Update (October 28, 2022)
As mentioned in our report published last week, the Cosmos V2 whitepaper was intended to be the starting point of an iterative process between contributors and the broader Cosmos community. Indeed, over the past week, the contributors of the proposal have issued a few revisions in response to community feedback which specifically address ATOM’s issuance schedule and treasury dynamics.
Instead of capitalizing the treasury up front within the first nine months, they now propose segmenting the process into ten equal tranches (of 4M ATOM) to occur annually, each of which would be subject to a separate governance vote. That said, the whitepaper stipulates that the timing and size of these tranches can change at any time via governance voting. Further, the latest version of the proposal suggests a one-time issuance of 4M ATOM to the Community Pool. Table 1 shows the revised issuance schedule is more conservative in terms of both the magnitude and pace of treasury capitalization. Importantly, by segmenting the treasury capitalization into tranches, the revised proposal is more adaptive and introduces increased accountability for the deployment of treasury funds.
Table 1. Comparison of proposed ATOM issuance schedules
Moreover, the revised proposal suggests that the distribution of future monthly steady-state tail issuance will be up to the discretion of the Hub based on:
- strength of interchain security and extent of liquid staking adoption at the time as well as
- whether there is sufficient validator compensation for the staking rewards that may be diluted by the tail issuance.
Notably, the determination of ATOM’s steady-state monetary policy will not be put forth by the Hub until they’ve garnered enough reliable data on the dynamics of the new revenue sources introduced by the broader proposal. Concurrently, contributors and community members have begun iterating on the drafted charter for the Cosmos Hub that will effectively govern the treasury and deployment of funds. We view these revisions positively as they (1) suggest a more conservative approach to capitalizing the treasury, (2) provide the community with greater discretion over the pace of capitalization and (3) increase the level of accountability for the deployment of treasury funds.
Cosmos (1) is best known as an interoperability solution for connecting multiple layer 1 blockchains. Although it’s technically not a blockchain itself, it represents a standardized development toolkit designed to facilitate the deployment of sovereign, application-specific blockchains (called appchains or Zones) which can effectively scale and interoperate with each other.
However, despite its potentially critical role in a multichain future, very little of the revenues generated by the growing ecosystem of Cosmos appchains have historically accrued to holders of the native token, ATOM. The Cosmos Hub V2 proposal – announced in late September – has aimed to remedy this by updating the tokenomics of ATOM to further secure the economic scaling of the Cosmos ecosystem. Technologically, the highlights of the V2 whitepaper focus on Cosmos’ infrastructure service platform with two key pieces of app-specific functionality: namely the Interchain Scheduler and Interchain Allocator.
While many of the new whitepaper’s proposals were anticipated by the broader community, some of these are now being scrutinized – particularly those relating to the reconsidered ATOM issuance model and the potential dilution of current stakers. Notably, the proposal would increase issuance of ATOM temporarily for 9 months to fund a new Cosmos Hub Treasury followed by a significant reduction over 27 months until it reaches a steady state. The details should ultimately go up for a vote, with much of the governance discussion available publicly. It is worth noting that the details of the proposal are not set in stone and are intended to be a conversation starter with the broader community.
In our view, the totality of the V2 proposal is ambitious. While certain components such as liquid staking, an onchain MEV marketplace and a system for the coordinated deployment of capital to grow the cross-chain ecosystem represent innovative protocol improvements that could catalyze future adoption, the suggested advantages of the updated monetary policy for ATOM are not as clear. In the absence of a well-defined plan for the future deployment of Cosmos Hub Treasury funds, ATOM holders will be diluted in the near-term and effectively bear the bulk of the risk associated with deploying the Treasury capital at high rates of return.
Cosmos represents critical infrastructure for enabling interoperable networks, referring to a stack of tools that allow application-specific blockchains (appchains) and proof-of-stake (PoS) networks to communicate. This is separate from the Cosmos Hub, which is only one blockchain among many within the Cosmos ecosystem – all of whom may be using some version of the Cosmos software development kit (SDK). The SDK facilitates the development of modular blockchains to establish standards for reliable interblockchain communication. Alongside the SDK, the technology stack includes:
- Tendermint, which handles the networking and consensus layers needed to reach consensus. While blockchains are not required to use it, it was developed as a streamlined solution so developers could focus purely on building application layers. It relies on the byzantine fault tolerant (BFT) consensus algorithm.
- Inter-Blockchain Communication (IBC) protocol, which is a general communication standard that allows heterogenous blockchains – with differing application and validator sets – to properly communicate with each other, facilitating everything from simple asset transfers, to cross-Zone data availability proofs, to slashing validators on remote Zones.
Using the Cosmos SDK, developers can leverage various plug-ins and modules to build application-specific blockchains without having to code each piece of functionality from scratch. Structurally, Cosmos is akin to a mesh network of Zones that are able to communicate with each other and have the choice to manage their own independent validator set or incentivize others to provide security once Interchain Security is available in 1Q23. Notably, Cosmos attempts to provide the necessary infrastructure to allow for a network of sovereign appchains to emerge organically via natural incentives.
The native asset of the Cosmos Hub (the flagship PoS blockchain of the Cosmos ecosystem) is ATOM. Validators can stake ATOM and participate in network security in exchange for a portion of block rewards which include transaction fees and new ATOM issuance. While the tokenomics of ATOM are likely to change in the wake of recent proposals (discussed later in this report), it is worth describing the current issuance schedule and monetary dynamics of the asset.
The initial supply of ATOM (detailed in Chart 1) was 236.2M tokens and since inception, new issuance awarded to active validators has grown the total outstanding supply of ATOM to 312.6M tokens at current. The annual issuance rate of ATOM is currently ~12.9% and was designed to dynamically adjust based on the proportion of ATOM currently being staked. Notably, the protocol targets a staking ratio of two-thirds of the total token supply. If more than two-thirds of ATOM are staked, annualized block rewards decrease gradually down to a floor of 7% and if less than two-thirds of ATOM are staked, annualized block rewards increase gradually up to a ceiling of 20%.
ATOM holders that are not operating validator nodes can still participate in the staking process as delegators in order to receive revenue in the form of block rewards and transaction fees. The revenue split between validators and delegators depends on the commission rate charged by the validator, typically ranging between 0% and 20%. Delegators can decide to change validators at any time via a “redelegate transaction” and can claim their rewards distributed each block via a “claim transaction.” These rewards can then be staked in order to compound yield for delegators. The unbonding period of 21 days only applies if the delegator wishes to undelegate their stake.
Chart 1. Initial ATOM supply
Cosmos Hub V2 & ATOM 2.0
Historically, however, very little of the revenues generated by the growing ecosystem of Cosmos appchains have accrued to holders of the Cosmos Hub’s native token, ATOM. This dynamic could soon change by virtue of several fundamental proposals announced at the Cosmoverse conference held in Colombia in late September. Cosmos released a new whitepaper that articulates the revamped vision for the Cosmos Hub focused on interchain security, allowing other Cosmos appchains to borrow or “rent” validator capacity from the Cosmos Hub in order to better secure their own networks (while also allowing Cosmos to more directly monetize the security assurances of the Cosmos Hub).
Further, the whitepaper proposes key changes to the issuance schedule of ATOM and aims to enhance the utility of the native token through the introduction of liquid staking. Unlike the current issuance schedule which dynamically adjusts based on the supply and demand of staking, the newly proposed monetary policy would temporarily increase issuance (relative to the historical issuance rate which has ranged from ~7% to ~20% annualized) for the first 9 months. That will be used to bootstrap the funding of a new Cosmos Hub Treasury before falling below current issuance levels and continuing to decline over the subsequent 27 months, eventually arriving at a steady state issuance of ~300k ATOM per month (or ~0.1% of the current outstanding supply).
At a high level, the combined effect of these proposals (if passed via governance voting) promises to more concretely position the Cosmos Hub and ATOM at the heart of the growing Cosmos ecosystem by enhancing the utility of ATOM and allowing the token to accrue value in tandem with the broader growth of the network. That being said, the Cosmos community has raised concerns about the proposals, which we believe have some merit. While the updated issuance schedule eventually tapers to a steady-state annualized issuance of less than ~0.1%, the proposal equates to ~88M ATOM (~US$1.1B) being issued over the 3 year period, with ~55M ATOM (~US$678M) being directed towards the Cosmos Hub Treasury. Importantly, the bulk of this new issuance (~65%) will occur in just the first 9 months of the proposal.
Current ATOM holders are rightly concerned about near-term dilution and have also scrutinized the manner in which the Cosmos Hub Treasury funds will be deployed. Certain community members, including the co-founder of Tendermint, have expressed the view that in order to entrust the Treasury with such a meaningful amount of capital, the tooling for community coordination to deploy that capital sensibly must be more well-defined and rigorously tested. Without a reliable model for coordination and deployment of capital, ATOM holders will be diluted in the near-term and effectively bear the bulk of the risk associated with deploying the Treasury capital at high rates of return.
Another feature proposed by the ATOM 2.0 paper is the Interchain Scheduler, which facilitates an interchain MEV marketplace on-chain. Assuming cross-chain activity continues to grow, the opportunity for MEV across the Cosmos ecosystem will be significant. However, the Cosmos development community also recognizes that not all forms of MEV are created equal and oftentimes MEV is subject to off-chain cartelization, advantaging a small minority of market participants. While taking advantage of unsuspecting users’ transactions by front-running or constructing sandwich-attacks could be considered malicious, other forms of MEV such as arbitraging prices between pools, DEXs or CEXs could be viewed as efficient. Therefore, the aim of the Interchain Scheduler is to create a rational, transparent, trust-minimized marketplace for MEV, allowing appchains to voluntarily sell blockspace in an auction format in an effort to incentivize the “efficient” forms of MEV and minimize the more malicious forms.
Another related proposal is the Interchain Allocator, which allows the Cosmos Hub Treasury to fund new Cosmos chains through on-chain agreements. In theory, the Interchain Allocator will function in tandem with the Interchain Scheduler to create a positive flywheel wherein a portion of proceeds from the onchain MEV marketplace are directed towards the Interchain Allocator. The funds will then be deployed by the Interchain Allocator to fund appchain development and grow the Cosmos ecosystem, which in turn should create incremental opportunities for MEV.
With the introduction of liquid staking and the potential monetization of shared security, Cosmos' revamped roadmap attempts to position “interchain security” as the core “application” of the Cosmos Hub. Further, by introducing a positive feedback loop between the Interchain Scheduler and the Interchain Allocator, the proposed solutions aim to better align the incentives of the ecosystem and position ATOM to benefit from the growth of the interchain network.
Broadly speaking, the collective aim of these proposals is to allow the Cosmos Hub to become a credibly neutral provider of security, while further aligning the incentives between appchains and ATOM holders. In this way they are trying to increase the likelihood that ATOM will generate a monetary premium. While the V2 proposal introduces a handful of innovative ideas aimed at achieving this vision, we remain wary of the suggested changes to ATOM’s monetary policy and whether the benefits of the future capital deployment of the Cosmos Hub Treasury warrant the risks of near-term dilution for token holders.