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Cardano handles the shortcomings of first-generation blockchain

Published 23.5.2023

The first generation of the blockchain, led by Bitcoin, initiated a decentralized financial revolution. However, blockchain itself has many shortcomings that are worse from a user perspective than what traditional financial services offer. Volatile fees, essentially almost no privacy, uncertain long-term economic sustainability, a tendency towards declining decentralization, and other things. You might be surprised by the way Cardano addresses these shortcomings, or how the IOG team plans to address them in the future. Cardano's success depends not on a single super cool feature that everyone will want to use, but on many small details that together will form a solid foundation for financial services.

TLDR

Ouroboros Leios will make Cardano an inclusive blockchain accessible to the poor. If users manage to submit a transaction, it will likely not fail. Fees will be paid in tokens. Staking is economically affordable for everyone. Consensus remains in the hands of stakers, as Cardano has liquid staking. The Nakamoto-style PoS is more robust than many BFT protocols. Distributed apps will allow stakers to keep control of ADA even while using DeFi. Additionally, it will reduce the concentration of assets at a few addresses. Midnight will take care of your privacy. The high utility will ensure economic sustainability. These and other features will make Cardano an unbeatable financial and social platform. Just keep implementing new features is necessary for success.

Fixed fees

In the financial world, there is nothing worse than uncertainty. Volatility is the enemy of business and usability. Users don't care that block space is a scarce resource and if demand is high, they have to pay higher transaction fees. If demand were high in the long term, transaction fees would regularly attack ATH.

The fee market mechanism (this model is copied by many projects) solves the demand for block space in a very inefficient way. Not from the point of view of the protocol, but from the point of view of ordinary users who compare the blockchain alternative to a banking service with low and stable fees.

Imagine that the fee for a Bitcoin transaction is 5 Satoshis and within a week it gets to 50 Satoshis, or very fast to 500 Satoshis. Within a relatively short while, Bitcoin is essentially unusable for many users. It's not easy to open and close Lightning Network (LN) channels, so a second layer doesn't solve the problem much either. LN is primarily made for micropayments, so it doesn't make sense to pay 50 USD to open a channel with 50 USD. If you opened a channel for 10 Satoshis, you don't want to close it for 500 Satoshis.

The volatility of fees and the prediction that somewhere in the future it will be common to pay 1000 Satoshis for a Bitcoin transaction is not a positive prospect for many. If you want to build a real business over Bitcoin, this uncertainty will discourage you from doing so. You can't assume that people will pay 50 USD for a service just to use the blockchain.

Cardano has fixed fees for on-chain services. This means that you will pay approximately 0.17 ADA for a common transaction, depending on the size. Cardano handles transactions on a first-come, first-served basis, as it is fairer. Similar transactions have the same fee, so there is no economic reason to choose transactions with a higher fee. This is slightly better, but the fees are still volatile as they are pegged to the ADA to USD exchange rate. Transaction fees are more stable than we can see in the case of Bitcoin or Ethereum, but if the market value of ADA grows, so will the fees.

The current higher fee stability has the disadvantage that if Cardano is overused, some transactions will be rejected and users will have to resubmit. In addition, it turns out that the fee market is probably the best possible solution to make access to block space as democratic as possible (but only for the rich) and to ensure sufficient profit for the network, which is important in the context of long-term economic sustainability.

How to make Cardano be inclusive, i.e. economically affordable for all, and the fees stable, i.e. predictable for the future?

High fees have only one possible solution and that is higher scalability of the blockchain. The IOG team will address scalability through the implementation of Ouroboros Leios PoS (input endorsers), which is arguably one of the best designs in the entire blockchain industry.

Another significant improvement will be tiered pricing. The tiered pricing paper proposes splitting block space into tiers. Each tier will have a different settlement delay and fee. The number of tiers, along with delays and fees in each tier, will be adjusted automatically depending on current demand. Tiered pricing will utilize traffic diversity to make Cardano more inclusive. At the same time, it allows users and applications to assign priority to transactions.

The ideal solution would be to peg fees for on-chain services to the dollar exchange rate in the first tier. Users could calculate approximately how much they would pay to use Cardano if they made, say, 10 on-chain transactions per month. It would also be good for business.

The Babel fees

Another improvement regarding fees for on-chain services will be the Babel Fees feature.

This feature will allow users to pay transaction fees in a token they have in their wallet and want to send to the counterparty. So users can use Cardano for stablecoins, for example, and don't need to hold ADA coins. This may simplify the onboarding of new users to DeFi and RealFi, as they will be able to install a wallet and receive stablecoin on them and then send it without having to use ADA as a GAS. This may seem like a small thing, but it's actually a very powerful feature for the gaming industry, for example.

Cardano does not need a smart contract for minting and token transfer as it is designed to have native tokens. Token transfer is done directly via the Cardano protocol which is similar to sending ADA coins in terms of computing resources. Token operations will always be more efficient on Cardano than on Ethereum, as the transfer through a smart contract is less efficient and therefore more costly.

Let's add that tokens can also be minted on Bitcoin through the BRC-20 standard. This is the least efficient existing solution that cannot compete with what smart contract platforms allow.

The impact of scalability on adoption

The first generation of blockchain, especially Bitcoin, does not scale well because it has a very long block time and the block size is limited by the speed of data distribution over the Internet.

At this point, it is uncertain whether scalability can be fully resolved on the second layers (L2). From our perspective, this is unlikely, as L2 solutions will always depend on L1 for settlements and on-chain fees. Onboarding large numbers of users can be very difficult, if not impossible, without higher L1 scalability.

Higher scalability is very important in the context of the long-term economic sustainability of the blockchain, as people are more likely to pay low fees rather than high fees.

Every blockchain network must have sufficient profit for its security. If the network does not scale, a small number of users must pay high fees. It means that for the majority of users, the network will not be economically or technically accessible (once the mem-pool is full, the network must discard some transactions according to some rules).

It is much more advantageous for the blockchain if it has high throughput and can handle a large number of transactions. Such a blockchain can have the same or even higher profit and at the same time satisfied users paying low fees for transactions that always make it to the next block.

L2 addresses scalability, but often at the expense of L1 security. Or L2 can solve scalability, but onboarding is slow and expensive because of L1, making L2 essentially unavailable.

Moreover, most current L2s do not inherit the decentralization and security of L1. Teams often struggle to reinvent decentralized consensus because L2s often run on only a few nodes or even a server.

The first generation of blockchain employs PoW consensus, whose security is based on high power consumption. The economic sustainability is very uncertain and within a few halvings the security may start to decrease. In combination with low scalability, the utility (transfer of value) will also be low.

Cardano employs PoS consensus. PoS is more than 99% less power-hungry while being equally or even more secure. However, PoS generally does not automatically scale better than PoW, as it is possible to only reduce the block time, but it is not possible to increase the block size in any significant way. Scalability can be increased in the order of several tens. This is insufficient if the blockchain is to be used by, say, 10% of the population and each user should send at least one transaction per day.

From our perspective, it is important that the IOG team plans to improve the scalability of Cardano via Ouroboros Leios. We do not believe that the scalability problem can be solved through L2 alone unless decentralization and security are to be sacrificed.

It is certainly better to prepare for the future and be ready than to wait for when people want to use blockchain and be unpleasantly surprised. Cardano should be ready for mass adoption within a few years without having to sacrifice high levels of decentralization and security.

PoS is a huge innovation not only in the context of reducing electricity consumption but mainly in terms of long-term economic sustainability. The first generation of PoW blockchains can theoretically reach a point where they cease to be secure. PoS blockchains may suffer a similar fate, but their chances of survival are higher as the transaction fees collected are more likely to be sufficient to ensure security.

Cardano is trying to solve the security budget problem through the scalability and utility of DeFi services. One is related to the other. In order to adopt DeFi services, the platform must scale.

Scalability is especially important for users who are assessing blockchain against what financial services can do. Specifically, they assess features such as transaction speed, reliability, and fees. If any network gets clogged, reliability drops, settlement can take days, and fees rise steeply. The quality of all L2 solutions, including custodial services, is directly dependent on L1. Therefore, the need for L1 scalability should not be underestimated.

Quality of Peer-to-Peer Services

Cardano has brought many innovations to the field of smart contracts. The first major player is Ethereum, which has defined the standard. Although many projects copy the Ethereum Virtual Machine (EVM), this standard has many shortcomings, or shall we say drawbacks.

Ethereum was the first to come up with an account-based model. Transactions are interpreted as events that change the global state. The previous state becomes an integral part of the next calculation of the new global state. In the account-based model, all accounts are stateful. The transition to a new state requires the global state to be temporarily locked. This mechanism requires that the order of the transactions in the block is maintained during verification. Transactions must be processed sequentially. It is not possible to process them in parallel.

EVM has a significant advantage for developers who don't have to worry about concurrency. However, there are several inconveniences for users.

It is not possible to check locally in advance whether a transaction will get into the block or not, because the context (global state after processing all previous transactions) is not available. It may happen that the transaction is not valid when the node tries to include it in the block. However, the user must pay a fee for the failed transaction. In addition, this complicates the building of smart contracts and can be considered a surface area for attacks. Due to the need of ordering transactions, there is a major attack vector known as Miner Extractable Value (MEV).

Cardano has adopted Bitcoin's accounting model and the IOG team has improved it. The Extended-UTXO (E-UTXO) model was created.

The E-UTXO model has higher expressiveness of programmability while maintaining all the benefits of Bitcoin’s UTXO.

E-UTXO offers some advantages over the account-based model. In particular, greater security during the execution of smart contracts (Plutus scripts), fee predictability, local verification ensuring that transactions will be (very likely) accepted after the submission, and an inherently fragmented blockchain state. This allows parallelization in transaction processing.

During the processing of transactions and scripts, their order in the block is not important. There is no need to consider previous execution results. There is no shared global state.

It has a positive effect on on-chain scalability. Ouroboros Leios could not be designed without the E-UTXO model. Parallelization is important for both validation of transactions and the execution of smart contracts. Both can be processed independently, i.e., in parallel. As a result, there is less surface for attacks.

Although this may sound too technical, it has concrete advantages for users who know in advance whether their transaction will get into the block (determinism) and what the fee will be. A transaction will not go unprocessed just because the fee is lower than the block producer node expects at that moment. Higher reliability and less room for attacks are significant shifts in the implementation of decentralized applications.

The E-UTXO model allows the implementation of applications that cannot be created with an account-based model. Many applications on Cardano copy the design of EVM applications. Developers have not yet exploited the full potential of E-UTXO.

Many dApps use multiple addresses where assets are concentrated. Users send assets to these addresses, for example when they want to provide liquidity to AMM DEX. The main disadvantages of this design are the concentration of assets and reduced user control. Assets at the application addresses are governed by smart contract rules. If someone gains control of the application (a hacker, but it can also be a team), they essentially gain control of the assets.

A high concentration of assets on addresses can be a problem for scalability and goes against the spirit of decentralization. Assets are not directly controlled by people (by the team) but by smart contracts. However, in the context of trust, admin keys or some form of DAO may be in play.

It is especially dangerous for PoS networks if someone gains control of a large number of native coins (ADA, ETH, etc.). Ideally, stakers should retain control over delegation (consensual decision-making power) even while using applications.

Is it possible to achieve that?

Thanks to the E-UTXO model, it is possible to consider the creation of distributed applications on Cardano. One of the concepts discussed is the use of so-called Beacon Tokens which simplify querying of on-chain data by efficiently tagging it. Through tagging, data can be easily accessed through off-chain APIs. Beacon tokens are used to tag data as required by the application logic. The application can tag addresses, UTXOs, or transactions. The app basically cleverly combines token minting to define the flow. Complex application logic can be achieved.

Distributed applications are censorship-resistant, as users retain control of assets throughout the use of the application and interact only with the counterparty (no pooling of assets). No third party is required to operate as the scripts are fully peer-to-peer. There is no need for additional governance tokens. The big advantage is that distributed applications are inherently concurrent regardless of the growing number of users. User addresses can serve as User IDs.

The concept of distributed applications is still not sufficiently explored. Developers need to change their mindset and start thinking differently from what they were used to in the case of EVM. Cardano is significantly different than Ethereum in many areas and allows for innovative concepts to be used.

Liquid staking and decentralization

I remember a time when they used to say that when staking a coin you had to lock it in for a period of time. But that doesn't make any sense because locked coins can't be used. But users want to use the coins for payments or in DeFi.

Cardano has native liquid staking. This means that users can stake directly from their own wallet and can spend ADA coins at any time. Cardano doesn't lock coins and doesn't have slashing.

It is possible to stake literally several ADA coins, so anyone can participate in the decentralization of the Cardano network.

This is a big advantage from a user perspective when you consider that PoW mining is unaffordable to regular people today (basically unprofitable in many countries). Staking on Ethereum requires you to have at least 32 ETH, or use a third party to exchange ETH for tokens. A tradeoff in decentralization is necessary.

The decentralization of blockchain networks will only increase if the number of people participating grows. Participation in PoW mining has been declining for several years in a row. Mining companies are emerging with a growing share of the total hash rate. More than 50% of the blocks are produced by only 2 dominant Bitcoin pools.

Over 1200 pools produce blocks in the Cardano network (there are MPOs) and the number of stakers will likely be growing over time (the trend so far is positive).

It is important to mention that Cardano uses Nakamoto-style PoS consensus, a very similar mechanism to that used in Bitcoin. If a node in the Cardano network produces a valid block, that block will be accepted no matter how many nodes are currently running. The other nodes in the network do not directly vote on the new block, but only validate it (and accept it if it is valid). In case of some major problem, the network will not stop even if a large number of nodes are unavailable. If the node that becomes the slot leader is currently running, it can produce a valid block.

Many networks use some form of BFT consensus. BFT protocols come to a consensus by voting on each block before adding it. Every proposed block must be approved by a 2/3+ vote in order to be added to the blockchain. The block might become final after the addition.

The downside is that once 1/3 of the nodes go offline unexpectedly, the network is essentially unable to form a consensus. Moreover, if the attacker gains ⅓ decision-making power, he essentially gains control of the network. In the case of Cardano (and Bitcoin), the attacker must gain control over half of the resource (ADA coins or hash rate).

Privacy

The first generation of blockchain is pseudo-anonymous. This basically means that anyone can anonymously create a new blockchain address. Once assets are moved to the address, the transaction with that address will forever be traceable on the blockchain. If addresses can be linked to specific users (and this is happening due to regulatory requirements), the blockchain essentially becomes a public database of transactions, including the ability to trace the people who made the transaction.

Transparency is a double-edged weapon. Most users do not want their financial transactions to be public. The same applies to businesses, where they are prohibited by law from disclosing certain information.

Popular L2 state-channel solutions often do not completely solve the problem, because even if transactions in, for example, Lightning Network or Hydra are anonymous (they take place only between the participants of an open channel), opening and closing the channel requires an on-chain transaction.

Cardano will have a Midnight sidechain that will protect users' privacy, even in such a way that it will be possible to comply with regulations (prove specific facts) without having to reveal users' identities.

Conclusion

New users will not use blockchain because it is a different technology, but because it will have better features than existing services. Let's not be naive and expect people to adopt en masse a technology that will force them to pay high fees, has a hostile user interface, and, on top of that, they may lose their money in an unreliable DeFi service.

In the current phase, it is necessary to continue implementing technology and to focus more on the real needs of users. People are not interested in the network consensus but in the possibility of securing passive income through staking. People are not interested in the name of the protocol but in the speed and fee of an international transaction. People don't care about decentralization, but they will care that their financial transactions are publicly available.

The IOG team has managed to solve many of the technological shortcomings seen in the first and second-generation blockchain. Many things are currently being worked on. Research is ongoing. Cardano will never be finished. It is more accurate to say that Cardano will be continuously improved.

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