Pitfalls of The Proof of Stake Paradigm
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Securing Proof of Stake networks is one of the most difficult challenges that the cryptocurrency ecosystem is currently facing. If we are to enter a new paradigm, the renaissance of crypto, where hundreds of new Proof of Stake blockchain applications are created each day, then we need to have not only tools to attract developers such as Cosmos SDK and Substrate but also secure incubation conditions where those projects can thrive.
Latest generation networks such as Polkadot, Dfinity, or Ethereum 2.0 allow an almost uncapped number of new blockchain applications to secure their operations through so-called sharding or “shared security”. Shared security enables new blockchain applications to reuse existing, trusted validators with pre-existing value at stake. However, just like in the case of Ethereum 2.0, those shards, which are the equivalent of parachains or parathreads, offer very limited economic incentives to investors that buy those dApps specific tokens. The lion part of network fees has to be either paid to the ”masterchain” or captured through locking mechanism by the main relay chain. Effectively making a native token of the mother-network a way better and conservative investment. This greatly undermines the value proposition and long term inflow of the foreign capital to such ecosystems, especially after foundation money (Ethereum, Web3 etc.) used to bootstrap new ecosystem projects starts to run out.
Investors can only hope that shards, once matured, could one day become their own independent zones, hubs or relay chains themselves, while maintaining a connection to the mother-networks through interchain protocols such as IBC or XCMP. However for that to become a reality there has to be a real value at stake, which means that clients must flock to the dApp’s and generate sufficient income to sustain the network operators.
Flawed tokenomics and maximalist tendencies of its authors often expose decentralized networks to threats such as nothing at stake, death spiral or security leaks, even if we ignore native token centralization, which is a huge problem as well. For this reason, in this ecosystem review, we will check out few of the fundamental issues that investors and the future tokenomics designers must be aware of.
1. Nothing at Stake
Security of the Proof of Stake is based on the assumption that the native assets “at stake” have value due to their blockchain applications’ ability to generate revenue through transaction fees and share this revenue with stake-owners. Although this statement might be true in the case of mature blockchain applications, it is definitely false in case of trying to secure new Proof of Stake blockchains by simply artificially printing and later inflating their token supply. It has to be thus clearly distinguished that “skin in the game” of initial investors is not equal to the real value “at stake” and that is definitely not proportional to often inflated and manipulated prices of tokens on the centralized exchanges.
2. Death Spiral
Lack of value at stake implies that network operators (validators) incentivized through block rewards are unable to sustain their operations, leading to decreased validator set, cutting costs on secure hardware setups, and eventual network halt. This issue occurs when validators and other network actors can’t realize the value of the inflated assets that they earn.
Even in case of networks that can sustain its operations, their security depends on access to the market, which is often not only illiquid but can be censored (delisting), leading directly to the death spiral of decreasing trust and size of the validator set.
3. Security Leaks
One of the most significant issues threatening Proof of Stake networks are security leaks, which occur when assets used to secure these networks are in the hands of centralized custodians. This issue is most prominent when voting power is proportional to stake bonded or if becoming a validator is permissionless. The main consequence of the security leak problem is a reduction of the Proof of Stake network security guarantees to the level comparable or in some cases lower than the Proof of Authority network. The most common example where this issue is most prominent is when centralized exchanges offer staking services and trading of stakes tokens at the same time, which effectively centralizes those tokens in hands of a single custodian. Those custodians are then able to influence or entirely take control of the network and pose an unfair advantage towards honest validators.
Security leaks even if not exploited can lead to the death spiral problems given market value in cryptocurrency markets is often correlated to the level of trust and safety of the supposedly “decentralized” ledgers.
4. Access to Foreign Capital
Almost all cryptocurrencies exercise maximalist tendencies by trying to force conversion of foreign capital into their native staking currency in order to secure new blockchain applications. This approach is flawed by introducing risks such as exposure to market volatility alongside downtime and double-sign slashing. Those risks exist even if the networks are not attacked, mostly due to market manipulation, human faults, and software or hardware malfunctions, which are unavoidable.
Finally, the process of staking is currently not optimized and does not allow to define risk factors that potential delegators are willing to expose themselves to, neither participate in multiple “virtual mining” opportunities or other DeFi products at the same time (assuming that not 100% of the capital is at stake) making it currently not only risky but also an inefficient investment.
Summary
Your choice to align with the specific ecosystem only for the purpose of the short term financial gains might bear long term consequences. The ability to distinguish between a “masterchain” ecosystems and a truly decentralized, interconnected blockchain applications can help prevent the cryptocurrency industry from going full circle, back into the world of handful centralized custodians and a single point of failure.
When deploying and designing new decentralized networks careful considerations have to be taken in order to address even basic vulnerabilities. In this ecosystem overview, we barely scratched the surface and it is clear that many of the prominent projects do not address even a single one of the pitfalls presented here.
Selecting the right framework, ecosystem, and making your new blockchain application successful requires unprecedented technical insight, access to capital, and know-how to engage clients’ base to compete with the world dominated by centralized applications that do not require any advanced skills and knowledge from their users. Decentralized applications need to be not only secure, but as easy to use as Venmo. Only then can we begin to see the true value of the decentralized, uncensorable and borderless world of crypto.
Authors
Milana Valmont, Co-Founder & CEO
Mateusz Grzelak, Founder & CTO
