The Double-Edged Sword of Masternodes: What Happens When Inflation Surpasses Reward

The Dash cryptocurrency network invented the masternode concept in 2014, and has recently come to an interesting conclusion: that masternodes heavily influence the coin’s market cap — both for better and for worse. 

The past six years have seen Dash’s dramatic rise to the number three spot in market cap rankings, followed by its meteoric fall to the 25th spot where it currently resides.

And now, after more than nine months of research, debate, and surveys, the Dash network thinks they know why this happened. And what’s more, they have a plan to do something about it. 

A Flattening of the (Expected) Curve

Once the Dash network deployed masternodes into its architecture in 2014, the network began gradually shifting block reward payments away from miners until they reached an even split: half the block reward went to miners, and half went to masternodes.

At some points in these early days, the annual return-on-investment (ROI) of running a masternode was as high as 20%. This understandably attracted many new investors to the Dash ecosystem, and the coin sat comfortably in the top-10 by market cap for nearly four years.

But then in late 2018, something started to change: the expected rate at which new master nodes were being created began to fall (see chart below). For the entire history of the Dash network, the curve of master node creation had always stayed in line with the curve of new coin creation. But now the master node creation rate started to lag behind the overall inflation rate.

Image via Dash Masternode Information

“Circulating” Coins vs. Collateralized Coins

In late 2019, Dash’s continuing fall in market cap rankings led Ryan Taylor, CEO of Dash Core Group, to start digging into potential reasons. He first compared Dash’s annual inflation rate with that of other coins like Bitcoin and Bitcoin Cash (below).

Image via Dash Core Group presentation on Dash Economics

While Dash’s annual inflation of 7.7% is significantly larger than its competitors that hover around 2%, Taylor found something much more compelling: that the slow sell-off of master nodes that started in late 2018 had, over time, dramatically increased the “circulating” supply of Dash (that is, the coins not collateralized in master nodes) to the tune of 22% per annum as of this year.

“It’s really hard for Dash to maintain price parity against assets like Bitcoin and Bitcoin Cash if the circulating supply is growing as fast as it is,” Taylor said during a on YouTube recently. “I think that it behooves the network to take a close look at this and see if we can get closer to parity with some of these other coins, and then allow our [technical & adoption-related] advantages to accrue to the network.”

Nominal ROI vs. Real ROI

But how to reverse the trend of masternode sell-offs? And why did they start in the first place?

In the initial years after masternodes were deployed on Dash, masternode annual ROI was nearly always higher than Dash’s annual inflation rate — or at least on parity with it. But since the block reward is a fixed pie, the more masternodes that got spun up over time, the less frequently each node received a payment. This caused annual masternode ROI to settle around 6%, where it sits today. 

And here’s the crux of the issue: Dash’s annual overall inflation rate is 7-8%, so this means masternodes now experience a net loss of at least 1% per year, owning less and less of the total Dash supply as time goes on. This effect has likely been felt for a couple years, and was what initiated the trend of sell-offs. Taylor said in a recent interview on :

“I was initially of the belief that masternodes valued primarily the nominal reward […] — that headline number that we all see… When I dug more deeply into the numbers and analyzing past behavior, I discovered that that isn’t entirely true. They also take into account […] the inflation that is created with new coins being formed… The dilution is more than the reward.”

This realization has prompted Taylor to put the issue up for a vote two weeks ago: shift the block rewards from their current 50/50 split to 60/40: 60% to masternodes and 40% to miners. This shift, he claims, will overcome the effects of inflation when it comes to owning a masternode, and should thus make masternodes an attractive option to investors once again.

What’s more, Taylor claims that such a shift should never need to happen again, because by the time the proposed gradual re-allocation completes (in about 4.5 years from now), Dash’s programmatic 7.1% decrease in inflation each year will take inflation levels below the predicted masternode rewards at that time.

The vote passed with overwhelming support on July 26th.

On-Chain Governance in Action

Members of some other coin communities have expressed major doubts that a decentralized network could ever come to consensus around such a large change to its protocol — especially one which affects the rewards that go to miners.

But Taylor left no stones unturned during his nine-month research period that preceded the making of the governance proposal this month. He consulted with the executive board at Dash Core Group, various economists, the Blockchain Research Lab at Arizona State University, the Dash community on Discord and in forum threads, and — of special pertinence — Dash’s miners.

“It’s counter-intuitive, but even miners are likely to benefit from this because it isn’t a net-neutral effect on price. So they may be getting less Dash-denominated rewards, but if it impacts our price and our ability to grow and attract users, it can actually be beneficial to miners, as well.”

Ryan Taylor, CEO Dash Core Group

The change in block reward allocation is slated to be included in Dash Core Group’s next software release, Dash Core 0.16, which is expected in the coming weeks. While Dash’s masternode owners and shareowners have already expressed strong support for the re-allocation via the July 26th vote, a successful upgrade will of course rely on Dash’s miners adopting the software, as well. This seems likely.

Eyes should be kept on Dash for the rest of 2020 not just to see the outcome of this block reward re-allocation, but because Taylor also intends to make another governance proposal in August — this one to fine-tune the functioning of Dash’s monthly “treasury.” Stay tuned.