What Is Polkadot? How Does It Work?

Polkadot is envisioned as an improved version of Ethereum. Launched in May 2020, Polkadot is the brainchild of Ethereum (ETH) co-founder Gavin Wood. The platform is now run by the Web3 Foundation (W3F), and developed by Parity Technologies, both co-founded by Wood.

Polkadot operates at a deeper level than a blockchain like Ethereum—think of it as providing a foundation on which others crypto projects can build. It calls itself a Layer 0 blockchain, whereas Ethereum and similar blockchains like Solana (SOL) and Cardano (ADA) are called Layer 1 blockchains.

When Wood first wrote the Polkadot whitepaper, he argued that crypto needed a new system allowing interactions between different blockchain networks. Noticing issues with Ethereum’s ability to grow and scale, Wood attempted to solve this problem with a new blockchain based on a proof-of-stake validation system.

Proof-of-stake validation was proposed in contrast to earlier blockchains, such as Bitcoin (BTC) or Litecoin (LTC). In proof of work, blockchain miners solve cryptographic puzzles to add the next block to the chain for mining rewards. With proof of stake, validators use tokens staked as collateral to determine the next block in the chain.

The primary scaling issue that Wood wanted to address with Polkadot was the amount of computing power Ethereum required for its original proof-of-work validation system.

David Lawant, director of research at Bitwise Asset Management, calls Polkadot a “heterogeneous multichain system”.

That’s just a fancy way of saying that there are different blockchains operating on the Polkadot system.

As noted above, a layer 0 blockchain functions as a foundational layer beneath layer 1 blockchains. Polkadot provides a built-in infrastructure upon which programmers can build their own blockchains with cross-chain interoperability.

Layer 1 blockchains, like the Ethereum project Wood built along with co-founder Vitaly Dmitriyevich “Vitalik” Buterin and others, allow programmers to build decentralized applications (DApps), smart contracts, non-fungible tokens (NFTs) and more.

But it’s hard for programmers to build a Layer 1 blockchain. They need to build the base layer before they can even start incentivising hundreds of people to run their Layer 1 program on a computer, says Bill Birmingham, chief investment officer at Osprey Funds.

Experts say Polkadot already has the base layer built. All the Layer 1 programmer has to do, then, is focus on optimizing their own project.

Thibault Perréard, head of finance for cross-chain staking hub Bifrost, says most of these Layer 1 systems are siloed. They don’t have much interaction between them. Polkadot intends to allow any public or private blockchain to communicate with each other—it’s meant to be the “internet of blockchains.”

The key to bringing all these factors together—proof-of-stake validation, cross-chain interactions and base layer programming—is DOT, Polkadot’s native token.

DOT is the token staked or put up as collateral by validators to approve the next block in Polkadot’s blockchain. In this way, DOT functions as Polkadot’s proof-of-stake mechanism.

Each separate blockchain built on Polkadot is referred to as a parallel chain or parachain within the system.

When moving data across these parachains, security is paramount. Polkadot ensures this security with a single underlying chain called the relay chain.

This relay chain is Polkadot’s main chain, and according to Lawant, it’s what distinguishes Polkadot from its closest competitor, Cosmos (ATOM).

Perréard even points out that “the relay chain ensures security.” He says the parachains can “leverage off the architecture and foundation of Polkadot.” In other words, they don’t have to worry about providing security.

DOT is the token used to validate blocks on Polkadot’s relay chain. But staking isn’t the only use for DOT within the Polkadot system. The token is also used for governance and bonding. All DOT holders are given the right to vote on network governance, such as upgrades and network fees.

The other factor Polkadot’s operators need to consider is which projects get a parachain in the Polkadot system at all. These parachains are bid on by distinct projects using DOT as collateral.

According to Birmingham, a project can “go out and buy DOT to pledge to” Polkadot for the parachain auction. Then, if the project has enough DOT, “They’ll win the slot.”

Once a project is approved for a parachain, the auctioned DOT is locked up for two years. Users will receive lock-up rewards in return for the projects.

Polkadot’s first parachain auction was completed in December 2021.

Ethereum, the world’s No. 2 blockchain, and Polkadot have a few things in common. However, the two blockchains have many more things that differ.

Here are a few similarities and differences between Polkadot and Ethereum:

Polkadot is an easily accessible crypto asset. For developers bidding on a Polkadot parachain or investors interested in acquiring tokens for speculation, DOT can be bought on most of the world’s major crypto exchanges.

Investors can also get exposure to Polkadot through the Osprey Polkadot Trust (ODOT), which is traded publicly through the OTCQX over-the-counter market.

Once DOT tokens are purchased, they can be kept in a crypto wallet. Crypto wallets are available either online (hot wallet) or offline (cold wallet). Online wallets carry greater security risks. You’ll also need to check that the crypto wallet supports Polkadot tokens.

Investors should remember that Polkadot, like all cryptocurrencies, is an extremely speculative and risky investment.

If you’re thinking about owning DOT tokens, you may want to consult a financial advisor first. You should never invest more than you can afford to lose, given the volatile nature of cryptocurrencies.