My preliminary analysis of the Polkadot ICO

In this article I'm going to cover some of the few facts that we know about the Polkadot ICO and add a little bit of my own analysis. The project is lead by Gavin Wood, founder and former CTO of Ethereum.

I saw him talk at a recent Ethereum London meetup and also read the whitepaper. The following links will be useful for insight:

Video of Gavin's talk at the Ethereum London Meetup
Polkadot's website (join the mailing list! :-) )
Polkadot's tech website
Polkadot's Whitepaper (pdf)
Polkadot's Reddit
Polkadot's Tech Reddit

What is Polkadot?

That's an interesting question. I have read the Polkadot whitepaper thoroughly and made notes as I went. It is a brilliant idea, but it isn't the easiest whitepaper to digest.

In Gavin's own words from his website: "a heterogeneous scalable multi-chain; the first of its kind."

In short: a means to facilitate cross-chain communication. This is a gross simplification but the idea is that you can move information from one blockchain to another with the assurance that the "transaction" is correct and valid. I may cover the technical aspect in a later blog but for now I'm going to give myself an easier time and only talk about the ICO.

Stephan Tual, former CCO Ethereum, provides a simple overview of the project on his blog "Introduction to Polkadot: what it is, what it ain’t"

Polkadot ICO

The latest update on the timescale for a Polkadot ICO is 'soon', but that may be the next couple of months or within the next couple of years. I think we ought to get more details before the end of 2017 but nothing seems to be concrete.

After hearing Gavin talk at the meetup in London I was hesistant about investing despite my interest in the project. After reading the whitepaper I think my 'hunch' were confirmed. In the whitepaper he talks about the value of the tokens (dots) in several places. It isn't entirely clear if Polkadot ICO will involve selling these tokens or something else in their place (e.g. tokens on Ethereum). If that isn't the case then some of my analysis could be incorrect.

When I look at this project from a technical perspective I see great things: this is next level thinking. If the team can make Polkadot function as intended then it ought to be massively disruptive. When I look at blockchain tech from an investment perspective I look at the economics of the tokens, as much as the technology, and try to guess if others also see the value in the technology and hence be willing to trade my money for tokens.

ICO lock-in / Illiquid tokens

There has been a suggestion on Reddit that there could be a 2 year lock-in period. This means that you won't be able to immediately sell your tokens. If I, as an investor, have to take an illiquidity risk then I expect a premium to be fetched for taking that risk: i.e. I want to get paid more for taking more risk.

A 2 year holding of the ICO investment isn't terrible by any means, but it is a barrier to entry and will deter some would-be investors. Moreover, once the project has launched Gavin expects the actual tokens (dots) to be fairly illiquid too. So there are two sources of illiquidity: the ICO (regardless of what tokens are issue), and then longer-term whenever the network is up and running (this will be the proper tokens).

How do I know the tokens used in the network will be illiquid for sure? We can't say for sure until the network is live, but it is the intention / expectation of the creator that the tokens will be illiquid. Evidence of this can be found in the FAQ on the last page of the whitepaper:

"Is Polkadot designed to replace (insert crypto-currency here):
No. Polkadot tokens are neither intended nor designed to be used as a currency. They would make a bad currency: most will remain illiquid in the staking system and those that are liquid will face substantial fees for transfer of ownership. Rather, the purpose of Polkadot tokens is to be a direct representation of stake in the Polkadot network."

That said, Illiquid does not equate to poor investment but rather that a premia should be paid for holding the tokens. If there are no premias then people will not want to hold them. People must be incentivised to run full nodes and help maintain the network. If such premia are inherent in the tokens then this could be a very good investment (disclaimer: not an endorsement to buy).

What value might the tokens have? Let's have a look at some of the clues.

Whitepaper, page 9, footnote 7:

"As a means of representing the amount a given holder is responsible inevitably encode some economic value. However, it should be understood any way for the purpose of exchanging for real-world goods and services, currency and as such the relay-chain retain its nihilistic philosophy regarding for the overall security of the system, these stake accounts will that since there is no intention that such values be used in it should be accordingly noted that the tokens not be likened to applications."

This suggest that while the tokens are not intended to be a currency they could have an economic value. The next question is to determine if that economic value is realisable through a sale: i.e. can the be traded? I don't recall seeing any details which made that explicitly clear. That would be the first question to answer. If the tokens are tradeable then a market can be made. To reiterate: Illiquidity is not necessarily a problem provided stakeholders can achieve premia for such a risk.

Inflation and dilution

One huge thing to be aware is that the supply of tokens is inflationary over an indefinite timespan. There is no upper limit on the total supply as there is in Bitcoin. Your first question will be to ask why? This is a mechanism to encourage participation: nodes (holders of the tokens) will receive a pro-rata payout from the rewards of 'staking' (Polkadot will be Proof of Stake). Those nodes (/holders) that don't take part will have their share of the total economy diluted. In some ways this does remind me of fiat money which are always inflating; the only way to avoid being completely diluted is to invest in risky assets which can provide a return investment: e.g. stocks. Return on cash is near zero in the current climate so essentially always at risk of dilution. As participating nodes receive a share of rewards then owning one is much like receiving interest on a bond.

This also reiterates the notion of illiquidity: by holding tokens in a node and using them in staking then the tokens are more likely to be 'hoarded'.

Conclusion

• Fascinating project that is, in my mind, taking blockchain technology to the next level.
• The ICO gives me some pause for concern as it has a 2 year lock-in period and the economic value is not currently clear.
• The tokens used in the network would be illiquid, but this is compensated by receiving a pro-rata share of the global staking rewards.

As an investor I want to be rewarded. I'm more than happy to donate to this project to ensure its success, and I'm also happy to have funds locked in for 2 years, but my level of investment will be far smaller if my 'return' is fuzzy feelings.

I'm watching with interest!

Disclaimer: I believe the details are correct. I encourage you to do your own research.
Disclaimer: this is not investment advice.
Disclaimer: this is not the opinion of my employer.