Arrington Capital: In-depth Analysis of Polkadot's Parachain Design Philosophy and Operational Mechanism

Author: Ninos Mansor, Partner at Arrington Capital

Original Title: 《The League Of Parachains: Polkadot》

Translated by: Linqi, Chain Catcher

Abstract

Polkadot presents a novel solution to the multi-chain problem, akin to the coexistence of multi-ethnic nations in the international community. Each nation pursues its own destiny and harbors a beautiful vision for the future, with these diverse cultures coming together to form alliances, engaging in trade, and living in a world of good diplomacy rather than war.

This is the underlying philosophy behind Polkadot's "Layer Zero" (L0) relay chain. Developers build custom blockchains (parachains) tailored to specific applications and user needs, but these chains collaborate under the banner of shared security. They each focus on establishing their core competencies in Layer 1 (L1) while collectively enjoying the security of L0.

Polkadot aims to be the blockchain of blockchains, separating state from application, allowing each L1 to focus on the customizability of its own chain. L1s outsource security concerns to the mothership: just as each nation can benefit from a standing army without needing to form, maintain, and deploy one, parachains can redeploy resources originally intended for L1 security to their core competencies. This shared security system liberates (1) the customizability of parachains without sacrificing their security; (2) the inherent interoperability between different parachains.

Polkadot requires unique economics. Parachains rely on the security of the relay chain, but security is not something that can be obtained at will. It is scarce. Therefore, the scarcity of parachain slots shapes the entire economic architecture around how developers acquire, maintain, and outsource security at L0.

To price and allocate this scarce resource of network security, Polkadot turns to the free market: candle auctions. In this way, future network users can fund support through a crowdsourced loan process, achieving permissionless, competitive, and fair distribution of resources. Projects unable to secure a parachain slot can still rent security from holders of parachain slots through a pay-per-use model.

In this report, we interpret the technical and philosophical foundations of Polkadot.

The first part will focus on how Polkadot addresses the blockchain trilemma, converging on the customizability of parachains;

The second part will interpret the financing issues of parachains through crowdsourced loans, candle auctions, and parathreads;

In the third part, we will explore well-known pioneering parachain projects and describe how they leverage Polkadot's architecture to build their custom blockchains.

1. Polkadot: Layer 0

1.1 Hypothesis of a Multi-Chain World

We will live in a multi-chain world. Nations and states differ due to their diplomatic histories, multi-ethnic compositions, and relative advantages in trade and production. Similarly, blockchains will provide various functionalities for users with diverse needs, with each region having a blockchain best suited to its goals. Different political and economic ideologies will manifest as consensus algorithms and release times.

The multi-chain world will appear in the image of its users. Real-time currency experiments unlock a new monetary order: users can seamlessly migrate to chains that reflect their worldviews, whether they are Austrians, Keynesians, or anything in between.

The same user will live on different chains simultaneously, demonstrating the inconsistency and fragmentation of human personality. The multi-chain world is a natural evolution of the multi-national world: while multi-chains are less constrained by geography than ever before, they still require a center. It will be needed for diplomacy, trade, and peacekeeping infrastructure.

This is the core of Polkadot and its contribution to the multi-chain landscape.

1.2 The Blockchain of Blockchains

1.2.1 Solving the Trilemma: Separation of Application and State

The DeFi boom of 2020 and the NFT surge of 2021 validated the multi-chain hypothesis. Moreover, the summer's prosperity demonstrated the extent to which developers and users are constrained by narrow design parameters. They must choose one chain and accept its integrity, security, and consensus, which is sufficient for some applications but not for others. Consequently, users have no choice but to either compete for resources (such as gas wars) or incorporate suboptimal designs into this constrained environment (such as DEX designs: AMMs vs. CLOBs).

The most common conclusion drawn from Ethereum's constrained experiments is that Ethereum needs to scale. While scaling can alleviate transaction congestion and reduce costs, users remain trapped in a single blockchain paradigm, subject to governmental laws.

Another conclusion is that no (or very few) networks will be suitable for all applications. Instead, we all need to use these applications. Which blockchain should host the aforementioned use cases? High-value transfers require extremely high security, at the cost of throughput and settlement time. Small, frequent transfers do not require these but need high speed (e.g., payment channels, derivatives trading, gaming).

Of course, specialization comes at a cost. A more general manifestation of these trade-offs is the blockchain trilemma: the need to balance scalability, security, and decentralization.

Our view is that over time, there will be different approaches to solving the trilemma. We have previously written about Vega's application chain approach, which resolves the trilemma by building L1s for its applications, and Algorand's desire to establish a single foundational layer that addresses the trilemma through cryptographic innovations.

Polkadot addresses this issue through abstraction, allowing different chains to coordinate and collectively solve the trilemma. Its execution takes the form of a network of networks, decoupling state from application. Each parachain is its own L1. Developers can customize their security assurances without sacrificing performance.

Polkadot does not attempt to solve the trilemma for L1s (parachains) but acts as L0 (the relay chain), coordinating among all these custom blockchains. Thus, Polkadot's approach to the trilemma focuses on composability: each blockchain relies on the decentralization and scalability of continuity to configure its parameters.

More importantly, due to the use of abstraction, Polkadot's L1 blockchains are fully customizable. Parachains determine their own architecture, consensus mechanisms, etc., but still rely on L0 for security. Therefore, like a nation, parachains focus on their competitive advantages while coexisting within a broader blockchain alliance. Each chain enjoys collective security, just as a nation benefits from the protection of an international military committee. Joining Polkadot is akin to joining an organization like NATO: L0 is based on the concept of collective security, protecting the global ecosystem of parachains.

A second, arguably more easily overlooked byproduct of security abstraction is interoperability. Since different parachains coordinate security through the relay chain, the relay chain can route information between parachains. This means that critical infrastructure such as decentralized oracles and bridges can operate within the local network and benefit from the same security assurances.

L1 chains can conduct unilateral transactions without needing to form bilateral agreements. Being part of the relay chain is akin to being a member of the WTO. Parachains can communicate and transfer value while relying on a single infrastructure (the collective security of the network). Polkadot thus eliminates the need for each oracle or bridge to bootstrap security independently, creating economies of scale and allowing parachains to double down on their comparative advantages.

Figure 1: Left: The blockchain trilemma of L1 blockchains—some trade-offs between scalability, security, and decentralization will always exist.

Right: Polkadot's approach to solving the trilemma: abstracting security assurances from L1s, thereby acting as L0 to coordinate L1 blockchains for security and scalability. This is how Polkadot achieves a customizable multi-chain world.

1.2.2 The Origin of Parachains

If developers want to deploy dApps, they can either deploy on existing blockchains or build their own custom blockchains. The advantage of deploying on major blockchains like Ethereum is that dApps inherit the security and liquidity assurances of the parent network. The downside is that developers (and ultimately users) are constrained by the L1 consensus properties. Since the blockchain is not tailored for the dApp, users are clearly second-class citizens on the network.

Another approach is to deploy on a separate, custom blockchain optimized for the dApp. The problem with this application chain approach is that custom blockchains need to bootstrap their own security. New blockchains need to attract sufficient capital to secure consensus, ultimately encountering cold start issues.

In itself, each potential L1 may not have enough economic value to bootstrap a network, but what if they could come together? Then, a long-tail blockchain could attract enough capital to ensure security. What if there were a way for small dApps to pool funds and form a collective to bootstrap security, even if they could not succeed on their own due to their small scale?

Polkadot offers a third option: parachains. Parachains are L1 blockchains that coordinate with the relay chain, outsourcing security assurances. Parachains have their own set of nodes ("collators") that work in coordination with relay chain nodes ("validators"). Generally, blocks produced by collators are validated and signed by validators to generate relay chain blocks. Validators verify blocks from any parachain and rotate among different parachains to prevent collusion.

The end result: developers can launch dApps on custom blockchains while still coordinating shared security with other chains through L0. This is Polkadot's defining feature: parachains enable dApps to share security without sacrificing customizability.

By decoupling state and application, the relay chain does not store the state of parachains; it only focuses on changes in state, not the state itself. Thus, the relay chain is unaffected by the storage requirements of various parachains, making each parachain a first-class citizen.

1.2.3 Outsourcing Security: The Relay Chain

Polkadot's consensus algorithm separates state from application. The relay chain uses a designated PoS model to achieve consensus, with validators ensuring honest behavior through staking. Other validators oversee the misconduct of this validator. Consensus on the relay chain occurs (roughly) as follows:

1. Each parachain uses its own custom consensus mechanism to propose candidate blocks and submits them to the relay chain.
2. Relay chain validators, randomly assigned to a given parachain, validate and distribute the candidate blocks they receive from the parachain.
3. A selected validator proposes a new relay chain block using the validated parachain candidate block.
4. Other validators oversee the block proposal (for both parachain and relay chain blocks) and vote to finalize a relay chain block (finality). By allowing parachains to use their own consensus algorithms while coordinating through the relay chain and outsourcing security to an L0, parachains can maintain scalability and decentralization.

Figure 2: The Polkadot architecture consists of three main components:

(1) The L0 relay chain as a center for shared security,

(2) Independently operating L1 parachains that rent security from the relay chain for fixed leases, and;

(3) Parathreads, which regularly rent security from the relay chain but do not have fixed parachain leases.

2. Polkadot Parachains

Due to the shared security of the relay chain, Polkadot can accommodate a limited number of parachains with sufficiently high security assurances. Thus, parachains are scarce, and candidates must compete for a slot. They must persuade the market to believe they should be anchored to the relay chain. The total number of slots is a function of the number of relay chain validators (constrained by computational limits).

Calculating based on a ratio of 10 validators per parachain, approximately 1000 validators can accommodate around 100 parachain slot positions. Below, we will describe how L1s compete for parachain slot positions and how parachains can rent their services to parathreads (L1s hoping to use the relay chain without securing a parachain slot).

2.1 The Wisdom of the Crowd: Parachain Auctions and Parachain Crowdfunding

Parachain slot positions are the "prime real estate" of the network, or rather, the primary asset. They are priced and allocated by the free market. As described below, slot positions are priced through "candle auctions." Candidate parachains raise funds through a process known as "crowdfunding" to finance their bids.

2.1.1 Decentralized Finance: Crowdsourced Loans and Parachain Leasing

To deploy on Polkadot parachains, L1s must secure parachain leases (with a maximum term of two years). They bid for parachains using DOT (the native token of L0), which they can collect through crowdfunding. The winning bidder is locked into the network's stake during the lease period (two years) and is used for governance of the relay chain.

The community, which consists of future users of the parachains, funds these bids. Thus, the resources of the parachains reflect the needs of the community. More importantly, since bidding occurs during the lease period, funders and parachain candidates have aligned incentives. Once the lease period expires, funders can withdraw their funds, so the winners of the parachain must rebid to maintain their positions, again presenting their case and attempting to persuade the community.

To attract this funding, parachain candidates typically issue tokens (granting governance rights to the parachain project) in exchange for DOT.

2.1.2 Effective Pricing: Candle Auctions

To facilitate fair and effective pricing, Polkadot employs "candle auctions" when allocating parachain slot positions. Historically, a candle auction is a bidding process that lasts until the candle goes out, making the auction period genuinely uncertain. Participants bid over an unknown duration and the auction ends at a random time.

In Polkadot, the candle auction is conducted using a fixed duration for the auction but retrospectively selecting the end time of the auction (this occurs within a subset interval, for example, in Kusama, the auction expiration is randomly assigned in the last two days). This design ensures that bidders' bids can express their true value, guaranteeing effective pricing and allocation of parachain slot positions.

Figure 3: Parachain candidates fund their bids through crowdfunding. During the candle auction, the best strategy for each bidder is to bid their maximum target. The auction winner will receive a fixed-term parachain lease. Failed bids can still regularly use the relay chain by becoming parathreads on any parachain. After expiration, the auction process will repeat.

2.1.3 Everyone Has a Share: Parathreads and Public Good Chains

2.1.3.1 Parathreads

Given that there are only about 100 parachain slot positions available, what happens to the long tail of applications? Polkadot again leaves this question to market forces. L1s that cannot secure parachains can still regularly connect to the relay chain using the parachain infrastructure.

Parathreads do not rent a slot position by pre-investing funds but generate pay-as-you-go fees, effectively renting the network's primary asset.

If a parathread project garners sufficient demand, it can bid for a parachain slot position once one becomes available. Similarly, a parachain project that no longer meets market demand can be relegated to a parathread. In this way, market forces continuously govern the allocation of resources within the Polkadot network.

2.1.3.2 Public Good Chains

Another example of long-tail projects is "common good" projects, such as bridges connecting to the Polkadot network (for instance, from the Bitcoin network). In this case, all parachains would benefit from the existence of such a bridge, but the economic returns may not be sufficient to ensure a win in the parachain auction. Instead, parachains (and general DOT holders) can collectively vote to fund common good projects to avoid the tragedy of the commons. Projects competing for common good chains cannot issue their own tokens, as they are directly funded by the governors (DOT holders).

3. Pioneers of Parachains

3.1 The Canary Network: Kusama

Polkadot has an incentivized test network called Kusama. This is Polkadot's "Kusama network," a testing ground for new projects and features. Kusama is structurally almost identical to Polkadot but has developed its own "life," hosting the first parachain auction.

In general, projects bidding for Polkadot parachains will launch a sister project on Kusama due to the lower risk value (which provides greater freedom for deploying experimental features). Kusama may become a partner chain for long-tail Polkadot parachain candidates and parachains with lower security requirements. Thus, Kusama can bridge the gap between Polkadot's parachains and parathreads: projects will attempt to either secure parachains on Polkadot, become parathreads on Polkadot, or secure parachains on Kusama.

Below, we summarize the winners of the first Kusama parachain auction and their corresponding projects on Polkadot.

Figure 4: Moonbeam combines Ethereum's vibrant ecosystem with Polkadot's customizability and native interoperability, ushering in a multi-chain world.

3.2 Customizable Ethereum: Moonbeam & Moonriver

In a sense, Moonbeam is the ultimate realization of a multi-chain nation: it is a parachain whose core focus is on diplomacy and trade with Ethereum. Moonbeam (Moonriver on Kusama) is an EVM parachain designed to expand the current experience on Ethereum by allowing dApps to be easily deployed on Polkadot. Moonbeam is fully compatible with Ethereum contracts and tools (including development frameworks, oracles, indexing tools, contract packages, etc.) and uses a permissionless set of collators with PoS consensus.

The project achieves the same development and execution environment as Ethereum while adding built-in interoperability with other parachains and extended foundational layer functionalities (on Moonbeam), including benefits such as staking, governance, and cross-chain transfers. Like every parachain, it operates as its own L1, making it particularly attractive for selective developers seeking options between Polkadot and Ethereum. As an olive branch to the largest developer community, the Moonbeam parachain and ecosystem can serve as a broader indicator of the success of multi-chain theory.

3.3 Native DeFi Chain: Acala and Karura

Acala (Karura on Kusama) is a DeFi layer compatible with EVM on Polkadot. It is the first native DeFi chain on Polkadot. DeFi on Acala is fundamentally different from Ethereum and other L1s. On Ethereum, developers can only customize applications at the smart contract level (i.e., the application layer). Beyond the application layer, they cannot control how Ethereum operates. They cannot control gas fees or the currency used to pay them.

Acala brings the spirit of customizability from Polkadot to DeFi: developers can step out of the smart contract sandbox and optimize the core blockchain logic of DeFi. Gas fees can be paid in any token, which Acala refers to as economic abstraction. Acala also supports native DeFi primitives, enabling developers to address specific domain issues, such as planned liquidation (for lending dApps) and ensuring protocol solvency during liquidity crises.

Other customizable features include whitelisted transaction types (e.g., oracle price update transactions can be gas-free) to ensure they are always included in each block. This is crucial during liquidity crises to materially incentivize faster liquidations and stronger solvency guarantees (again addressing a specific domain challenge in DeFi).

3.4 Polkadot's Layer 2: Astar and Shiden

Astar Network (Shiden on Kusama) is a scalable, EVM-compatible smart contract platform that supports L2 scaling solutions, aiming to build Ethereum 2.0 on Polkadot. Astar will support cutting-edge rollups, including Plasma, Optimistic, and ZK-rollups. By natively enabling L2 technology on Polkadot, Astar can scale throughput without dApp enablement and liquidity fragmentation storage. By occupying a parachain, Astar unlocks L2 scalability for Polkadot parachains while maintaining interoperability. Theoretically, given Polkadot's fundamental interoperability, this could help address existing liquidity fragmentation issues on Ethereum's L2.

3.5 Decentralized Cloud Computing Network: Phala and Khala

Phala Network (Khala on Kusama) is a decentralized private cloud computing network. Phala allows for large-scale private computation on the blockchain by separating consensus and computation processes. Phala uses a designated PoS consensus, where computing tasks are randomly assigned to different nodes in the network. By ensuring large-scale data privacy, Phala can facilitate intensive and sensitive data processing, such as authentication, healthcare, proprietary trading, and on-chain forensic analysis.

3.6 Staking Platform: Bifrost

Bifrost Network (Bifrost on Kusama) is a protocol for unlocking liquidity for staked capital. It serves as an intermediate abstraction layer between the validator staking layer and the user application layer. Bifrost eliminates the opportunity cost of securing the network.

Users can deposit any PoS token into the Bifrost network, which will then issue 1:1 staking derivatives and collateralize assets on its native chain using cross-chain bridges. Staking rewards will subsequently accumulate to the derivative tokens.

3.7 Polkadot Indexer: SubQuery

To coordinate with each other, parachains need a secure and decentralized data aggregation layer to standardize communication between applications. SubQuery is a chain-agnostic decentralized data aggregation, indexing, and querying layer between blockchains and applications. It abstracts the blockchain-specific data characteristics using the SubQuery SDK.

If different parachains are different nations, then the relay chain is an international alliance for these nations, and SubQuery is the universal language of this new global order. SubQuery supports seamless communication between multiple dApps within and across parachains. Using SubQuery, developers can deploy applications on parachains without building their own querying frameworks.

Application developers (consumers) request data from the blockchain, while indexers are dedicated to cleaning and providing that data. Data indexing is established based on a manifest, which is a document describing which specific protocol's data needs to be indexed. Nodes operated by indexers record these instructions (i.e., what events to listen for, how to store data, in what format to store it) and update the data index with newly acquired data periodically.

SubQuery uses a data market to rationally allocate capital and parachain data. Unlike other data indexing protocols, consumers and indexers equally share the upfront indexing costs. Consumers and indexers enter into a custom agreement called a procurement order contract, agreeing on the structure of the data indexing, with consumers prepaying their fees.

Thus, if indexers fulfill the data indexing contract, their income is guaranteed. This means that both consumers and indexers are first-class citizens within the SubQuery protocol, rationally allocating their capital through coordination to achieve standardization, indexing, and aggregation of parachains.

Conclusion

Polkadot is a free market for L1s, mediated by a single relay chain L0. This relay chain is the foundation of parachain security, allowing each custom blockchain to focus on its unique relative advantages. By outsourcing security, they can more effectively customize chains and deploy resources, focusing on improving liquidity, user interfaces, and community growth.

Since security comes at a cost, parachains are a scarce resource. They are the primary asset of Polkadot. Candidates must compete to win a slot position, persuading the community (funders) to stake their DOT and help the project bid for a parachain. As leases expire after a certain period (up to two years), they must continuously repeat this process, ultimately inviting long-term participants into the ecosystem and incentivizing ongoing innovation.

We are interested in tracking the relationship between the economic value on parachains and the economic value on the relay chain (DOT). Many open questions remain. How will the economic value of parachains be distributed? How will parachains coordinate with each other? Given their collective fate, will they be able to cooperate effectively and avoid the tragedy of the commons? Will we see conflicts between parachains, just as conflicts arise between nations with different strategic and political goals?

How will these chains compete not only internally but also with L1s outside of Polkadot? Will parachains focused on inter-chain diplomacy (like Moonbeam) be able to successfully forge alliances not only with other parachains but also with empires extending beyond the ecosystem (like Ethereum)? Will we see the GDP of individual nations (parachains) exceed the GDP of the collective (relay chain)? Will the tremendous success of specific parachains pose a threat of fragmentation, prompting that chain to break away from the L0 alliance?

Polkadot's most profound contribution may be that it makes collective security a solution of the free market. The League of Nations, established after World War I, ultimately failed. Polkadot is the first attempt at decentralized collective security, a scarce resource that can be bought and sold in the open market, ultimately captured by parachains.

We are excited to deploy capital not only in emerging parachains and the tools that support them but also in applications built on each L1 (such as Moonbeam and Acala). As we move towards a multi-chain world, we will continue to see use cases that are not only increasingly customizable but also increasingly interconnected.

This touches on the core of Polkadot's design philosophy. The project ultimately seeks to balance the customizability of a free market for L1s with the unified internationalism of shared security—the parachain alliance.