Why would investors hold blockchain nodes or validators?
- igonzalezdelmazo
- Oct 15, 2020
- 4 min read
Blockchain protocols need nodes or validators to create or validate the blocks that allow individuals to use the blockchain. These are normally just computers or other electronic devices and can be hosted in the cloud. Normally, nodes or validators are rewarded to perform their duties and can also be punished if they do not behave according to the protocol rules. As of now and given the monetary rewards nodes or validators, they are hosted by investors, exchanges, custodians or individuals/entities looking for return, but they are also very useful for research and regulatory purposes.
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Blockchain protocols, especially those that are open source, are rooted in the idea of the TCP/IP internet protocol. They are a set of public rules that allow individuals to interact on the blockchain to send value (or data). Protocols are normally explained in publicly disclosed white papers and include instructions on how participants should behave.
Protocols need nodes or validators to work. These are just computers or other electronic devices running software that create/validate the blocks on a blockchain. The more nodes or validators a blockchain has, the more decentralized a protocol is. Decentralization is desirable in open protocols since it reduces the probability of a 51% attack and eliminates the single point of failure that our financial system sometimes relies on.
Nodes can also be hosted in the cloud. For example, it was reported in September 2019 that 60% of the Ethereum nodes were running in AWS cloud[1]. However, they can also be hosted in Google Cloud, Azure, etc. This possibility of hosting nodes in clouds has raised several questions on what the real decentralization of some of these protocols is.
Protocols need nodes or validators to work, which are just computers or electronic devices running software. Nodes can also be hosted in the cloud
Depending on the protocol, nodes or validators are expected to perform different tasks to be able to create or validate the next block of the blockchain and achieve consensus in the network. To make sure that nodes or validators perform their duties, protocols often offer them rewards. Some of the processes by which these rewards work are proof-of-work (PoW), proof-of-stake (PoS), and delegated-proof-of-stake (dPoS). PoW makes nodes compete among each other to solve a math problem and the first one who sells the problem writes the next block. PoW is used by used by Bitcoin and Ethereum 1 and it is also called mining. PoS makes nodes put part of their tokens in escrow, what is called ‘staking’, and a pseudo-random mechanism that can include length of staking, randomization, and the node’s wealth is used to choose the node to write the block[2]. PoS is considered more energy efficient and used by Ethereum 2.0, Polkadot, Cosmos and many protocols. dPoS offers the possibility to nodes of voting third parties to outsource their work, this allows further scalability.
To make sure that nodes or validators perform their duties, protocols often offer them rewards
Some protocols, in order to incentivize security and participation among nodes, have punishments. One of these punishment techniques is called slashing, which means that a percentage of the tokens staked are lost if the nodes do not behave according to the rules. The two main reasons why this punishment happens is because either a node disconnects temporarily or tries to create two blocks at the same time.
Given these rewards mechanisms, more and more investors want to hold these nodes or validators. A report from PwC on Crypto Hedge Funds mentions that 42% of funds use staking strategies and, as of 2019 the industry had assets-under-management (AUM) equal to USD 2 billion. While holding nodes for PoW mechanisms require lots of electricity, holding nodes for PoS mechanisms only require buying a minimum number of tokens from the protocol, which makes it easier to participate as node or validator.
Given these rewards mechanisms, more and more investors want to hold these nodes or validators. A report from PwC on Crypto Hedge Funds mentions that 42% of funds use staking strategies
Additionally, nodes and validators are also used for research purposes. Hosting a node allows to download the full length of the blockchain since its genesis. This is very valuable for universities, research companies and regulators. The SEC has confirmed that it holds an XRP validator (but XRP has not a reward mechanism) and it requested a quote in 2019 to buy on-node data for Bitcoin and Ethereum and as many of the following: ‘Bitcoin Cash, Stellar, Zcash, EOS, NEO, and XRP Ledger’. For regulators this information is wanted ‘to monitor risk, improve compliance and inform Commission policy with respect to digital assets’[3].
The SEC holds an XRP validator and, in 2019, it requested a quote in 2019 to buy on-node data from several blockchains including Bitcoin and Ethereum for risk monitoring, compliance and policy purposes
Overall, it is very likely that we are going to see an increase in investor and research institutions holding nodes and validators. Which will be the winning protocols is yet to see. The number of protocols is increasing and their robustness as well, which may generate new winners and attract more interested parties. In addition, the financial incumbents are leaning more and more towards the technology as well as regulators.
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