Crypto Market Commentary 

11 August 2019

Doc's Daily Commentary

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Checkmate's Corner


Project Overview

Tezos is a relatively new blockchain project which pitches itself as a smart contract platform with on-chain governance. If I was to summarise: Tezos is to Ethereum as Decred is to Bitcoin (in design intent only, not in relative merits). It essentially introduces an on-chain governance mechanism to enact protocol level changes in a smooth manner.


The idea is that on-chain governance by XTZ holders enables adaptability and implementation of features with the express approval and vote of stakeholders. This is an alternative approach to the governance model of Bitcoin and Ethereum where all decisions are made off-chain and agreed between the miners, developers and the users of the network  (nodes running code). The comparison between these models is an important distinction, we don’t know which model has greater longevity and it could be a right tool for the right job problem.


Indeed BTC and ETH governance have the longest timelines and the largest network effects. However my rhetoric has always been, the future is uncertain and variable and perhaps the surviving blockchain will need to be flexible in response. The counter point is that inflexibility is a strength, particularly for sound money protocols like Bitcoin.


Tezos has a 1 min block times and in general operation, is very similar to Ethereum. It features smart contracts and accounts rather than UTXO based transactions. There is a slight difference to Ethereum regarding the fee structure where a fixed cap is placed on the number of steps allowable in a smart contract to prevent excessive smart contract size clogging the network. Tezos also maintains a ‘state rent system’ similar to what is planned for ETH 2.0 where the amount of storage required by a smart contract on the ledger carries a fee in tez.

Network security and consensus

Tezos is a proof of Stake blockchain with a perpetual inflation rate to subsidize security. The network uses a delegation process for stakers who own less than the minimum 10,000 Tez required to operate a fully validating Baking Node (like a miner or an ETH 2.0 Validator). Bakers receive a reward of 16Tez plus any transaction fees in the block. As a note, the first protocol adaptation call Athens is now live which I believe lowered the Baker requirement to 8000 XTZ.


To avoid dilution by inflation (which is a maximum of 5.51%), one must post collateral up as a bond, sacrificing liquidity in return for securing the network and validating blocks. Collateral must be locked up for a period of “one cycle” which equates to around 2 days and 20hours (4096 blocks).


Each block is ‘mined’ by a random staker (the miner) which includes signatures from the previous block by other random stakers (the signers). Both Mining and signing are provided with a reward for locking up collateral for one cycle, sacrificing liquidity and opportunity cost. My understanding here is that there are layers of redundancy and multiple signatures in order to maintain consensus on the real chain based on the consensus rules. All parties receive a payout relative to the work and stake provided. If a bad actor is caught, they reward is stripped and their staked capital is slashed and distributed to honest nodes.


One thing I must admit here, it is extremely difficult to gauge whether this system is secure. The cycle time of ~2days is not a long lockup and therefore not exactly the skin in the game model one would hope for to enact protocol level governance votes. In my personal opinion, I am not convinced that pure PoS is an appropriate security system as the inflationary rewards are more like ‘not dilution’ rather than an actual reward. I do question whether this is a legitimate incentive or just a ‘not bad’ outcome.


Furthermore, delegation of votes by small users effectively turns Tezos into a dPoS network rather than a true PoS network. One thing to be aware of is that the majority of coins are held by a relatively small pool of users (discussed more later on) most of whom were KYC’d ICO participants and as a result, I am not overly comfortable with the censorship resistance of the Tezos network.


As a final note regarding network security, right now, there are only 79 nodes on the Tezos network. 44 of those are in the USA, 8 in Germany, 7 in Ireland and 1 in all other countries shown in blue. Not quite the most decentralised chain one would hope for and a potentially small pool of people (most of whom are KYC known from the ICO) with which an attack vector could be realized.

Figure 1 – Tezos node geographical distribution, all 79 of them…


The concept of on-chain governance is extremely interesting on paper, yet extremely challenging to properly execute. In order to have a viable system, a delicate balance between soft signaling (social media, Politeia, public discussion) and hard signaling (on-chain binding votes) need to be struck. In my opinion, there must also be some mechanism such that those who govern today are diluted such that without continued investment, they will cease to have superior influence unless they continue commitment. There are alternative views, particularly in the Ethereum community that stake on the line and penalties for bad actors is deterrent enough however this is a separate debate.


This is a risk intrinsic to Pure PoS systems as the inflation rate is evenly distributed amongst stakers. Those who do not stake are diluted by those who do. Large holders will have a large say in governance and since they can afford to stake large volumes, they are likely to be in a position of wealth and power in perpetuity. It is also important to establish whether the initial coin distribution was fair and reasonable as this can often pre-select the validators on the network permanently.


Some examples of how this has played out in other coins:


Bitcoin – holding BTC gives users zero governance rights. The Proof of work mechanism makes for compulsory sellers (the miners) who distribute coins through the network. Pure PoW is arguably the fairest distribution however has a very raw and slow governance process. A feature for Bitcoin, potentially a bug for competing projects (See last week’s report on ZCash governance). That said, users running nodes ultimately have final say in the consensus rules as was shown during the UASF fork wars in 2017.


Ethereum – the ICO participants still own 70% of the supply and distribution from PoW mining has diluted their share slightly over the last 5 years before the move to PoS. At the current ETH 2.0 design, stakers will be immune to dilution and thus will remain in governance control in perpetuity. Since Ethereum has off-chain governance, effectively stakers who own the security system will ultimately decide the consensus rules that they support, they are both the nodes and the miners.


Decred – initiated a genesis premine of 8% of the total supply with 4% airdropped to community stakeholders and 4% to the developers. This bootstraps the PoS and gives them greater say than miners in the early days. The 30% PoS block reward also means that over time, stakers are always diluted and therefore must continue to invest to retain governance rights adding skin in the game commitment. Decred has fully on-chain governance whereby stakeholders and miners both vote on consensus changes. Protocol changes need 95% of miners and 70% staker approval to proceed.


Tezos – As a pure PoS network with large stakes needed (8,000 Tez to Bake) and no staker dilution, there is a high likelihood that those who stake today will be the ones who stake tomorrow. The ICO was effectively a premine giving 100% of the circulating supply to early investors who can afford to keep capital locked up and also benefit from delegated votes from smaller users. Coin distribution relies on these Bakers selling their inflation rewards which may actually lead to price fixing as the supply side is owned by a discrete number of entities. At this stage, I cannot see any mechanism by which wealth inequality can be resolved in the Tezos network.


The main voting process held on Tezos so far was for Athens which is a protocol change that reduced the required stake from 10k to 8k to be a Baker. A whopping 1.82% of Tez holders showed up to vote…This is not uncommon for crypto networks with MakerDAO regularly seeing <2% of MKR vote. Decred is an example on the other end of the spectrum where 30% to 40% voter turnout is commonplace especially for protocol level changes.

Coin Distribution

For any Proof of Stake network, the network coin distribution is immensely important as it dictates who controls security on the network.


The Tezos initial coin distribution was via a somewhat controversial ICO mechanism that raised $230Million distributing tezzies to around 32,000 accounts and distributed 680 Million XTZ. The inflation rate is around 5% which if people are not staking they are diluted. I do question whether this is really interest or just ‘not losing money’.


In general, the Tezos genesis wealth distribution is disproportionately favoring large holders who participated in the ICO. What this leads to is a very high GINI coefficient of around 0.9 which is a measure of how disproportionate the wealth gap is in a particular system. What you will note in the graphics below is that Ethereum and Tezos both have relatively high Gini coefficients due to the ICO process whereas Bitcoin has a much more distributed wealth pool due to the PoW mechanism.

Figure 2 – Tezos genesis block distribution by account size and the Gini coefficient as a measure of wealth inequality (source: The Tezos Experiment)

Figure 3 – A snapshot of the Tezos distribution by Meltem Demirors who is operating a Tezos Baker (source: Medium link)


Tezos utilises Turing complete smart contracts very much similar to Ethereum where XTZ is used as gas to pay for computation and transactions on the network. From most reports, the main difference between ETH and XTZ in design is that XTZ has a semi-formal governance process to ‘self amend’ the protocol. In all honesty, it appears that this is the main distinction between XTZ and ETH. If you believe that Ethereum’s off-chain governance system is a problem that on-chain governance resolves, Tezos may be a good hedge. If not, there is not a great deal else that XTZ brings to the table in terms of functionality.


The main application of interest for Tezos has been the STO industry and asset tokenization. At this stage, a lot of news has circulated Tezos in this space however from my research there is only a one company (a Brazilian bank) looking to tokenise assets on the platform. A few of the tokenization companies like TokenSoft are enabling XTZ support however I see things as hedging their bets and allowing any blockchain to be supported rather than a specific endorsement of Tezos.


The one benefit Tezos seems to have over Ethereum in this regard are capacity for multi-signature which is necessary for proper custodianship of STOs. Ethereum has challenges as an STO platform as it is heavily distributed and smart contracts are tech heavy and prone to bugs. I suspect Tezos will have the same constraints.


That said, Ethereum has a growing moat of developer activity, network effects and STO infrastructure such as exchanges and issuers. Additionally, the concept of top heavy blockchains (where the assets hosted by the chain become very valuable) makes STO blockchains a security risk and thus security must be prioritized to deal with this risk. It is early days and Tezos will need to develop a significant following in order to achieve the required network effects and security required to become a true competitor.


Closing thoughts

I am an advocate for strong hard coded incentives in crypto networks that organically attract users, developers and security providers.


Bitcoin got it right, scarcity brings in users, price goes up, miners come in, rinse repeat.


Decred aligned incentives with the block reward structure of 60/30/10 to miners/stakers/builders. To retain governance control, you need to participate and continue to commit capital.


Ethereum is a weird beast but it strangely is working. It wins on attracting builders which then (ideally) leads to security and users. We will see with the transition to PoS whether the ICO wealth concentration becomes a problem.


Tezos has opted for the pure PoS (read: dPoS) system with an ICO distribution. It has an extraordinary wealth concentration and a questionable security model (most nodes are KYC investors). Is on-chain governance enough to compete with Ethereum’s developer capital?


I love all the experiments in this industry. However I am firmly of the opinion that most will fail and we must hedge our bets as intelligently as possible. At this stage in the game, it is way too early to call winners and therefore we have to work off the relative merits brought to the table.


For Tezos, I am not convinced that the security model, incentive structure of inflation vs not inflation and adaptability is going to be enough to compete with Ethereum 2.0 (if it launches). Since Ethereum is so flexible in what it can do in terms of smart contracts, the value of on-chain governance is heavily diminished in my opinion.


The STO market is the most promising outcome for the platform however the hype so far for Tezos is much louder than the reality. I am under no illusions that both Ethereum and Tezos are not designed specifically for this use case and as a result, I remain aware that they can be disrupted down the line.


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