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Blockhead Capital: Decred Investment Thesis

Updated: Jul 30, 2019

Decred (an amalgamation of ‘decentralized credits’) is a cryptocurrency (token: DCR) with a hybrid Proof-of-Work (PoW)/Proof-of-Stake (PoS) consensus model. The hybrid nature of Decred’s consensus model allows for several unique uses of a public blockchain which are not currently available in the large networks of today. This post assumes a working knowledge of Bitcoin’s monetary policy, its consensus/sybil protection mechanism (Proof-of-Work (PoW)) and the general Bitcoin investment thesis. If you’re familiar with the overview of Decred, feel free to skip to the Thesis section below.


For a look into our thoughts on Bitcoin as an investment, please see our post exploring the macroeconomic environment and Bitcoin as a hedge to the hidden risks inherent in the global financial system.


What is Decred?


The Hybrid Proof-of-Work (PoW)/Proof-of-Stake (PoS) Consensus Model


Overview


Decred borrows Bitcoin’s Proof-of-Work (PoW) consensus mechanism (which roughly equates to 1 CPU = 1 vote) and combines it with a novel Proof-of-Stake (PoS) system (which in other systems typically provides for 1 token = 1 vote) in a hybrid design (more below on how Decred’s PoS system differs from the typical model).


Decred’s Proof-of-Stake (PoS) model requires holders/stakers to purchase tickets in order to participate in Decred’s on-chain governance system. The nuance in Decred’s system is that 1 DCR ≠ 1 vote, but rather that 1 ticket = 1 vote. A ticket is a right to validate a block proposed by a PoW miner and earn a stake-miner reward for doing so. Tickets must be “purchased” by staking (or depositing) a certain (dynamically adjusted) amount of Decred. By staking, an investor elects to lock up its capital for a certain period of time in order to secure the network and participate in governance decisions in return for network rewards. The system automates (through dynamic pricing) for a target of 40,960 total outstanding tickets and new tickets are made available for purchase periodically (as others are selected or expire) at a rate of up to 20 tickets per block. The continually increasing ticket price is a result of the increasing (as denominated by total DCR staked) interest in staking tokens for tickets.


A maximum of five tickets (and minimum of 3) are selected to validate each block and three out of five (⅗) tickets (or two out of three (⅔) in the event of 3 selected tickets) must vote to validate a block (presumably by first validating that the transactions within the block are valid) before new blocks can be built on top of the subject block. Interesting tidbit: a miner is penalized for not including the full ideal 5 selected tickets in a block so that it loses 20% of the total PoW reward for each ticket omitted.


This results in a network that is:


...More Secure


Tickets are periodically selected to vote on blocks proposed by PoW miners - providing a check on the blocks proposed by miners and creating ‘checkpoints,’ prior to which blocks can not be reorganized (limiting the effectiveness of several typical PoW attack vectors e.g. 51% attacks and long range attacks). Because of the lottery ticket based staking system, stakers make a longer term commitment to the network (tickets are on average selected every 28 days but can take up to 142 days - compared to a 3 day unstaking period in EOS or 21 days unbonding period in Cosmos). These attributes make Decred far more expensive to attack than an equivalent PoW-only network - and based on current staking levels, likely impossible as an attacker will need to acquire nearly all of the currently unstaked DCR.


...Fair to Token Holders


Further, the hybrid design returns some of the consensus power to token holders, where in a typical PoW network, the power resides solely in the miners. Some argue that token holders ultimately control any PoW network as disputes will result in a hard fork - and the “winning” chain is ultimately the one with the most economic backing (allowing for greater network capitalization and therefore hashpower to secure the network). I argue that a network which can avoid contentious hard forks is better positioned to achieve a stable, global store of value status. Decred's PoS voting system makes contentious hard forks highly unlikely and therefore better positioned to fill the global store of value role.


...Upgradeable


With stake-based (‘skin in the game’) on-chain voting, Decred’s network is self-upgradeable to include any new features desired by token holders. Most recently, holders voted to decentralize treasury spending - a topic and ramifications of which I’ll dig into a bit later in this post.


Decred’s Monetary Policy


First and foremost, Decred’s blockchain includes a premine (typically a dirty word with respect to currency tokens), meaning that the genesis block included a pre-distributed supply of tokens and did not begin with 0 distributed tokens (although in Decred’s case the transactions were included in the first block following the genesis block). Decred’s premine consisted of 1.68 million tokens (8% of the total future supply of 21 million),where half were distributed (840k tokens) to Decred developers to compensate them for initial development work and half (also 840k tokens) to 2,972 airdrop participants in an effort to jump start the network (both from a network effects perspective but also because token/ticket holders are required for the PoS element of Decred’s consensus). While not an “immaculate conception” like Bitcoin’s, the premine was reasonable and isn’t in the realm of egregious money grab like most premines.


In Decred, new blocks are created roughly every 5 minutes. Each block includes a block reward split three ways:

  1. 60% goes to the PoW miner who found the block;

  2. 30% goes to the PoS voters on that block (6% to each of the 5 voters); and

  3. 10% goes towards the Decred Treasury, creating a sustainable source of funding for development (more on this later).

Unlike Bitcoin, which experiences a “halving” of its block reward approximately every 4 years, Decred has a much smoother new supply reduction schedule, where the block reward is reduced by ~1% approximately every 21 days. The initial block reward was ~31.2 DCR and is currently ~17.69 DCR.


The last block reward will be created in September 2120. The upper limit on the total supply of Decred is ~21 million coins. Current supply is ~10 million coins



Decred’s monetary policy ethos is exactly in line with Bitcoin’s and has all of the same potential sound money and hard asset properties (once at scale). An important difference is that Decred is currently far earlier in its supply issuance schedule, roughly where Bitcoin was in late 2012. Because of this, Decred is currently in a period of higher inflation and therefore experiencing more downward price pressure than it will later in its lifecycle. This attribute is both a risk and an immense opportunity, as those who were involved in Bitcoin’s early years later discovered.


The Thesis


So how does this all come together? Decred and Bitcoin are both competing for a stake in the “money” cryptoasset bucket. Many, including me, believe that the money bucket is the most readily addressable market for a cryptoasset as well as the one with the largest currently addressable market size (hundreds of trillions of dollars). While we find the Bitcoin model extremely compelling, we think Decred has a high likelihood of growing to be the “silver” to Bitcoin’s “gold” and even stands an (outside) chance at usurping Bitcoin’s position as the preeminent store of value (which, in this author’s opinion, likely requires a catastrophic failure in Bitcoin’s network).


Decentralized Finance and the Sound Money Thesis


A recent rebranding of Ethereum’s core use case, away from ‘the world computer’ and ‘smart contract platform’ and toward ‘decentralized finance’ (“DeFi”) or ‘open finance’ is primarily an adjustment of expectations but also a pivot toward market demand (and they are in demand). A major problem with the Ethereum model is that there is no predictable supply schedule and is generally periodically modified (to a lower inflation rate) at the whim of the loudest voices in the room and (often) community consensus. While some are comfortable with this model, we find it unlikely that a cryptocurrency without a strong social contract revolving around issuance schedule and total supply can develop into a global store of value. Enter Decred...all of the best parts of Bitcoin’s monetary policy, with the ability to evolve to include decentralized finance uses.


In order to build out DeFi uses, Decred requires more advanced scripting/programming capabilities than Bitcoin allows today - this exists and the possibility exists for further programmability. Advanced scripting language would allow for several DeFi uses, including:

  1. the issuance of tokens atop the Decred platform (DAO tokens or tokenized assets like Tether were issued atop the Omni Layer) - otherwise, the platform could adopt a solution similar to BCash’s Simple Ledger Protocol;

  2. creation of decentralized autonomous organizations (DAOs) - (more on this below);

  3. asset exchange through a decentralized exchange (DEX), which is already in the works now (read more here, here, and here).

As an example of how additional features (Lightning Network, in this case) were implemented in Decred read more here: https://blog.decred.org/2017/05/23/Lightning-Network-in-Practice/


DAOs/Dispute Resolution Layer


Among the most exciting developments in the blockchain space is the advent of the decentralized autonomous organization. A DAO can take many forms but ultimately replaces traditional business entities in order to organize and facilitate communal effort and decision making. Little known to industry participants is that Decred is not simply a cryptocurrency but also a DAO. As mentioned above, 10% of block rewards are directed to the Decred Treasury, which is controlled by ticket holders. The Decred Treasury achieves multiple things: supports future development of the platform, ensures development teams are only being paid for work completed (unlike most ICO exit scams), and stands as the first of many fully autonomous DAOs built on the platform.


In 2018, control of the treasury’s expenditures was turned over to ticket holders through the Politea system while withdrawals from the Treasury are currently handled in an off-chain manner. Recently, a Politea proposal to fully decentralize spending from the Treasury was passed and sets the stage for fully autonomous DAOs on Decred. The Treasury DAO is slated to succeed because of Decred’s ticket system - where there is true buy-in through purchase of tickets and an inability to anticipate when a ticket will be selected or expire. This keeps a voter staked to the system following any governance decision - creating a barrier of entry for both attackers or short-term opportunists. In fact, the infrastructure to develop new DAOs atop Decred is next in line for development following the decentralization of the Treasury DAO.


Decentralized Autonomous Entities
The method for decentralizing control of the dev org funds will be generalized to support user-created entities that we refer to as decentralized autonomous entities (“DAEs”). Since the main distinguishing point of a corporate entity relative to an individual is ownership and control of funds and assets, we will use decentralized control of funds as the basis for DAEs within Decred. We will focus less on the speculative component of tokenization and more on the fundamental mechanics of making it work since tokenization creates several serious scalability issues, which have led to substantial congestion on the Ethereum chain. In short, a DAE will be comprised of a simple on-chain smart contract that delegates control over funds in the contract to a group of individuals.

We envision a future where user-created DAO/DAEs are able to call back to Politea (the base protocol voting system) to utilize the staked ticket holders as an arbitration or dispute resolution system. This service would come at a cost and ultimately act as a value driver for DCR (and ticket) holders. Without diving into detail, this would give DCR a “right to work” token property and accrue value much in the way that a taxi medallion or liquor license accrues value for its holders.


Monetary Premium as a Base for Future Use Cases


Cryptocurrency critics frequently enjoy arguing that there is no intrinsic value to cryptocurrencies and that they only retain any value due to the shared delusion of its holders. While we might agree that monetary premium (more on this below) is at least partially achieved due to shared delusion (or more accurately expressed as a ‘shared belief’), we greatly disagree that there is no intrinsic value to cryptocurrencies. The primary intrinsic value of any particular cryptocurrency is to purchase block space within the native blockchain hosting that cryptocurrency. There are several novel uses for highly secure blockspace outside of securing the monetary cryptocurrency - including, but not limited to, timestamping events or files (“timechain” anyone?).


Similar to the industrial uses of gold, this intrinsic value is not sufficient to sustain a multi-trillion dollar market capitalization but provides a baseline value proposition for the token. In a world where several blockchains are competing to provide this type of service, there’s a benefit to being able to provide extremely secure blockspace (as discussed above) at an efficient price point (through Decred’s use of its hybrid consensus model). We think Decred is best poised to deliver this “security as a service” model.


More important than any feature discussed above is whether or not Decred is able to achieve a monetary premium (like Gold, which if was strictly valued for its commercial uses would not have near its existing market cap). As early as 2015, Reddit users analyzed low stock-to-flow ratio [measuring annual new supply of an asset (flow) to its total existing supply (stock)] as a primary attribute leading to gold’s ability to attain a large monetary premium and how that applies to Bitcoin. More recently, Twitter user Plan₿ (@100trillionUSD) has conducted what we believe to be some of the most thorough analysis on Bitcoin’s emergence as an asset with monetary premium and forecasting its eventual valuation through a stock-to-flow model.



Twitter user Checkmate (@_Checkmatey_) applied Plan₿’s stock-to-flow analysis to Decred and found that Decred also follows a very similar stock-to-flow model formula - an early indication that Decred is and will continue to obtain monetary premium. At the same time, tokens generally viewed as similar (e.g. DASH) are not able to obtain sustain growth along the stock-to-flow model and are not achieving monetary premium.



Decred is even holding a larger monetary premium for a longer period of time (vis a vis the Stock-to-Flow model) than Bitcoin did in its early years - a promising start to Decred’s ability to develop a similar long-standing monetary premium.



We believe that it’s essential for an underlying cryptocurrency to achieve monetary premium, otherwise recipients of the token will not desire to continue holding it and the token will be subject to higher velocity and therefore less likely to capture or retain any significant value.


Read more about Checkmate’s Stock-to-Flow analysis here: https://medium.com/@_Checkmatey_/monetary-premiums-can-altcoins-compete-with-bitcoin-54c97a92c6d4


Concluding


Decred is an adaptive cryptocurrency with a rigid monetary policy. The rigid monetary policy provides the base required to achieve monetary premium while the adaptive nature of its on-chain governance allows for integration of more dynamic features. The hybrid consensus mechanism creates adequate checks and balances between the various ecosystem parties while eliminating contentious hardforks as the primary method to resolve disputes - a highly desirable feature for an aspiring global reserve asset. Further, the hybrid consensus creates for more secure blockspace, making the blockspace more valuable, and provides for a more censorship resistant currency.


Decred iterates on Bitcoin’s strengths and shores up many of its shortcomings, putting it in a position to complement or compete with it as a digital store of value.


Additional Reading


A beginner’s guide to Decred


Unpacking Decred’s Social Contract: why Decred and Bitcoin can coexist


Decred Governance: An Iterative Approach


Decred Canon: a collection of readings and resources to help people understand and build upon Decred

 

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