Parachain auction economics tells you whether to choose Kusama or Polkadot?

The first thing that made me curious about Polkadot is that it has a distant cousin worth $4 billion, Kusama, which can be seen as a mini version of Polkadot, or a test version.

I couldn't help but start to mumble in my head: "There's a big difference between the two... Why?"

I think we need to do a deeper analysis to understand how relative prices are formed today. If Polkadot and Kusama are indeed going to be important parts of the new digital economy, as all the crypto players say, I also want to know the investment risks and benefits.

Choose Polkadot or Kusama?

Choose one?

Why should I choose one or the other? Can't I invest in both?

Of course, I can save some trouble and buy both. However, when a group of people with superior IQ build a unique project like Polkadot, it is meaningful to truly understand its underlying construction logic and economic logic. In this way, when evaluating other projects in the Polkadot ecosystem, I may have a correct basic direction. In terms of investment, I may also find some characteristics that Polkadot is better than Kusama, or some characteristics that Kusama is stronger than Polkadot.

The value of each token is closely tied to the fundamentals and mechanisms of its unique design, which is the charm of cryptocurrency. Through detailed analysis, we can identify the main pressure points and leverage points to guide value creation.

How it works

In other blockchain projects such as Ethereum, projects can simply create what they want on the blockchain. Polkadot and Kusama have different ways of operating. They have a relay chain that links all projects in the ecosystem, and projects need to pay rent for connection rights. I use an analogy to explain the business model:

Polkadot’s business model is like an airport. The airport rents out terminal space to airlines that are interested in participating in the airport’s economic ecosystem. The airport provides a hub for passengers to transfer, operate efficiently, and ensure safety.

Airlines have brought a variety of flight options, enhancing the function of the airport. If the airport is well managed, more and more airlines will join, further increasing the value of the airport, which in turn increases the value of the airlines, and finally everyone is happy to retire in Hawaii.

Now suppose I buy an island to build an airport. I plan to build a main large airport and a small airport. The small airport is used to handle local tourists, and the main airport is used to handle international tourists. The small airport is also used as a testing ground to develop different pricing strategies for airlines, test new airlines, use new security equipment, etc.

This way, we can try out new things in a less risky environment before deciding whether to reuse them at major airports. Maybe we launch a new pricing strategy and it turns out to be suboptimal, but that's OK, only the small airport will suffer some economic losses.

As for airlines, they have to pay rent to airports. When the lease expires, they need to compete with other airlines to regain a seat.

Applied to the Polkadot ecosystem, major airports = Polkadot, smaller airports = Kusama, and airlines = parachains. The busier the parachains, the more Polkadot and Kusama earn.

The auction is crucial in this process. The auction determines which parachain will be connected to the relay chain and how much rent it needs to pay.

The importance of auctions lies in: (1) adding value to Polkadot and Kusama; (2) allowing investors to participate in profits; and (3) helping us understand parachains and ecosystem behavior.

Cryptocurrency projects must first deposit rent in the form of corresponding DOT or KSM tokens before applying to become a parachain. The lease term depends on the needs of the project itself during the auction period, and can be as short as 6 months or as long as 2 years. Auctions are held every 1-2 weeks.

If a project doesn’t win a slot in one auction process, they may try again in the next one. Now, let’s discuss how these auctions work economically.

Parachain Auction Economics

For theoretical analysis, let's assume that we have a great project called Project X. The main chain can provide governance, strengthen security, and improve efficiency for our project, so we decided to join the Polkadot and Kusama ecosystems.

We think other good projects will also connect to these two networks, so that we can leverage the functionality of other projects in our own projects and provide more utility to users. Let's say our market cap is about $100 million, Polkadot's market cap is $30 billion, and Kusama's is $4 billion.

For simplicity, let’s assume we want to bid for a parachain slot with a lease term of one year. To put this into practice, when we choose to bid in an auction, we need to decide: (1) How do we pay? (2) How much loan do we need? How much interest do we pay?

1. How do we purchase tokens?

Project X has two options:

(1) Buy DOT or KSM tokens from the open market;

(2) Rent coins from DOT/KSM holders.

Option 1: Buy coins from the open market.

First, we are a startup and don’t have much cash, so we have to look for venture capital or go to the public market for financing.

Either way requires selling more tokens of Project X. The result of this operation is obvious: other conditions remain unchanged, the current share of each coin holder will be diluted, and the current price of the coin will decrease.

Selling your ownership stake in a project to buy DOT and/or KSM tokens is not an ideal option. We are all fans of our own projects and will not spend a lot of time to exchange for exogenous assets that we cannot control.

Furthermore, when we buy coins together with our opponents in the open market, the value of DOT or KSM will go up, hindering our own transactions. This operation is really a bad idea.

Option 2: We borrow DOT or KSM tokens from holders on the open market to participate in the auction.

To do this we need to use economic incentives for token lenders to lend tokens and lock them for a year, which is similar to debt, and we need to pay "interest" for the borrowed DOT/KSM tokens.

Although we have to pay the interest by selling the tokens of Project X, the difference between Option 2 and Option 1 is that Option 2 is much cheaper. We do not need to buy DOT or KSM tokens, we only need to pay "interest" to the borrower. Option 2 is more cost-effective for us.

Therefore, I guess that in the real auction process, all projects will probably choose the second option to raise tokens, unless they were lucky enough to buy some DOT or KSM a few years ago.

2. How much loan do we need? How much interest will we pay?

This is a very critical question. Before answering it, we first need to briefly understand the economics of DOT tokens. I will explain the token economics as simply as possible:

Polkadot’s token economics suggest that in its “ideal” state, the following holds true:

1. In a POS (Proof of Stake) blockchain network, 50% of DOT tokens will be staked through the normal staking system, and the interest rate received by the stakers will reach 20%. Remember that in the POS mechanism, interest is paid in tokens, so it is also the inflation rate.

2. 25-30% of DOT tokens are stored in parachains (these tokens do not earn interest from the DOT/KSM network)

3. 20–25% of DOT tokens are in free trade (these tokens do not earn interest from the DOT/KSM network)

How do they come up with these numbers? In general, POS blockchain networks want 60% to 75% of staked tokens. Because more staked tokens mean more security, but fewer freely traded tokens and poorer liquidity.

What is special about DOT/KSM is that they created a parachain structure, so 60-65% of the stake needs to be distributed between traditional stakeholders and parachains. Following the following logic, we can see why, ideally, a lower percentage is allocated to parachains compared to stakeholders:

If the percentage allocated to parachains is too high: more percentage allocated to parachains → more DOT tokens stored in parachains → parachains become more expensive → the need for parachains to connect to Polkadot decreases, and parachains choose to connect to other blockchains. This is like the airport rent is too expensive, and airlines move from JFK to another airport, which is not what we want.

Isn’t this ingenious design worth keeping in mind? Building a system with parachain storage means:

1. Parallel chains have real projects in operation.

2. The security of the network is not only maintained by stakeholders, but also supported by parachains.

3. Because there is no need to pay interest on parachain deposits, Polkadot can pay more interest to ordinary stakeholders to attract them to join the Polkadot ecosystem. Therefore, without causing excessive inflation, Polkadot can attract more stakeholders to join.

In other blockchains without parachain designs, raising the interest rate for stakeholders would result in one-to-one inflation, but this is not the case with Polkadot, because parachain token deposits do not earn a dime in interest from DOT/KSM! The creators of Polkadot have essentially shifted some of the inflation burden to the parachains that need to pay out crowdfunded loans.

What methods did they use to incentivize the system to reach an equilibrium where 50% of stakeholders participate in order to achieve this "ideal" state?

If the staked tokens exceed 50%, they will drastically reduce the interest rate, and conversely, if the staked tokens are less than 50%, they will drastically increase the interest rate.

Here is a chart of interest rate (green line, y-axis) vs. staked tokens (blue line, x-axis). Key point: If the percentage of stakeholders exceeds 50%, the interest rate will drop exponentially and people will unstake to create liquidity for DOT/KSM tokens.

Why do I care about this? Because the cost of parachain lending needs to cover the opportunity cost of traditional stakeholders staking on the network. The percentage of DOT/KSM tokens staked determines the interest rate and therefore the cost of the parachain. I will explain this further below.

Now that the token economics are explained, we can finally answer the question: how much loan do we need and how much interest do we pay?

1. How much loan do we need?

Based on an ideal situation, we know that about 30% of tokens will be stored on parachains. From this, we can work backwards to calculate what this means for parachains in general:

In my experience, a project needs to borrow about 3 million tokens to participate in DOT, and about 26,000 tokens to participate in KSM. This is equivalent to $96 million in DOT and $13 million in KSM, which is a bit high.

Right now, it’s hard for DOT/KSM to reach the “ideal” 30% because the project is still in its infancy and borrowing 96 million is very expensive.

2. How much interest do we need to pay?

Let’s look at this from the perspective of a DOT or KSM holder.

If I hold DOT or KSM, my options are as follows:

1. Stake DOT or KSM tokens and get an annualized interest rate of about 20% per year under ideal conditions.

2. Lend my tokens to Project X for one year and get interest in Project X tokens.

3. Store DOT or KSM tokens in your wallet, waiting for transactions, with zero returns.

For DOT/KSM holders, option 3 is not reasonable in the short term because it has a 0% yield, so we exclude it. Therefore, option 2 needs to at least beat option 1 to incentivize holders to choose it.

So here’s our answer: the “interest” we pay to the crowdsale’s creditors (in Project X tokens) must be at least more than the 20% annual interest we earn from staking (in DOT or KSM tokens).

It is important to note that a 20% interest rate is only possible when the percentage of staked tokens is at the "ideal" state of 50%. If the stake exceeds 50%, the interest rate and the borrowing cost of the parachain will drop sharply.

The core question becomes:

What is the cost of borrowing a parachain worth in USD today? How would this dilute a hypothetical project X? What is the implied interest rate for a crowdsale?

The following is an ideal description:

What happens if the collateral percentage is not ideal? Here are the interest rate sensitivities:

What did we find?

I calculated that in an ideal world, the total interest of DOT and KSM stakeholders is about $3 billion and $4 million, respectively. This is the opportunity cost of not staking all of their DOT/KSM tokens and lending them to parachains.

Assuming there are 100 parachains, we divide the total interest by 100 to calculate the average fee that each project has to pay to stakeholders: $32 million for DOT and $4 million for KSM.

Think about how expensive it would be for a startup to pay this fee every year! For a project with a market cap of $100 million today (such as our otherworldly Project X), joining as a parachain on Polkadot, we would have 32% annual token inflation, and joining as a parachain on KSM, the depreciation rate would be 4%.

I came to the conclusion that the “ideal state” is unlikely to occur in real life because until now, unless cryptocurrencies are more mature, it will suppress the demand for parachain projects.

When the stakeholder stake percentage on the network exceeds 50%, the ideal state is broken and the interest rate drops sharply as shown in the sensitivity chart.

My intuition tells me that the equilibrium state reached will be slightly above 50%, between 50%-60%. This is because the total amount of staked DOT tokens has now reached 65%, and I don’t think that 15% of stakeholders will withdraw their stakes and use the DOT income to participate in more risky parachain projects.

KSM currently has 55% of staked tokens. Stakeholders are happy with the current 13% staking rate. I guess connecting to a parachain at 13% would also satisfy them. At 13%, a project would have to spend $20 million to connect to DOT and $2 million to connect to KSM. If you ask me, I still think connecting to DOT is too expensive.

Although based on logic, we already know that joining as a parachain means we have to pay rental costs, the price of project X will be under downward pressure, and projects on DOT are more expensive than on KSM.

We learned the hard way how to quantify this difficult inflation battle. In this case, a $100 million market cap project will pay $20 million in interest fees, which means their token inflation dilution is over 20% per year, and a $50 million project must offset 40% of negative token dilution, which is outrageous!

Anything else worth mentioning? I think it's shocking that connecting to Kusama is so much cheaper: is Kusama "underrated"?

Competitive Analysis: DOT VS KSM

Why do DOT and KSM appreciate or depreciate in value?

People buy DOT/KSM tokens from outside → cost of parachain rent goes up → aspiring projects can’t afford it, demand decreases → DOT or KSM holders are no longer incentivized → price of DOT/KSM goes down → rent cost goes down, more projects emerge, and the cycle repeats.

The supply of parachain slots on DOT and KSM on each network is fixed at 100, so demand is the differentiating variable, and the need for projects to connect to the network is the real driver of DOT/KSM price stability. Which of the two has more project demand?

KSM is a small airport next to the main DOT airport. Let's change the metaphor. Instead of talking about an airport, let's talk about a nightclub.

In my opinion, KSM is the cheaper, busier nightclub, while DOT is the fancier, more expensive nightclub. But if the cheaper nightclub has always had more customers, why doesn't it raise the price of drinks to equalize supply and demand? If the fancier club doesn't have the same fill rate as the smaller club, it can't raise the price further.

Let's review what we just learned:

1. The quantitative study above shows that the economic cost of connecting to Kusama is negligible compared to Polkadot.

Kusama is 7 times cheaper to connect to. Yes, that’s obvious just looking at the market cap difference. But now that we know the cost is per parachain, realistically that’s about a 20% dilution for a $100 million project. Unless an aspiring project has a very high valuation initially, they’re going to lose real value by connecting to Polkadot instead of Kusama.

I think that under this mechanism, the demand for projects with smaller market capitalization will flock to Kusama. They originally just wanted to make a try first, but may never connect to Polkadot afterwards.

2. Does this mean that only smaller, lower quality projects will be connected to Kusama, and better projects will only be connected to Polkadot? No.

The first-class Polkadot projects will still be connected to the Kusama project, which is very cost-effective for high-value projects. Especially in the emerging experimental digital economy, the economic value of Kusama as a testing ground will offset its rental costs.

Compared to Polkadot, Kusama has the same functionality at a much lower cost, so it has received more project demand. But how much more demand? Let’s see more numbers!

I found on Coingecko that in the Polkadot ecosystem, there are only about 20 public Polkadot projects with a market value of more than $100 million, and about 30 projects are valued at less than $100 million.

Based on today’s prices, a 30/50 or 60% annual dilution would be more than 20%. Let me wail again, we did not count the projects that have not yet been listed, but this set of data can form a bell curve, which is still very representative.

Therefore, in the short term, the Kusama ecosystem will have more asymmetric demand and supply-demand imbalance than the Polkadot system.

The 7x market capitalization gap between the two is really huge. Should I compare them?

Based on the expected staking rate of more than 55% and inflation rate of 10%-13%, projects connecting to Kusama today will spend 2.5 million per year. If Kusama's market value doubles, the cost will increase to 5 million. If a 20% currency dilution rate is acceptable, the cut-off market value is 5 million divided by 0.2, which equals 25 million.

On Coingecko, I found that only 14/50 or 28% of the projects failed to meet this criterion. Tripling the price of Kusama would only exclude 18/50 or 36% of the projects.

I think Kusama and Polkadot still have a lot of room to grow before reaching a balance between supply and demand, because now projects can offset the 20% dilution of the currency value by raising the price of Kusama by 2-3 times.

If I were strapped for cash, I would bet on Kusama appreciation rather than Polkadot.

What might be wrong

1. I hope my calculations above are all correct.

2. I am not a technical expert, so the basis of my inference is based on the fact that Kusama and Polkadot have the same functional effects, which is crucial to our assessment of the demand for Kusama. My interpretation of the Polkadot market does not imply any views.

3. Some projects may "lose" to Polkadot, either by upgrading to Polkadot or getting used to operating on Polkadot, and no longer need Kusama. My reason for opposing this is that they will still use the Kusama ecosystem for a long time, test some new product features and update performance, and then reuse it on Polkadot.

4. Higher market value undoubtedly means higher security for proof of stake. Therefore, some people may think that Polkadot's higher security will bring more project demand than Kusama. Of course, I agree that Polkadot is more secure on this basis, but it is too costly and not everyone can play with it. Do you want to park your plane at a major airport and just snap your fingers and magically have a rent-paying space?

5. If the entire market cap of the aspiring parachain adjusts upwards and can afford the rent of Polkadot, then my argument fails. So far, this is not the case, but it will change in the future, when the entire market cap of Polkadot and Kusama will adjust upwards.