What is Polkadot?
Polkadot calls itself a “next-generation blockchain protocol connecting multiple specialized blockchains into one unified network.” In plain English, this means that Polkadot is sort of like a blockchain of blockchains.
This happens through a process called sharding. In computer science, sharding means horizontally splitting up a database. For blockchains, sharding is a way of increasing throughput by spreading out the computational workload. Remember that a big unresolved problem of blockchain technology is scalability. Usually, all blockchain nodes have to confirm all transactions, slowing the blockchain down in the process. With sharding, nodes no longer process all transactions, but each shard, consisting of several nodes, processes only a part. The result is bigger throughput and increased scalability.
This is precisely how Polkadot works. The main blockchain is called relay chain, while the sharded chains are called parachains, which can all have different use cases. One might be focused on identity management, while another concentrates on storage. As a result of this architecture, the main chain is less cluttered and faster than other blockchains.
What is DOT?
DOT is the native token of the Polkadot ecosystem. It has three functions:
- Securing the network and confirming transactions. In the Polkadot ecosystem, validators confirm transactions. They require DOT to do that because Polkadot follows a nominated proof of stake system. You either have enough DOT to run a node, become a validator, and confirm transactions, or you can nominate someone with your DOT to do that for you. The validators get DOT as a reward for their work.
- Governance. As in many other blockchain projects, DOT holders exercise control over the Polkadot network. They can determine the network’s operating fees and auction dynamics, and decide, when necessary, to execute upgrades and fixes on the platform.
- Adding new parachains. This process is called “bonding” in the Polkadot ecosystem. DOT tokens are unavailable for use during this period and will only be released once the bonding period is over and the parachain is removed.
Who created Polkadot?
Polkadot is the brainchild of three founders. The most prominent one is Dr.Gavin Wood. He was a co-founder of the Ethereum blockchain and invented fundamental components of the blockchain industry, including Solidity, Proof-of-Authority consensus, and Whisper. He is also behind the now-famous term Web 3.0 and President of the Web3 Foundation.
The other two founders are Robert Habermeier, who has a research and development background in blockchains, distributed systems, and cryptography, and Peter Czaban, the Technology Director of the Web3 Foundation, where he works on supporting the development of the next generation of distributed technologies.
What are the different ways to earn a yield on DOT?
There are three ways to do that. The first option is to stake DOT on the Polkadot network. The second option is depositing your DOT into a crypto interest account that a third party company offers. The last option is providing liquidity through DeFi (decentralized finance).
Which one is better?
One is not necessarily better than the other because there are advantages and downsides to all of them. The main trade off between them are self-custody vs giving custody. With staking and DeFi, you will retain full custody of your DOT. It’s your responsibility to manage the private keys of your Polkadot wallet. With a crypto interest account, you hand over custody of your DOT to a third party company, who in return generates a yield for you.
What is a Polkadot interest account?
Instead of staking with the Polkadot network directly or using a DeFi protocol, you might choose to deposit your DOT with a company that earns yield for you. Similar to a bank, these companies take your DOT and lend it out at a higher interest rate than what they pay you. These types of services are often called crypto interest accounts or crypto savings accounts. They are a great option if you don’t want to manage and secure your own crypto wallet directly.
What should I look for in a company that offers Polkadot interest accounts?
You should do some basic due diligence before deciding upon an interest account for your DOT tokens. First, check the internet for reviews of this company/exchange and its security mechanisms. Then, take a look at whether the company has regulatory licenses to operate a crypto business.
Look for how much in assets under management this company or exchange already has. A good rule of thumb is that the bigger the company/exchange, and the longer it has been around, the smaller the chance that your assets will be at risk.
Can the interest rate on a Polkadot interest account change?
While most Polkadot interest account platforms aim to pay consistent rates on user deposits, these rates can change from time to time. Often these changes are due to market dynamics and don't happen more than a few times per year if at all. If they do make an adjustment to interest rates, they’ll often give customers a few days to a few weeks of notice.
How do I open a Polkadot interest account?
To open a Polkadot interest account, you will need to go through the KYC (know your customer) process on these platforms. When opening an account, they ask for an ID, proof of address (this can be a utility bill or a bank statement), and often a selfie with your ID and the current date written on a piece of paper. Don’t be surprised or irritated since this is standard procedure when opening an account with these companies. It’s just standard procedure just like opening up a traditional bank account.
What is staking?
Staking is essentially equivalent to locking up your coins and earning interest on them. It pretty much works like in a bank where you deposit your money into a savings account to get a better interest rate than your current account. However, this comes at the expense of not being able to withdraw your staked coins immediately. Most staking programs include a “cooldown” period between a few days and a couple of weeks. This is one downside of staking compared to just holding on to your coins.
Though most users merely care about the yield when staking, it’s worth noting that staking helps to keep blockchains secure and running because it’s essential to the consensus mechanism. With staking you are always in control of your DOT.
How do I stake my DOT on the Polkadot blockchain?
To stake DOT on the Polkadot blockchain you need to open the Polkadot web application and connect your wallet. You can then nominate a validator and start staking your coins. If you have your DOT in cold storage, for example, on a Ledger Device, you first need to install the Polkadot application on your Ledger Application. After that, connect to the Polkadot web application like in the previous example. Then select a validator, and you are ready to stake your DOT.
You need to be comfortable interacting with decentralized applications and handling your own funds. For a newbie, the process might feel a bit overwhelming. Another issue is having to choose a validator. In theory, this does not matter so much. But in practice, a validator might misbehave, and a part of the tokens he’s been nominated for might be slashed. Therefore, you should do some due diligence when choosing a validator, again something that a first-timer might not be comfortable with.
Can the interest rate from staking Polkadot change?
Yes. The protocol itself determines the interest rate on staked coins. Staking is used as an incentive to grow the project and widen the user base. Therefore, the earlier you are to staking, the higher the rates will be. For example, Polkadot had an interest rate of 65% when the project was just starting. But with more users, the interest rate has decreased over time.
You should also keep in mind that as more DOT tokens are being emitted, your DOT holdings will suffer from inflation. Staking your DOT tokens will help to ensure you don’t get diluted from this emission.
What is the difference between staking DOT and depositing DOT into an interest account?
When you deposit into a Polkadot interest account, you relinquish custody of your coins to another company or exchange. These companies and exchanges in return lend out your crypto to borrowers. The interest rate they pay you for your deposit is lower than what they change borrowers, thus creating a yield for you on your DOT tokens.
Whereas when staking with the Polkadot blockchain itself, you always maintain custody of your coins. With staking, there is no borrower on the other side of your deposited DOT tokens. Instead the Polkadot network pays you a reward for helping to secure the network and make sure it runs properly.
What is DeFi and how do I use it to earn yield on Polkadot?
Decentralized finance (DeFi) is the use of blockchain based smart contracts to automate financial products and services in a decentralized and transparent manner. Most DeFi applications require liquidity in order to facilitate trading or borrowing/lending services. These DeFi protocols incentivise liquidity by rewarding liquidity providers with rewards in the form of a yield.
While the Polkadot DeFi ecosystem is still early in development, there are DeFi projects that offer yield for providing your DOT tokens as liquidity. Be mindful that you will be responsible for the management and secure handling of your crypto wallet private keys when interacting with DeFi protocols.
Also DeFi does carry a lot of risk in the form of smart contract bugs, scams and failed project economics. It’s up to you to make the decision whether or not a DeFi protocol’s yield is worth the risk of losing your DOT.
Do I have to pay taxes when earning yield on DOT?
Taxes on cryptocurrencies are an evolving topic since the entire space is still comparably new, and the pace of innovation makes it difficult for tax authorities to keep up with. In the US, you first need to recognize whether your yield earning can be classified as a business or a hobby. Depending on how you classify your crypto activity, different tax rules will apply. However in all cases, if you do earn staking yield or interest, you will have to pay some form of taxes on the proceeds.
In the EU, each member state has different regulations with regards to taxing crypto. Some countries employ the same rules as the US and treat staking rewards as income and selling assets as capital gains. Some countries, such as Portugal, charge no tax on crypto-to-crypto transactions. They only tax when you go from Crypto to Euros.
The bottom line is that you should do some research or speak to a local accountant on how your government treats income from cryptocurrencies.
What’s the difference between APR and APY?
APR stands for annual percentage return. APY stands for annual percentage yield. Mathematically, the difference is as follows:
- APR = Periodic Rate x Number of Periods in a Year
- APY = (1 + Periodic Rate)Number of periods – 1
That might seem a bit confusing. In plain English, this means that APY accounts for the effect of compounding. Say you get an APR of 1% per month. Then your yearly APR is going to be:
APR = 1% * 12 months = 12%
But the APY is going to differ depending on how often your initial deposit is compounded. Here are examples for weekly and monthly compounding:
- Weeky compounding APY: [(1 + 0.01)^52 – 1 = 67.76%]
- Monthly compounding APY: [(1 + 0.01)^12 – 1 = 12.68%]
You can see how much of a difference compounding makes. When searching for the best opportunity to stake your DOT, make sure you always compare equal rates, i.e., APY to APY. Also, pay attention to how often your staked DOT compound.