Tezos: consensus, governance and bakers
At Validators, we chose staking of Tezos crypto currency XTZ as a starting point for our business growth as we believe that Tezos provides great opportunities for the ecosystem development, innovative on-chain governance and attractive rewards for participating in the blockchain. In this post we are looking at the basics of the Tezos consensus algorithm, on-chain governance and the opportunities to earn crypto assets in Tezos.
What is Tezos?
Tezos is a platform for smart contracts and decentralized applications, or “a generic and self-amending crypto-ledger” as stated in the White paper. The main attractions for the users provided by Tezos include a variety of applications, self-amendment, high security and advantages of Proof-of-Stake consensus algorithm.
Tezos’ vision is to offer a platform for smart contracts and decentralized applications that cannot be censored or shut-down by third parties. According to the Tezos founders, the blockchain facilitates formal verification, a technique used to improve security by mathematically proving properties about programs such as smart contracts. As a result, proper application of this technique can help avoid costly bugs and the contentious debates that follow.
The idea of Tezos was born in 2014 when mathematician and computer scientist Arthur Breitman published the first white paper under the pseudonym LM Goodman. The concept was further developed with the support of his wife — Kathleen Breitman, who at present is the CEO of the company. The couple is based in San-Francisco, USA. In 2017 Tezos had a successful ICO in Switzerland which raised around 230 million USD. Also in 2017, following the interest in the project from the Swiss government, Tezos Foundation was created in Zug, with the goal to provide support to Tezos and related technologies.
When speaking about Tezos development, it is difficult to avoid mentioning one of the biggest scandals in the history of ICOs. The stories of internal conflicts, lawsuits, communication issues and regulatory confusions associated with one of the most successful ICOs in history can be found in abundance. At present, internal governance issues seem to be more settled and the company is focused more on developing the blockchain.
Self-amendment is probably the most debatable item in the Tezos blockchain setup. According to the founders, the on-chain governance system in Tezos ensures that in order to upgrade the protocol there is no need to split (“fork”) the network into two different blockchains which is considered to be a problem for many blockchains, like Bitcoin. However, some blockchain enthusiasts argue that the problem of forks is not solved yet and the proposed on-chain governance overall has generated some serious criticism in the industry (Ethereum´s Vitalik Buterin is one of the critics). It is too early to say who won the debate as Tezos is still evolving and there is not enough data for any empirical evidence. Time will tell.
Liquid Proof-of-Stake
Tezos consensus algorithm is often referred to as Delegated Proof-of-Stake (DPoS) meaning that the validation and creation of new blocks in the blockchain is performed by a set of delegates who manage the stakeholders’ assets. However, as Jacob Arluck explains in this post, Tezos consensus algorithm is better described as Liquid Proof-of-Stake (LPoS).
In the Delegated Proof-of-Stake blockchain, the stakeholders transfer their validating functions to a predefined set of delegates, without losing the ownership of the crypto assets.
The main distinguishing characteristic of LPoS is that the delegation here is optional and a set of delegates is dynamic. This means that an owner of the crypto currency can decide if she/he wants to delegate her/his assets and the validation functions, to perform validation directly or just hold the assets without supporting the blockchain.
A set of delegates in Tezos is dynamic which means that new delegates can appear while the existing ones can be excluded from the system (for violations of the consensus, for instance).The owners of the crypto assets are free to choose among the delegates based on their performance history and offered conditions. Therefore, there is a competition on the delegation “market”, and higher competition is generally good for a consumer as demonstrated by the economic theory.
Each time a block needs to be created or validated, the validators are chosen from a set of delegates and validators semi-randomly, with the probability to be selected increasing if their stakes are higher. Validators are also required to provide “bond”, or deposit which is currently expected to be 8,25% of the stake. The bond is “frozen” in the blockchain for several weeks and cannot be withdrawn, which incentivises validators’ honest behaviour.
On chain-governance
Together with the possibility to perform the validation functions, owners of Tezos crypto currency (Tezzies, or XTZ) receive voting rights on the system changes. On-chain governance of the Tezos blockchain assumes a decentralized approach to the management of the changes in the ecosystem, where all amendments are decided by direct or representative votes of the stakeholders.
Such governance system can be compared to a mixed democracy where citizens can participate in the governance directly or through representatives. Such democracy does not exist in a real world, as it would require a very complex institutional organisation, while in a blockchain ecosystem such arrangements become possible.
Tezos approach to on-chain governance is aligned with the ideology of decentralisation on which blockchain is built, where each stakeholder has a voice in the governing decisions. A stakeholder can choose not to participate in the vote, however usually it is in her/his interest to actually cast a vote as the changes can affect every stakeholder in the blockchain.
The system gives more weight to the stakeholders with higher stakes. The logical ground for this is that higher stake means higher impact and risk for a stakeholder. At the same time, there are some concerns about plutocratic nature of such governance. While to the present moment there is no real answer to such concerns, there is an opinion that the “liquid” characteristics of the Tezos consensus algorithm can be helpful to address the problem of plutocratic votes.
At present, when a crypto owner delegates her/his assets the voting rights are also transferred to a delegate. In theory, the interests of the owner and the delegate are aligned as the delegate’s earnings are proportionate to the ones of the owner. This way, the risks of the agent-principal problem are minimised. However, if a large share of assets is concentrated in one delegate’s hands or the stakeholders suspect that the delegate is not acting in line with their interests, they can re-delegate their assets to another delegate, or simply withdraw them.
Some delegates provide opportunities for crypto owners to express their opinion on the voting matters, through various communication tools (direct communication through messengers, informational blogs, etc) . If participating in the votes is important for you, we recommend to learn about the ways your potential delegate handles the issue before delegating.
The first vote on Tezos protocol was completed in March. The voters were choosing between options Athens A and Athens B. Athens A won with the majority of 18.181 votes out of 25.855 participating. While the options did not include any radical changes to the algorithm, it was an important step in the development of Tezos ecosystem.
Athens A, the voted-for proposal, will increase computation limits per block to allow for larger transaction throughput and will decrease the roll size from 10,000 XTZ to 8,000 XTZ (we will look at rolls in the next section).
Baking Tezzies
If you are reading this post as a potential investor, this is the most interesting part for you. How can you earn money by owning Tezzies?
While you can just hold Tezzies expecting higher price in the future, you can also make your investments more “active”. Here comes the so-called “baking” of Tezzies.
“Baking” is a name for validating used in Tezos universe. The validators in the Tezos blockchain are called “bakers”. Validators in the system perform their functions based on stakes, as Tezos uses a Proof-of-Stake consensus. Each new block is produced (“baked”) by a random validator and authenticated (“endorsed”) by 32 other random validators.
The blockchain rewards validators for baking and endorsing with a share of the inflationary growth of the crypto assets volume and transaction fees. The financial rewards incentivise bakers to provide blockchain infrastructure and actively participate in the consensus algorithm. The rewards are calculated based on a 5,4% nominal inflation rate. This means that the volume of XTZ is expected to grow 5,4% every year, nominally.
To hedge against dishonest behaviour around the time of block creation, Tezos requires bakers to put up a safety deposit for several weeks. If a baker explicitly tries to double bake or double sign blocks, she loses this safety deposit. As mentioned previously, the deposit is referred to as “bond” and required to be at least 8,25%.
Another concept in Tezos baking which is useful to know is “Rolls” — 10.000 XTZ bundles (which will be decreased to 8.000 according to the voted-for Athens A proposal). The more rolls a baker has, the higher her chances are to be selected for the validation. The size of the roll also defines the minimal amount of XTZ you need to start baking.
Your baking opportunities start when you become an owner of Tezzies. Here, you can either set up your own baker (consider requirements for deposit, minimum amount of 10.000 XTZ at stake, and a strong and reliable server which should be always online) or choose a baker to delegate to.
If you have a small stake of XTZ or if you are a big investor, you can find some compelling reasons to delegate your assets. First of all, specialised bakers have secure and reliable infrastructure which allows to minimise lost rewards (which can happen if when a baker misses block creation slot). Even if this happens, responsible bakers compensate their delegators for the loss. Furthermore, you can delegate even amount of XTZ which is smaller than the current requirement of 10.000. As bakers have many delegates, they benefit from the scale. Also, delegates take care of the deposit for you.
The deposit requirement can result in a baker’s “over-delegation”. Over-delegation can occur when the baker’s deposit drops below 8,25% of all the assets delegated to her. In this situation the blockchain will only pay out rewards on the stake that is hedged by deposit. As a result, some of the rewards can be lost. Responsible bakers always monitor their bond rates not to allow such lost opportunities and inform the users if they are close to be over-delegated and cannot accept any new delegations.
The return rate on baking Tezzies depends on several factors such as the baker’s infrastructure and quality of service, delegate´s commision and possible over-delegation. At the moment, the expected return on XTZ is around 7,2%. While there are crypto assets on the market which offer much higher returns, they usually come with higher risk. We think Tezos offers a well-balanced option in terms of risk/reward and definitely has a place in a balanced crypto portfolio.
We highly recommend choosing a trusted and responsible baker. To get more information about baking with Validators.com, we invite you to visit us here.
Disclaimer
This content has been produced by Validators IVS for general information purposes only. While care has been taken in gathering the data and preparing the content, Validators IVS does not make any representations or warranties as to its accuracy or completeness and expressly excludes to the maximum extent permitted by law all those that might otherwise be implied. Validators IVS accepts no responsibility or liability for any loss or damage of any nature occasioned to any person as a result of acting or refraining from acting as a result of, or in reliance on, any statement, fact, figure or expression of opinion or belief contained in this content. This content does not constitute advice of any kind.
