opportunity costs. Whether it’s a monetary decision like an investment choice, or a decision in any aspect of your life, the true cost of something is not only its sticker price, but also what choices you are giving up when you decide to pick something.

You can’t have your cake and eat it, too

For example, if I wired you $50 now or $100 tomorrow. The $50 you could get now is not free, but instead comes at the cost of getting $100 tomorrow. This is the opportunity cost of getting $50.

For crowdloan participants, the opportunity cost comes from other things they could do with their DOT. Namely, this is:

Stake them
Trade them

1. Staking DOT:

This is the clearest and simplest opportunity cost measurement when analyzing the value of a crowdloan. DOT tokens can be used to nominate a validator and get interest back. You can look here for a rough estimate on how much you would make from staking, but it would be roughly 10 ± 3%.

Thus, you should expect that the rewards from participating in any crowdloan after two years should be more than at least 10 ± 3% of the value in DOT.

2. Trading DOT:

Crowdloans are not the only way you could get access to the tokens of a project. Very soon after a project launches, those tokens that were released to investors and crowdloan participants will find their way onto exchanges and DEXes. In fact, you’ll probably see a point where a small supply shock will drop the prices of the tokens and give you a good opportunity to trade your DOT for tokens of the project.

Of course, this is a riskier play since you’re risking the DOT that you trade, but having this opportunity at all is something that you would give up if you lock up your DOT in a crowdloan. If your goal in participating in a crowdloan is to get exposure to these projects, then you might be better off just buying their token outright. You can get much more exposure to your project with a lot less capital by doing it this way.

Hidden Cost 2: Illiquidity

The other cost of crowdloaning DOT is that your DOT are stuck for almost two years. During this 96 week period, you cannot sell your DOT. We already mentioned the inability to trade them for other tokens, missing out on opportunities there.

What if you have a medical emergency and want to liquidate your DOT to pay the bills?
What if you anticipate a market crash and you want to liquidate your DOT before the crash?
What if you want to re-balance your portfolio because its currently outperforming the market?

In any of these cases, you can’t do anything with those DOT tokens.

They’re stuck in the crowdloan and you’ll just have to forget about doing anything with them for the next 96 weeks.

Losing access to liquidity, thus, presents a risk and you should be compensated for taking on this risk of locking up your funds.

Mitigating liquidity risk

I spoke above about how a crowdloan participant takes on risk by locking up their DOT for almost two years. However, there is an innovation where you can reduce this risk.

Polkadot locks any crowdloan contribution for the lease period (96 weeks). Contributing directly makes your DOT illiquid for that time.

However, what if I make a smart contract that will take your DOT and give you lcDOT and the stream of crowdloan contributor rewards in return? After 96 weeks, the contract will allow you to convert your lcDOT to DOT.

From the perspective of the contract, all the DOT that gets contributed can be put into the crowdloan. It can collect and distribute the rewards and after 96 weeks, it will receive the DOT back allowing redemptions.

From the perspective of the participant, the lcDOT received can be traded for DOT on an exchange. Because lcDOT is an IOU for DOT at a future date, it would need to be traded at a discount, but at least that option becomes available.

Moreover, you can use your lcDOT tokens to earn interest in a liquidity pool on a DEX. After 96 weeks you are more or less assured that lcDOT will trade 1 for 1 with DOT. You could, thus, farm the lcDOT to earn some good fees without much risk while you wait.

This exact offering is already available.

A protocol called Parallel Finance offers just such a service (link). They even sweeten the deal by offering Parallel tokens for participating in a crowdloan with them! This is definitely a great option to consider when participating in a crowdloan.

Another option is to invest through a CEX if it offers the opportunity. Binance, Kraken, and Kucoin are some exchanges that offer such opportunities, and might be significantly more liquid than direct contributions.

So why use direct contributions at all? It seems like this way gives you everything and more. Direct contributions however have one advantage. For the liquidity you get, you are required to provide trust.

In the case of Parallel Finance, you need to trust that the smart contracts are safe and that they will have the assets in them to distribute.

In the case of a CEX like Binance, you do not own direct access to your crypto so you have trust that the exchange will not freeze or otherwise take away your DOT, not only due to malicious or incompetent actions, but also from compliance with government regulators.

For many, the trustless, un-censorable nature of direct blockchain interactions outweighs the benefits offered by these options, but for most people the comfort of liquidity as well as other potentially stacked rewards makes this option quite an enticing one.

Weighing your options

Crowdloans are a wonderful way to “get in on the ground floor” for many projects in the Polkadot blockchain with minimal risk to your DOT contribution. Although you get your DOT back, your contribution is not free.

Consider what else you could be doing with your DOT, whether it be staking them as a nominator, or trading them for other investments. Also consider the liquidity you are giving up by locking them for 96 weeks. In crypto, that time-frame will feel like eons, and for better or worse, you’ll be forced to HODL any DOT loaned out.

If you want more liquidity, there are options to get it, but you’ll need to trust the protocol or exchange to do it, as they will effectively take custody of your DOT. Both options have their use cases, so if you’re going to participate, weigh which risk is more important to you and make your move accordingly.

If you use Parallel to join a crowdloan, you can support me and get a 5% bonus by using my referral code: 0x02652cd402af3940d31a5e904dfde9af0c652c5623566918746000358a2a3740
Kucoin referral code: https://www.kucoin.com/ucenter/signup?rcode=rJ3TEWH
I am not a financial advisor and views expressed in this article are not financial advice. Cryptocurrencies and smart contracts are complex instruments and come with high risk of losing money. You should carefully consider whether you understand how these instruments work and whether you can afford to take the high risk of losing your money. I encourage you to perform your own research before making any investment decision, and to avoid investing in any financial instrument which you do not fully understand how it works and what are the risks involved.

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