Evaluating a Validator—Establishing Jurisdictional Risk Metrics for DPoS Networks

Assessing the Importance of Jurisdiction for Delegated Proof of Stake Validators

Jay Derenthal

Blockchain systems are a fundamentally new class of economic organisms. They are decentralized entities that exist entirely in cyberspace, maintained by a combination of cryptography, applied game theory, and consensus.

Introduction

Blockchain technology has given rise to decentralized entities like Ethereum that exist solely in cyberspace. These entities rely on cryptography, economics, and social consensus to maintain their integrity.

Delegated Proof-of-Stake (DPoS) networks, including Cosmos, Tezos, Livepeer, and Horizen, depend on on-chain governance to ensure robustness. The vetting process for block producers plays a vital role in supporting network strength and mitigating issues such as missed earnings and slashings for delegators.

Optimizing staked asset returns and minimizing costs is crucial for delegators on the Cosmos network. Entrusting staked Atoms to a poorly vetted validator can lead to financial losses and other undesirable consequences. The level of due diligence in vetting a block producer affects delegators' net yield directly.

When evaluating a validator on the Cosmos network, delegators consider several key metrics:

1. Reliability—The percentage of time the validator stays online.

2. Efficiency—How often does the validator miss blocks?

3. Data security measures implemented by the validator.

4. Experience and ability of the validator's team.

5. Validator's financial position.

6. Jurisdictional risk.

Jurisdictional risk holds particular significance for delegators. The jurisdiction, which refers to the corporate domicile or primary place of business, plays a role in determining contractual obligations and the extent of government control.

A blockchain network transcends national, state, provincial, and economic union boundaries. Validators can have their offices and nodes anywhere worldwide. When the validator and delegator reside in different countries, the principles of contract and ownership may vary. Even within the European Union, slight differences can arise. These disparities become more significant when a delegator in the U.S. interacts with a validator in Russia.

From a delegator's perspective, it is ideal for both the validator and delegator to reside in the same stable and progressive jurisdiction, offering clear, legally defined rules, property rights, and corporate transparency. Both parties should domicile in similar and geographically close jurisdictions when an optimal situation is impossible.

Contracts are vital in assessing a node's reliability as a validator on the Cosmos blockchain network. Evaluating jurisdictional risk becomes part of the delegator's fiduciary responsibility as they establish favorable and enforceable terms within the off-chain contract. At the very least, a validator must faithfully execute the blockchain and not abscond with the stake.

Jurisdictional Risks

1. Authoritarian Governments

When assessing jurisdictional risk, it is crucial to consider the operating environment for validators in countries hostile to blockchain innovation. For example, in 2018, the Chinese government temporarily banned blockchain mining. Similar actions could be taken against PoS validators.

2. Malicious Governments

Although hypothetical, there is a theoretical risk of state-level malicious actors trying to disrupt block producers within their jurisdictions. These actors may enforce censorship of specific transactions or coordinate with others to act maliciously. Venezuela serves as an illustration of this potential jurisdictional risk.

3. Securities and Fintech Regulation

Validators are subject to regulations specific to securities and fintech industries, including reporting requirements. Some jurisdictions, such as the United States, Canada, Malta, Hong Kong, Singapore, and parts of the EU, have stringent licensing requirements and regulatory clarity. However, many others do not.

If regulatory actions in a validator's jurisdiction make it commercially unviable to maintain regulatory approval or if running a node or distributing tokens becomes illegal, a Cosmos block producer may cease its operations. Regulatory risk encompasses federal, provincial, and cross-border laws and regulations related to consumer protection, data privacy, and other areas. These laws and regulations and their interpretation and application are subject to change. The enactment of new laws or regulations can significantly affect the utility of tokens and the operation of a blockchain platform.

4. Taxes

Uncertain or unstable tax regulations can have a detrimental impact on a company's operations. Changes in a validator's tax status or the introduction of new tax legislation can affect the value of their financial holdings and cap table. Financial stress may affect their ability to produce blocks at a steady rate. Validators need to consider the potential impact of tax-related regulations on their business.

Conclusion

As the DPoS blockchain ecosystem evolves, several essential considerations, including jurisdictional factors, come into play. While the user experience for voting and delegating on DPoS networks can be cumbersome, efforts to address this within the Cosmos community are limited. Including governing law and jurisdictional clauses to provide legal certainty for delegators requires more attention.

Ranking validators based on jurisdictional risk and liability can be a valuable selection metric. However, defining rules and applying them in a decentralized environment presents its own set of challenges. Nevertheless, involving knowledgeable individuals and services capable of evaluating jurisdictional merits and risks could significantly contribute to the stability and success of the Cosmos network.

Tools like Hubble, provided by organizations such as Figment Networks, offer delegators a ranking system to aid in choosing validators based on their performance and stake accumulation on the Cosmos network. While Hubble focuses on objectively measurable criteria, it omits subjective and self-reported metrics like jurisdictional details. Implementing third-party auditing to verify such claims would require substantial effort.

The choice of validators in specific jurisdictions may carry varying risks for block approval accuracy. Monitoring this metric closely and assessing its impact over time is essential. A diverse distribution of validators across different geographic locations, hosting and energy setups, and regulatory/legal jurisdictions has the potential to strengthen the Cosmos ecosystem. By considering jurisdictional factors and other metrics, delegators can make informed decisions prioritizing the security and optimal returns on their staked assets within the DPoS ecosystem.

Article by Jay Derenthal