Cardano reserve depletes more slowly than expected

People observe that the rewards from staking ADA are gradually decreasing. Anyone who understands Cardano's monetary policy is not surprised. Nevertheless, the rewards are smaller than what was expected about three years ago. Let's take a look at the reasons why this is so and some graphs that will clarify everything for you.

Monetary policy of Cardano

The monetary policy of the Cardano project was defined at the very beginning of the project in the Genesis block. During the public sale that took place in Japan, 57.6% of ADA coins were sold. Cardano Foundation received 1.4%, IOG 5.5%, and Emurgo 4.6% of ADA coins. It is important that 30.9% remained in the reserve for staking rewards and further development of the project. It was 13,888,022,853 (roughly 14B) ADA coins.

Staking rewards are based on two pillars. The first pillar is the reserve, from which 0.3% is taken every epoch, and the second pillar is the collected fees. We described the monetary policy of the Cardano project in detail in one of our previous articles. However, a single picture is all you need to understand the basic mechanism.

Note that 20% of the virtual pot (the maximum of ADA coins for the epoch reward) is moved to the treasury. Also, note that part of the ADA coins is returned back to the reserve (unclaimed rewards).

Why are staking rewards decreasing?

Rewards are falling for three reasons. First, the reserve is gradually depleted each epoch, so 0.3% is taken from an ever-smaller number of ADAs. Secondly, the conditions for achieving the maximum possible reward are not met, so a significant part of ADA coins is returned to the reserve. The third reason is that the amount of fees collected in an epoch is not large enough to compensate for the decreasing number of coins in the reserve.

At the time of writing, there are 8,969,722,014 ADA coins in reserve and 1,336,737,021 ADA coins in the project treasury. In epoch 427, 126.9K ADA coins were collected in fees. Note that the amount of fees collected tends to increase over time.

You can examine for yourself how the reserve is gradually depleted and the treasury grows in Cexplorer.

0.3% of 9B is 27M. So 27M is roughly the amount that is taken from the treasury as the maximum possible reward. As already explained, part of the ADA coins will be used for rewards and part will be returned to the reserve. For each subsequent epoch, a smaller number of ADA coins will be taken from the reserve as a potential maximum reward. ADA coins that are paid out on rewards gradually increase the number of coins in circulation. When there is only 8B in the reserve, 0.3% will only be 24M ADA coins. And so on.

In practice, only about half of the maximum possible reward is paid out, i.e. about half is returned to the reserve.

Note that the amount of fees collected does not even correspond to 1% of the amount taken from the reserve. In other words, more than 99% of staking rewards are taken from the reserve. The amount of fees collected is currently essentially negligible. As we said, in practice only half the rewards are paid, so the ratio is slightly better in favor of the fees that the network collects each epoch. Fees can be roughly 1-2% of the total reward.

If staking rewards are to be sustainable in the long term at a similar level as today, it is imperative that an increasing amount of ADA is collected for network usage. The declining reserve must be compensated by using the network.

If the average fee is to stay at 0.16 ADA and the network is to collect 10M per epoch (5 days), roughly 60M people must use the network per epoch. That is roughly 250 times more than today's average. Roughly 50K people use Cardano every day (sometimes more, sometimes less).

Why aren't the maximum possible rewards paid out?

Staking rewards would be significantly higher if the conditions for paying the maximum possible reward were met. However, this is not the case. Markus, a member of the Cardano Foundation, presented a chart with the maximum possible reward and a chart reflecting reality (and possible future developments) in one tweet.

In the following picture, you can see how the reserve would gradually be depleted if the maximum possible reward, i.e. 0.3%, was paid every epoch.

By mid-2023, the reserve was predicted to be only 7B. The reality is that it is roughly 9B, so 2B more.

In the graph below, the red line represents the maximum possible rewards (the same as in the above chart). The green line represents reality. The purple line on the bottom left is the Cardano treasury.

The incentives of the Cardano protocol are designed to encourage the growth of decentralization and for operators to provide quality services to the network. Deviations from protocol expectations reduce staking rewards.

The maximum possible rewards were paid by the protocol if there were K fully saturated (100%) pools. The K parameter is the required number of pools, set to 500 at the time of writing. Furthermore, all pools would have to mint 100% of the blocks and have an ideal pledge.

Slot battles, oversaturated pools, ADA coins delegated to retired pools, low pledges, missed slots (pools not minting blocks for various reasons), more existing pools than required by the K parameter, many undersaturated pools that do not mint a single block in each epoch, this all reduces staking rewards.

In other words, even if Cardano is highly decentralized and there are actually more pools that mint blocks than required by the K parameter, the conditions for maximum possible rewards are not met.

In practice, it is almost impossible to achieve an ideal state, so the maximum possible rewards could not be expected to be paid all the time. However, I personally assumed that the staking rewards would be a bit higher than they currently are. The deviation from the ideal state is relatively high.

Conclusion

The fact that the maximum possible rewards are not paid and that there are 2B more ADA coins in the reserve than expected has one positive. Cardano has more time for adoption. There is a relatively large amount of ADA coins in the project treasury for Catalyst, governance, and further development of the ecosystem. The adoption of blockchain technologies is slower than expected and the use of blockchain networks and DeFi is declining significantly in the bear market.

There are two paths to higher rewards. Stakers should think more about what pool they decide to delegate ADA coins to. If they want to meet the requirements of the protocol, there should be 500 fully saturated pools that have required pledges and minted all blocks when become slot leaders.

When deciding whether to increase the K parameter, everyone should think about the current state. Would the staking rewards increase if the K parameter were increased to 750 or 1000?

The long-term goal is clear. It is necessary that as many people as possible use Cardano and pay fees. Long-term economic sustainability is directly linked to utilities. This does not only apply to Cardano but basically to all public blockchain networks that have a fixed number of coins. Cardano does not have inflation (tail inflation), so once the reserve is exhausted (or significantly reduced), it will be fully dependent on collected fees.

Increasing scalability at the first layer (Input Endorsers) is a prerequisite for success. Furthermore, it is necessary to think about the introduction of a fee market (tiered pricing). The most difficult task is to attract real users to Cardano, which many other ecosystems are trying to do.