Cryptocurrencies

What is Polkadot? The Beginner’s Guide

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Polkadot is one of the most popular smart contract platforms. It has built a unique infrastructure that can connect multiple blockchains together seamlessly. This article is a Polkadot beginner’s guide. We’ll go through Polkadot technology, history, and the potential as an investment.

Polkadot is solving the interoperability problem

First, we’d take a broader look at all cryptocurrencies and categorize Polkadot. This will help you understand the project better. We divide crypto projects into three categories: currencies, platforms, and tokens.

The best-known currency is Bitcoin. This category also includes Litecoin, Bitcoin Cash, Dash, and other similar coins. Currencies are designed to be digital P2P money. The main function is to store and transfer value.

The king of platforms is Ethereum. These are entire ecosystems, which run smart contracts and distributed apps (Dapps). You can think of platforms like iOS or Android. They provide a framework for software developers to build apps. Other known platforms are BNB Chain, Solana, Terra, and Cardano.

Tokens are always issued on platforms. They are usually either utility tokens or governance tokens. Tokens play a role inside a specific application. DeFi coins, such as Aave, Uniswap, or Chainlink, are good examples of tokens.

There is no doubt that Polkadot is a platform. Even if this is a case, analysts don’t really see it competing against Ethereum or other platforms. Polkadot doesn’t try to be a “world computer” for smart contracts. It is focused on solving the interoperability problem.

Below is a Polkadot presentation from the official Youtube channel.

Polkadot (and similar projects) are sometimes described also as “the internet of blockchains”. Cosmos is currently another popular project that competes in this niche.

Polkadot has a native token with a similar name. The ticker is DOT. The Polkadot token has two major functions: it is used to pay transactions (gas fees) and it is also used in governance (staking).

Next, we’ll dive into the history of Polkadot.

Polkadot is founded by Gavin Wood

Even if Polkadot has reached wider publicity in 2020, this project goes back many years.

The founder of Polkadot is one of the most famous names in the industry, Gavin Wood. He is one of the original founders of Ethereum, which is nowadays the only truly significant project in the industry after Bitcoin.

Gavin Wood was the CTO of Ethereum when the project was launched. There weren’t many developers working for Ethereum back then, and Wood was one of the core ones. He has also written the Ethereum yellow paper and created the Solidity programming language.

Gavin Wood is certainly a name any crypto enthusiast knows. His involvement is one of the main reasons so many people are interested in Polkadot. See Gavin Wood’s interview below.

Gavin Wood left Ethereum already in January 2016. The public opinion is that Wood was frustrated with the development process of Ethereum 2.0, which is still being developed today.

Wood started to work with his own vision of how Ethereum should have become. He published the Polkadot white paper in October 2016.

Around this time, a development company called EthCore was also established. It included other former Ethereum team members with Gavin Wood. This company was later renamed Parity.

In 2017, Web3 Foundation was established in Switzerland. This is a non-profit organization overseeing Polkadot development. It is not a big surprise that Web3 Foundation chose Parity to build the Polkadot ecosystem.

Web3 Foundation was also behind the Polkadot ICO in October of 2017. This was in the middle of the ICO boom, and the name of Gavin Wood helped to raise 145 million dollars for the project. This was a much larger sum than the average ICO raised.

Despite a promising ICO, things derailed fast. Most of the ICO funds were lost due to hacking of the Polkadot multi-sig wallet. At the time, this was over 500,000 ETH meaning over 90 million dollars. The case is known as the Parity wallet hack.

Polkadot had already suffered a similar attack earlier in 2017, where over 30 million dollars were lost.

The team continued development despite these huge setbacks. This was the right decision since Polkadot has since raised more money and built a working product. The team got over 100 million dollars in 2019 and 2020 through private funding rounds.

Polkadot was pretty much hiding in the shadows until the summer of 2020. It was barely mentioned in social media and there was no major interest. This all changed when the Polkadot MainNet was released. The MainNet was first run by the Web3 Foundation and decentralized in July 2020.

The other major event after the MainNet was the launch of parachain auctions. This process began in November 2021 and the first parachains were running in the Polkadot ecosystem in December 2021. We’ll come back to this topic later in this article.

The price development of the DOT token

The Polkadot token had been pretty stable in 140-150 dollars from 2019 to the halfway of 2020. When the MainNet was launched, the token price went over 300 dollars before crashing to 3 dollars. There is a good explanation for that.

The Polkadot community decided to multiply the number of coins in circulation by 100x. This meant that the price of each DOT dropped to one hundredth from before. DOT token’s price history data often starts from this point.

dot-price-history

Polkadot’s price has followed the general altcoin market in recent years. It did not react to the rise of Bitcoin in late 2020 but soon after ten-folded its price during the altcoin rally in 2021. At the beginning of November 2021, DOT reached its new ATH. Most altcoins reached their 2021 peak prices around the same time.

At the time of writing this article (2/2022), Polkadot’s price is about 69 percent below its ATH. Many other well-known altcoins have dropped more than 60 percent from their peaks.

Polkadot’s relay chain 

As mentioned earlier, Polkadot is not a direct competitor of Ethereum. Polkadot has built an architecture that connects different blockchains through Polkadot’s governance model. The blockchain that controls the ecosystem is called the relay chain.

The relay chain is not a smart contract blockchain, so no dapps will be built there. In the Polkadot model, each decentralized application (dapp) gets its own blockchain. These are called parachains. The system is significantly different from Ethereum, Solana, and other smart contract platforms where all dapps are built on one layer.

The relay chain could be called a ‘master chain’, while parachains can be thought of as side chains. The relay chain handles the safety of the Polkadot ecosystem. Staking takes place on the relay chain too. In addition, all of the parachain transactions are validated by the relay chain.

Polkadot uses a Nominated Proof of Stake (NPoS) consensus algorithm. It is quite similar to the popular Delegated Proof of Stake (DPoS) algorithm.

polkadot npos

The basic idea for both DPoS and NPoS is the same: blockchain is maintained by a certain number of validators. These, in turn, are staking the native token. In Polkadot’s model, selecting (or voting for) the validators works slightly differently. There are usually only around 20 validators in a DPoS system. In Polkadot, there are hundreds of validators.

Becoming a validator requires support (staking) from parties called nominators. Each nominator must stake a minimum of 120 DOT tokens. It can stake tokens for up to 16 different validators. Each validator must stake a minimum of 350 DOT tokens.

With Polkadot’s Nominated Proof of Stake, nominators select up to 16 validators they trust, and the network will automatically distribute the stake among validators in an even manner. Polkadot uses tools ranging from election theory to game theory to discrete optimization, to develop an efficient validator selection process that offers fair representation and security, thus avoiding uneven power and influence among validators. Another key difference in Polkadot’s Nominated Proof-of-Stake in that nominators are subject to loss of stake if they nominate a bad validator. (Source)

The nominator has also a risk of losing some of its tokens if the validator they vote turns out hostile. This is not possible in a DPoS solution.

Each parachain has its own validators as well. These are called collators. They send transaction data to relay chain validators which confirm and store the transactions to the Polkadot blockchain.

Validators of the relay chain are therefore responsible for maintaining the entire architecture. Each validator is responsible for the data of a particular parachain, but these responsibilities circulate randomly. This ensures that validators can’t collude to corrupt the data.

Polkadot parachains

In Polkadot’s architecture, all applications are developed on parachains. Each dapp has its own parachain, which can also be customized to meet its needs. Parachains have even their own native tokens, which means they are full-blooded smart contract platforms.

Each parachain is linked to the aforementioned relay chain. The image below illustrates architecture well. It has six different parachains (A,B,C,D,E,F) and the relay chain in the middle.

polkadot-parachains

There can be a maximum of 100 parachains in the current Polkadot architecture. There are three different types of parachains: common good parachains, parathreads, and ordinary parachains.

A common good parachain is a kind of utility parachain that provides important functions to the entire ecosystem. This could be for example a bridge between Polkadot and Ethereum. An estimated 10-20 of these kinds of slots have been reserved. Each common good parachain is selected separately through the governance mechanism.

A parathread is practically the same as an ordinary parachain but can be sold for the highest bidder. There are around 10-20 of these.

Parachains, on the other hand, are being auctioned. This process will be explained in detail in the next paragraph. There are an estimated 70-80 parachain slots available. The exact number depends on the number of common good parachain as well as parathreads.

All Polkadot parachains are compatible because they are built with the Substrate architecture. Substrate is a tool that makes it easy to build a blockchain in the Polkadot ecosystem. It can be compared to the SDK of Cosmos.

Polkadot has created a separate XCM protocol that allows parachains to communicate with each other. Polkadot Wiki contains more information about this.

Parachain auctions and PLO

We have already mentioned parachain auctions a couple of times in this article. They began officially in November 2021. The first parachains went to projects called Acala, Clover, Moonbeam, Astar, and Parallel.

As stated in the previous paragraph, there are only limited slots available for parachains. In theory, the maximum amount is 100, but parathreads and common good parachains reserve some slots. Parachains slots are decided in auctions where the DOT token is used.

Parachain auction works like a typical auction. Anyone can participate and stake their DOT tokens in the project they want. The project which has the most DOT staked wins the auction. Polkadot is using a candle auction model that is hundreds of years old. It means the auction ends at a random moment before the end date.

The Coin Bureau video below goes through the Parachain auctions thoroughly.

The PLO, Parachain Loan Offering, is also an essential part of the auction. In practice, it is a crowdfunding mechanism. A single project can only buy a limited number of DOT tokes. It can attract more investors through a PLO.

Investors lock (stake) their tokens for the desired project. If the project does not win the auction, investors receive tokens back automatically. If the investor was backing the winning horse, all staked tokens will be locked up.

PLO is a bit confusing term, as the winning project does not have access to investors’ funds. Hence, a PLO is not a direct loan for the project. Instead, tokens are locked for the leasing period, which is 96 weeks. This means the winning project does not own the parachain forever.

What is the point of all this for an investor? Since each parachain has its own native token, PLO investors will be rewarded with such tokens once they are issued on the winning parachain. The more DOT tokens you lock up, the more new tokens you will receive. When the leasing period is over, DOT tokens are returned back to PLO investors.

One may see the PLO as a risk-free investment, as the DOT invested will not be borrowed or lost. In addition, native tokens from the winning project will be added as a bonus. The real risk, of course, is the 96-week lock-up period. If Polkadot doesn’t feel like a good investment anymore and you’d like to sell your DOT tokens one day, they’re locked up.

Parachain auctions are running continuously. One round lasts 1-2 weeks, after which a new parachain-winning project is selected.

Polkadot vs. Kusama

Some readers might also have heard of Kusama. What is it exactly?

Kusama is Polkadot’s testnet. It is also called a canary network. Although Kusama is closely connected to Polkadot, it is a completely independent blockchain. Kusama also has its own native token, KSM.

The differences between Kusama and Polkadot were described as follows before the launch of Polkadot MainNet.

Kusama and Polkadot are independent, standalone networks built on very similar codebases, but Kusama has faster governance parameters and lower barriers to entry. While Kusama is wild and fast, Polkadot is more conservative, prioritizing stability and dependability, with slower, more methodical governance and upgrade processes. Kusama is great for bold experimentation and early-stage deployment. Polkadot is designed for stable execution of risk-averse, high-value applications.

Other blockchains have also testnets. The idea is more or less the same, testing new updates to the ecosystem. Kusama’s role is, however, one degree more important due to Polkadot’s infrastructure.

Kusama provides a platform for projects to test their operations while convincing potential Polkadot investors. This makes it easier for them to get investors to the upcoming parachain auction. It is also worth remembering that Kusama also has its own parachain auctions.

If you want to get a good understanding of Kusama, check out the video below from Gavin Wood.

Wood mentions one important factor for Kusama’s existence in the video. The problem with traditional testnets is that it is difficult to test certain functions without any value mechanism. Testnets operate with valueless tokens that developers can create for testing purposes.

In such an environment, it is difficult to test how staking and other governance functions would work in real life. Kusama provides a solution to this as it is a test network only on paper. KSM token currently has a market value of over $1 billion. Kusama, therefore, combines the pros of a traditional test network and a production-ready network.

Kusama is more or less a launching pad for Polkadot projects. It does not compete with other smart contract platforms. Kusama wouldn’t be valuable without Polkadot either.

Polkadot as an investment

Polkadot is an interesting project in the category of smart contract platforms. It’s hopefully easy for the reader to understand now why Polkadot does not compete directly with Ethereum. Polkadot’s niche is considerably narrower, the internet of blockchains. Of course, there’s competition too.

The project was in the development phase for a long time and was hidden from the mainstream. The MainNet launch in the summer of 2020 was the first time most investors heard about the project. The DOT token has been firmly in the top 15 rankings ever since.

The overall market situation looks good for the project. Parachain auctions are running and the roadmap is almost completed. Polkadot gained also popularity among institutional investors in 2021.

However, there are challenges too. You can check them out in more detail in the Coin Bureau video below (should start directly at 17:41).

The competition can be approached from two perspectives. The first one is Rust. This is the programming language used in Substrate for building smart contracts. There are also two other popular platforms using Rust: Near Protocol and Solana. After all, the competition for smart contract platforms is about which project attracts the most app developers.

The second risk relates to Polkadot’s interoperability focus. Cosmos is a really strong player in this sector. BNB Chain, Terra, and Crypto.com’s Cronos, are built with the Cosmos SDK. All these blockchains are compatible due to the IBC protocol developed by Cosmos.

In addition, most major blockchains are building bridges with each other. Only time will tell how popular Gavin Wood’s solution is.

Parachain auctions are a big advantage for Polkadot. Each closed auction means more DOT tokens locked out of the market through the PLO. The Proof of Stake consensus also ensures that lots of tokens are being staked and, therefore, withdrawn from the market.

Many investors have been surprised by the non-existent impact of parachain auctions on DOT price. This can be partly explained by the collapse of the entire crypto market. Parachain auctions started at exactly the same time as the crypto market began to drop in November 2021. Once the market returns to an upward trend, the impact of the auctions may be more visible.

Polkadot has also attracted institutional investors. The PLO is a very suitable concept for them, and the 13-14% staking reward in Polkadot’s NPoS system is also attractive. Of course, we have to take into account annual inflation of around 10%.

Polkadot has a better chance to succeed than many typical smart contract platforms. Gavin Wood’s status also carries the project a long way. Kusama should not be forgotten either. It can be an even better investment than Polkadot during a bull market.

Polkadot price and how to buy Polkadot

Polkadot’s native token DOT is available on the biggest cryptocurrency exchanges. Binance has the best liquidity and lots of trading pairs.

Buy Polkadot from Binance

Polkadot can be also found on Coinbase and KuCoin. You can also stake DOT in these exchanges.

There are several different alternatives for a Polkadot wallet. Polkawallet and Trustwallet are great options for mobile. Atomic Wallet is a free desktop wallet. Check all Polkadot wallets from here.

Stay up-to-date with Polkadot by following the @Polkadot on Twitter. The Reddit page can be found at reddit.com/r/dot and the official website is polkadot.network.

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