Layer 1 Blockchains: The New Nation States

Written by: Bernat Ferragut

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07 July 2022

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Opinion Piece

Layer 1 Blockchains: The New Nation States

In this article I am going to talk about how Layer 1 Blockchains should be considered, as in my opinion they are more similar to the economy of a nation rather than the activity of a company or a large stock. Analyzing the different Layer 1s such as Ethereum, Solana or Avalanche to name a few, it can be observed that these L1s provide an infrastructure and a security layer, thereby creating an economic ecosystem to allow the establishment of different DApps, or in what in a sovereign country we would consider as companies, being able to carry out their activity in this new ecosystem.

L1 own monetary policy

Just as a state has its own, federal reserve controlling the nation's monetary policy, so does a blockchain. In the same way that the FED prints US dollars to stimulate the US economy with new investments to make the country grow — inflation as a consequence — a blockchain also distributes its new native coins for the same purpose as a central bank does.

A L1 blockchain — if it wants to succeed — has to have a good strategic plan based on giving out blockchain native coins to incentivise the growth of its ecosystem. These are based on different grants for development within their ecosystem and the creation of new DApps on top of the Layer 1. The same way a nation stimulates its economy by giving loans for the creation of companies through banks, a Layer 1 stimulates its "nation" by giving grants to different developers of DApps, thus forming the "companies" of this digital nation.

But here’s where blockchain nations and the Fed differ, aside from the programmability of their policies. The Fed has to rely on traditional finance — intermediaries: banks & shadow banks — to push its monetary policy out into the economy, and here is where the main problem comes in as money creation goes to big multinationals instead of small businesses, causing a huge economic imbalance in society. To sum it up very briefly, this is mainly because it is more profitable for a bank to make a $1M loan to a single multinational than to make 10 loans of $100k each to 10 different businesses. You end up with imbalances in the system that catch you by surprise later. In contrast, Proof of Stake provides blockchain economies with a mechanism for monetary policy transmission that is fairer, more efficient and more sustainable.

Proof of Stake (PoS) gives a sense of citizenship

In a Proof of Stake (PoS) system people lock their capital in the native L1 cryptocurrency in order to become a validator and validate transactions of the blockchain. Validators get rewarded in exchange for providing security and execution of the network via its own node. This means that in a PoS system people benefit from the underlying economy behind this nation through steady yield on behalf of a possible equity appreciation of the currency.  

With a Delegated Proof of Stake (DPoS) is even way better, because anyone can delegate its own capital to a validator, meaning that one doesn’t need a minimum amount of capital to participate in a node and take profit of blockchain validations. Also in a DPoS system, one doesn’t need software to develop its own node. 

The beauty of it is that in a L1 PoS system, every citizen will have the same rewards, whatever their purchasing power is. Whether you have $100 or $1M, you will always receive the same yield on an L1 blockchain. Many people are not very aware of this or don't give it much importance, but this is an abysmal change. This is the real meaning of decentralization! In the 21st century, differences in equal opportunities still exist today. By this I mean that if you have $100 or $1M in a traditional bank, you are going to be treated differently. In the first case you will have to pay $30 a year for a credit card, if you have access to credit at all, whereas in the second case you will have exposure to very attractive financial products where most people don't have the opportunity to invest. Hence, the famous saying that the rich get richer and the poor get poorer. 

By this I do not mean that the blockchain is going to lead us to communism, because luckily whoever invests more will get more rewards in yield, it is simply that the blockchain is leading us to equal opportunities for societies — in this case with yield —, because whoever you are or wherever you come from, you will always get the same opportunity as others. This is what real democracy looks like!

Proof of Work (PoW), not the way to go

On the other hand, in a Proof of Work (PoW) system people don't get benefit from the blockchain's economy, as the only ones able to validate transactions of the blockchain are the miners through expensive hardware instead of people locking their capital in the native L1 cryptocurrency — and obviously not everyone can buy expensive machinery or has the place to install them in order to become a miner —. So the only thing one can expect from a PoW cryptocurrency is an equity appreciation of the coin, as steady yield doesn’t exist and people don't benefit from the economy. Apart from this, the miners are obliged to sell part of the rewards to cover the costs of their hardware activity causing sell pressure and there is also the environmental aspect.

One can compare it in another way and make the assumption that Bitcoin price — PoW system — will not go up forever (and I hope this occurs far away). So how will a person that holds Bitcoin will get benefit from when this occurs? If one instead is holding a PoS cryptocurrency, that person will still get steady yield even if the price doesn't go up since the rewards depend on the on-chain economy inside the L1 instead of the price. Proof of Stake encourages a wider democratic participation as everyone gets a piece of the pie, giving meaning to the citizens of that virtual nation.

The consideration of a L1 cryptocurrency to "stabilize" its price in the long run

An important aspect to consider is that the value of the Layer 1 cryptocurrency does not have to have a high volatility. When there are aggressively fluctuating currency values, this is usually not good for establishing economic activity within the nation.

First of all, if we have a very volatile Layer 1 cryptocurrency price, this leads to higher transaction costs in this cryptocurrency, especially with long term transactions such as lending and borrowing. It is important for a lender and borrower to have the same expectation of what the borrowing contract actually means. By this I mean, who is the misguided person that is going to borrow bitcoin in order to realize a 30-year mortgage? Obviously the price of Bitcoin is not known 30 years from now, so it is not interesting to enter into this contract. In the case of a price increase, the borrower will feel as if he has been scammed by the lender because he will have to pay multiple times what he should have paid in the first place, the same vice-versa. How do you calculate the interest rate of this operation?

Secondly, if you are a company and want to set a cost of a product, that price has to be stable over a significant period of time. In the blockchain world we can see this problem when making deals with NFTs, if we want to cite an example. A company that sells NFTs through the blockchain is interested that the value of the cryptocurrency in which it sells its NFTs is stable at least in the short term. If that currency has a 50% increase or a 50% decrease in the same month, it puts complications with the execution of the business because apart from constantly changing the price of the product, the business has to pay employees and suppliers, where these costs occur in different time frames than the sale and revenue of the product. 

A Proof-of-Stake system helps to have a stable price for the L1, as it encourages the user to stake and participate in the economic activity of the blockchain, instead of having a heavy inflow and outflow of capital to and from the ecosystem.

L1 cryptocurrencies to replace FIAT currencies?

Last but not least, L1s Cryptocurrencies will not replace FIAT currencies as these are the currencies of nation states too (Obviously!). As long as the physical economy and nation states exist, FIAT currencies will exist and it will be the public sector that will ensure that they continue to be used — by paying taxes with local currency —. That said, how this FIAT is going to be improved into CBDCs (Central Bank Digital Currencies) is a separate issue which I will not go into in this article.

If an individual physically lives in the United States, he or she has to pay in dollars as this individual is part of this society. This does not detract from the fact that the same individual may be part of new societies such as different L1s. I see that in the future, or not to say that it is already the case, an individual will be a citizen of a physical society as usual — e.g. the euro — while in parallel this same individual is a citizen of several public ledger societies — e.g. being part of the Ethereum ecosystem —. Therefore, we have that people will be dual, triple, quadruple citizens without having to give up their passport.

Tags:

Layer 1s

Monetary Policy

Economy

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