Cosmos: The Ecosystem of Blockchains
September 22, 2022
If blockchain technology is to gain widespread adoption, interoperability between blockchains is a necessity. We’ve seen bridges try and solve this issue, essentially sitting on a pool of different assets and offering their own guarantee that an asset can be bridged over to another chain. However, bridges have been the target of several hacks this year, such as the $615m hack of Ronin, or the $320m hack of Wormhole. A total of around $1.4 billion has been lost to breaches on cross-chain bridges since the start of the year.
A more secure solution to cross-chain interoperability is when a network permits inter-chain communication, allowing different blockchains to interact with one another on the same, or different networks, eliminating the need for any bridges. Cosmos is one of the most ambitious projects addressing this need and in this article I’ll break down the technicalities of how they’re solving blockchain interoperability, as well as the reasons behind the recent surge of interest, on both spot and derivative markets, in the blockchain’s native token ATOM.
ATOM outperforms
The ATOM token has rallied lately and has been one of the best performing coins in all of crypto in the last month, outperforming BTC, ETH and all of its closest competitors.
The token has rallied largely based on hints from the founding team of big announcements at a Cosmos conference next week, pointing towards a model of better value accrual for ATOM holders as part of a new tokenomics plan that “will make EIP 1559 look like a joke” according to one of its foremost contributors. Before I take a look at the implications of these announcements for ATOM, I think it’s important to introduce Cosmos as an ecosystem and take a peek under the hood at how it differs from its competitors.
An ecosystem of blockchains
The Cosmos approach to solving inter-chain operability is multifold. Firstly, they have something called a Software Development Kit (SDK), that provides a framework for developers to create their own proof of stake blockchains within the Cosmos ecosystem. Most, if not all, the largest blockchains in the Cosmos ecosystem are written using its SDK, including Binance Smart Chain, Terra and Crypto.com. Having separate chains, known here as zones, running within one overarching ecosystem allows Cosmos to create an inter-linked network, all powered by a central hub, called Cosmos Hub. This kit not only saves developers time and money, due to the ease of onboarding a blockchain or project on Cosmos, but also avoids higher transfer fees between chains because it’s all part of the one ecosystem.
This is why Cosmos is known as a layer 0 rather than a layer 1. Layer 0’s main product provided to customers is security, and their customers are other blockchains. Layer 1’s on the other hand offer blockspace as a product, charging any user that interacts with the blockchain. Under this criteria, Cosmos’ closest competitor is probably Polkadot. Cosmos has outperformed Polkadot as of late, with the ATOM/DOT ratio climbing from as low as 0.85 in June this year, up to 2.5 at the start of September.
One of the most pivotal and unique components of Cosmos’ SDK is their Inter-Blockchain Communication (IBC) protocol. IBC acts as the connection between the different blockchains, or zones, on Cosmos and is aided by something called the Tendermint consensus engine. Tendermint consensus is when finality is instant — this differs to consensus on Ethereum where transaction finality requires that a transaction in a block is built upon by a number of follow-on blocks. This finality is a feature of Tendermint which all Cosmos blockchains built with SDK share, allowing interoperability between blockchains due to the synchronous nature of final transactions.
Crucially, recent advancements in IBC have connected to blockchains outside of the Cosmos ecosystem such as Polkadot and NEAR. Connecting to Ethereum post-Merge is something which is also being worked on and if successful could become a significant tailwind for the adoption of Cosmos.
Cosmos Projects
As a layer 0, the success of Cosmos is somewhat dependent on the success of the blockchains on the network. The biggest driver behind the increased adoption of Cosmos earlier this year was Terra, which was part of the Cosmos ecosystem. Terra’s rapid rise, and subsequent fall, changed the makeup of projects on Cosmos — at one point Terra accounted for over 90% of the TVL on Cosmos. Despite a significantly lower TVL after the Terra collapse, Cosmos is still serving as the breeding ground for a lot of great projects such as Kava, a cross-chain borrowing and lending platform, and Osmosis, a DEX aiming to serve across multiple chains.
The ability for projects to build their own blockchains on Cosmos means they gain full control over the features they want included on their blockchain, so they can design a chain which is suited to their product offering. Compare this to building on a layer 1 like Ethereum, and the projects would be confined to the parameters set by the Ethereum blockchain. This is the main reason behind the announcement that dydx, a decentralized derivatives exchange, is moving its v4 iteration away from Ethereum and onto Cosmos. dYdX outlined plans in January to fully decentralize in 2022 and the project’s blog post emphasized that using the Cosmos SDK to spin up its own blockchain is what will allow the project to fulfil that goal — a vindicating moment for the ambitions of Cosmos.
ATOM Tokenomics
As I pointed out earlier, interest in the Cosmos ecosystem, specifically for the token ATOM, is surging lately. We’ve observed a significant spike in volumes traded for ATOM in the last couple of weeks.
This is largely down to the rumored improvement to the ATOM token itself. Despite Cosmos’ innovation in blockchain technology, the ATOM token has always struggled with value accrual. This has been due to each blockchain built in Cosmos running its own validators, and therefore securing themselves with their own native tokens, via proof of stake. For example, Binance Chain uses its native BNB token while Terra used LUNA to secure the network. Having each blockchain stake their own tokens left ATOM struggling to accrue any value from increased adoption on those chains due to the lack of a share of fees earned. Not only was this arrangement unfavorable for ATOM holders, but the blockchains themselves would usually be paying out highly inflationary token rewards for their stakers to secure the network, or risk worse security on their own chain and leave themselves vulnerable to hacks.
The improvement in the tokenomics of ATOM will be addressed by Interchain Security, a process which we’ll undoubtedly hear more about in next week’s conference. What we do know however, is that this security will allow Cosmos chains to essentially secure themselves with ATOM, thanks to the Cosmos Hub validators. At the time of writing, ATOM’s market capitalization sits at $4bn, making it a lot harder for a hacker to take control of the network compared to the amount it would take to seize control of a smaller startup chain with fewer validators. As new chains launch and choose to secure themselves with ATOM, fees will accrue to stakers and help drive demand for ATOM.
Market Reaction to ATOM 2.0
The reaction to the potentially improved outlook for ATOM has been significant in both spot and derivative markets. ATOM amassed a 23% share of spot volume as of last week, relative to some other L1 tokens of a similar market cap, rising from 4% at the start of summer.
The reaction in derivative markets for ATOM has been as receptive to the new improvements, if not more so. We’ve observed a 10x increase in volumes traded on ATOM perpetuals in the last month.
This has correlated to a significant increase in open positions denominated in USD for ATOM, rising from $67m at the start of August to just below $150m as of writing.
The first reaction to open interest rising in USD would be to assume it’s related to a price increase of ATOM increasing the overall USD figure. However we can take a closer look at open interest denominated in ATOM to remove price effects.
The result is an increase of open ATOM positions from 6m to 10m, acting as a significant leveraging force now on the price of ATOM. Interestingly, funding rates show us that there isn’t an overwhelming bias to the long side ahead of the announcement next week — rates have fluctuated between positive and negative with no real pattern for over a month now. Notably, funding rates dipped negative at the time of writing, with traders perhaps preparing for a sell the news type event at the conference next week.
Conclusion
The Cosmos contributors are promising the world to ATOM holders and the future sounds almost too good to be true. ATOM has had two big problems in the past, value accrual and token inflation. Its value accrual is set to be solved by the rollout of Interchain Security, resulting in smaller blockchains being secured by ATOM and ATOM stakers finally being rewarded with a share of transaction fees. Under its current economic model, the target inflation rate of ATOM is 13% which is probably too high to foster price appreciation in the long term. However, apparently this is to be addressed in next week’s announcements which the market has evidently welcomed in the lead up to the conference.
Token aside, the Cosmos ecosystem is trying to solve a legitimate problem in its current state — blockchain interoperability. The improvements to the token should drive demand and the Cosmos Hub will become the shared security layer for the network of blockchains. With SDK, IBC and now Interchain Security, Cosmos has a three pronged strategy that has the ambitious goal of being the link, the hub and the foundation connecting all of crypto.
