Understanding Dotsama’s Inflation And Staking Rewards

Welcome back. Today we’re diving into the relationship between inflation and staking rewards — who benefits from increased purchasing power, and who loses purchasing power.

Inflation

Inflation of the US Dollar decreases the purchasing power of each dollar, evident by the fact that a loaf of bread used to cost a few cents, and now costs a few dollars. The cents lost their purchasing power — they cannot buy as much.

In the ancient age of the 20th century, you could (usually) deposit your USD into a bank and receive a higher rate of return than the inflation rate, thereby increasing your purchasing power.

Fisher’s Equation: Real Rate = Nominal Rate - Inflation Rate

The Nominal Rate is the rate the bank advertises to you, and the Real Rate is the actual effect on your purchasing power. Inflation is usually measured by the Consumer Price Index, which tracks the cost of a basket of consumer goods Year-Over-Year.

If your savings account pays you 5% per year (Nominal), and inflation is 2%, your purchasing power is only increasing by 3% per year (Real Rate). For an example, we can revisit the chocolate bars from the last article. Today you have a $1,000 and chocolate bars cost $1. You could buy 1,000 chocolate bars. However, you do not, and instead put your hard earned money in the bank. A year from today, you have $1,050, but now chocolate bars cost $1.02, due to inflation (inflation does not directly drive up prices, but sellers will increase prices so that they receive the same purchasing power benefit for each sale, due to each dollar/cent having less purchasing power). You can now buy 1,029 chocolate bars. You have gained purchasing power due to your savings account.

If, however, you did not put your money into your savings account, and put it under your mattress, a year from today you will still have $1,000, but the chocolate bars will cost $1.02. Now, you can only buy 980 chocolate bars. You have lost purchasing power due to inflation. Per Fisher’s equation, your Real Rate was -2%, as your mattress provides a Nominal Rate of 0%, and the Inflation Rate is 2%. Two percent of 1,000 is 20. Before, you could buy 1,000 chocolate bars, and now you can only buy 20 less than 1,000, or 980 chocolate bars.

Such is life with an inflationary monetary system. Normally, it’s not a big deal, as you can earn a risk free return that is greater than the inflation rate. Currently, this is absolutely not the case. Banks are advertising their “high yield” savings accounts that pay less than 1% per year, but the Federal Reserve has increased the supply of USD by over 25% since the beginning of 2020. If you haven’t increased how many dollars you have by over 25% since then, you have lost purchasing power.

The Federal Reserve has robbed you.

By printing money and loaning it to the big banks for nearly nothing, or using it to increase their balance sheet, the Federal Reserve is devaluing your dollars and stealing your time by doing so. Meanwhile they just get free money. It is legal counterfeit, a theft of your wealth and time.

The problem with inflation is this: it is a zero-sum game. Someone has to lose so that someone else can gain.

Inflation In The Dotsama Ecosystem

You may be thinking that inflation sounds like the worst thing possible, and why would such excellent projects like Polkadot and Kusama have inflation? The reason why is that it promotes network security.

In last week’s writeup, I mentioned that Dotsama runs on Nominated Proof of Stake. Here’s an excellent article detailing how NPoS works.

Network security has a direct correlation with the % of the total supply of DOT or KSM tokens staked. Maximum security would be achieved with all tokens staked to nominate validators. Obviously, this will never happen, as the tokens are not usable while staked (until the Acala/Karura parachains launch and provide liquid staking). Network security is vital on a distributed ledger.

In NPoS, nominators and validators are rewarded. Transaction fees will always help to pay for the rewards, and currently, inflation helps as well (the rate of inflation for DOT and KSM could be reduced to 0% with an on-chain governance vote). New tokens are minted and paid out as staking rewards.

I’ll talk about Polkadot, but Kusama works the same way. The inflation rate of DOT is determined by what % of tokens are staked. The maximum inflation rate for DOT is 10%, and that happens when 50% of DOT tokens are staked. Above and below 50% staking, the inflation rate drops off. Currently, DOT is at 8.8% inflation rate with 63.1% of all DOT staked.

All of the new DOTs that are created due to inflation are deposited directly into the Polkadot Treasury, along with all transaction fees. The Treasury is what pays out the rewards to nominators and validators. Here is an important part: the Treasury does not pay out all of the new tokens it receives. Therefore, the effective inflation rate is actually lower than 8.8%, unless the Treasury spends all of its funds.

The staking rewards will always be higher than the inflation rate. This is programmed in. Nominator staking rewards will vary depending on a number of factors, but the Kraken exchange offers a flat 12% staking reward service, which means they are making over 12% on average from staking on their end (I doubt they would offer it if they weren’t making a profit). Inflation is 8.8% and you can make over 12% via staking. Right at 12% on Kraken, your real rate of return is 3.2% annually. Much better than the bank’s “high yield” savings accounts.

Effects of Dotsama Inflation

Now, if inflation is a zero-sum game, and Polkadot has inflation, who wins, and who loses?

Due to clever design, those that enhance network security win, and those that do not, lose. Staking helps to enhance network security and not only protects you from inflation, but gives you a real return on top of it. Those that do not have their funds staked will suffer from a steady loss of purchasing power due to inflation.

Dotsama transfers purchasing power from mere network users to those enhancing network security.

Additionally, inflation takes purchasing power from those that are not staked, and gives it to the Treasury. Having funded Treasuries is vital to the Dotsama ecosystem’s success. Funding ongoing development and community efforts will ensure that Dotsama continues to grow into the future and meet the needs of tomorrow’s developers. You can begin to see how Polkadot and Kusama will evolve — they are Decentralized Autonomous Organisms.

The Takeaway

Could Dotsama function without inflation? Yes, it could. Staking rewards and Treasury funding could be based entirely off of transaction fees. The problem with this is that either the staking rewards would plummet, and network security and Treasury funding along with it, or transaction fees would skyrocket to keep staking rewards high and adequately fund the Treasury.

With Dotsama, the only downside to inflation, loss of purchasing power, is a choice. Unlike with the US Dollar, nobody can forcefully steal your purchasing power. You have to make the choice not to stake. If you want to maintain your purchasing power, you need to be staked for the majority of the time, and if you want to increase it, you should be staked all the time.

If you want to stake but still want to be able to use your tokens, Acala/Karura and Bifrost have you covered (imagine if you could put your USD in your bank’s savings account and checking account at the same time).

At the end of the day, Dotsama’s inflation is a good thing. While it could be reduced to 0% with an on-chain governance vote, I do not see that as likely. It promotes and ensures solid network security, as well as funding future development and growth of the ecosystem.

In the words of Crab Network, “Expect Chaos is a reasonable expectation.”

Polkadot: 14x6ah3J21QonWASv6QKwqd8SWrS7ddqmMzyRCmGQWMaPzae

Kusama: GXR6g86nbAG6cyNjAANhe9yjV92Dztt9F7Eea3sLDYYxbRq