The Virtuous Cycle of Masternodes

Proof of Stake is hardly a battle-tested concept, few successful cryptoassets are native Proof of Stake.  Most notably, Ethereum’s impending hard fork to the Casper Protocol is the first time a large network-value asset will change from Proof of Work to a staking consensus mechanism.  However, instead of pricing in any risk associated with this, the impending hard fork seems to have triggered a vertigo-inducing price rally – as if investors and speculators are fighting for the sidecar seat on Evel Knievel’s motorcycle.  I argue that this is a general phenomenon for assets with masternodes, a “virtuous cycle” of price action and liquidity.

Masternodes and Proof of Stake

Proof of Work can be generalized a bit more readily than Proof of Stake (PoS), but we can say that most Proof of Stake schemes bundle some requisite number of the coins in “masternodes.”  The masternodes then earn more coin if they propose good blocks and have their stake slashed if they propose bad blocks to the blockchain.  Alternatively, masternodes can route transactions, handle blockchain governance, or provide anonymization services.  More on that later.  In the case of Ethereum, the masternode bundle will consist of 1000 ether which cannot be moved from the ETH address while the staking node is functional.  Operationally, therefore PoS schemes turn the currency into a dividend-paying asset – for those with the requisite number of coins to make a masternode.

There are many important details and technical considerations here as well.  We can suffice it to say that running a masternode may carry risks beyond the usual cryptocurrency risks and you should learn what you’re doing before broadcasting to the internet that you have a high-value bundle of cryptocurrency, even if the broadcasting is through the node topology.

The Virtuous Cycle of Cryptocurrency Masternodes

As to the point of this post, since masternodes require the cryptocurrency to be taken out of active circulation, a cycle begins:
  1. Masternodes take coins out of circulation, increasing scarcity
  2. Increasing scarcity drives prices up
  3. Increasing price makes masternodes and their stake rewards worth more
  4. Greater stake rewards incentivize more masternodes
              …GOTO 1.

Evidence of the Cycle in Other Masternode Currencies

Since masternodes are not unique only to PoS assets, this gives us an opportunity to see if there’s evidence that this is, in fact, a significant price action effect.  The Dash cryptocurrency has blocks which are verified by a PoW algorithm, however, the protocol allows for masternodes which perform additional services of “tumbling” coins to provide anonymity and allowing nearly-instantaneous transactions through the masternode network (similar to the federated nodes idea of Stellar or Ripple).  At the beginning of the 2017 cryptocurrency bull market, Dash experienced a sharp upswing.  It’s only really sensible to make the apples-to-apples comparison to bitcoin’s price, so we include the Dash vs. bitcoin chart to see the price appreciation.
Chart of Dash, denominated in BTC. from

We also can look at the two next-largest masternode utilizing currencies, PIVX and Zerocoin to see if there’s a similar appreciation, possibly due to the masternode liquidity effect.
Chart of PIVX, denominated in BTC. from
Chart of ZCoin, denominated in BTC. from
The natural next question is whether the virtuous cycle on an upswing will become a vicious cycle upon price depreciation.  The good news is that there may also be negative feedback mechanism that works against a “masternode liquidation run,” depending on the exact payout structure of the protocol.  Imagine the cycle starting to run in reverse, perhaps kicked off by lowering value of the underlying coin.  People choose to liquidate their masternodes, increasing the circulating coins and adding more selling pressure, causing more masternode operators to liquidate their nodes.  If the masternodes are paid by overall share of block rewards (as opposed to the share of transactions the node itself has verified), the runaway liquidation should have pressure to stop since the remaining nodes are getting an increasing supply of the block rewards – and incentive to remain.

The other good news here is that you’re not left out of price appreciation if you either don’t have enough coins to make a masternode or are, for whatever reason, squeamish about staking. The masternode price appreciation will carry even the unstaked coins with it.

The usual suite of due diligence questions about a cryptocurrency protocol still needs to be asked and answered, regardless of whether it has the sweetener of a masternode or staking reward, however understanding the masternode/liquidity connection can be another useful tool in your crytpoasset analysis toolkit.

Some Resources on Masternode Coins