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How the Cardano reward mechanism works

Published 21.3.2023

Cardano uses ADA coins to reward pool operators and stakers, but also to fund Catalyst projects. In the future, coins from the project treasury will be used to reward DReps and the team that maintains the source code and implements protocol changes. Where does Cardano get these coins? Let's study the project's monetary policy and reward mechanism.

TLDR

  • Unlike Bitcoin, Cardano has a project treasury so that development and governance can remain independent of VC funding.
  • From the total epoch reward, 20% of the ADA coins will be moved to the project treasury and the rest will be used for staking rewards.
  • Part of the incentive mechanism is to promote decentralization. If the protocol requirements for pools are not met, a portion of the staking reward is returned to the reserve.
  • Cardano may find itself in a situation where the block production group is fighting for resources with the governance group.
  • ADA coins are being used up from the reserve at a slower rate than originally anticipated.
  • Decentralization is dependent on the project treasury.

Monetary policy of the Cardano protocol

Cardano is being built to be independent of external funding in the future, especially from VC funds. The IOG team has been working on the development of the protocol and will hand it over to the community in the Voltaire era. Cardano needs to have enough ADA coins not only for block production rewards but also for the on-chain government. Delegation Representatives (DReps) will also receive rewards.

In addition to the reserve, which every blockchain has in some form and contains coins for future rewards for those who participate in the production of blocks, Cardano has a project treasury. ADA coins from the project treasury will be used to fund governance (Voltaire), protocol development, and ecosystem development (Catalyst).

The monetary policy of blockchain protocols is usually set by the team in a fixed way at the beginning and then accepted by the community. In the case of Cardano, it was defined in the Genesis block that there would be 45,000,000,000 ADA coins. 30.9% (~14,000,000,000 ADA) was put into reserve, 57.6% (~26,000,000,000 ADA) of the coins were sold to the public, and the remaining 11.5% (5,000,000,000 ADA) was split between the IOG, Cardano Foundation, and Emurgo teams.

In the figure below you can see how each epoch (lasting 5 days) Cardano moves some ADA Coins from the reserve and uses them for rewards. Note that the reserve and project treasury are outside the rectangle representing the epoch. This is to illustrate that these two piles of ADA coins are still present for the protocol and the community. To be more precise, the protocol is responsible for moving ADA coins out of reserve while the community will decide about moving ADA from the project treasury through DReps. The project treasury is filled from the reserve and from fees collected.

If you take away the project treasury, the system works very similarly to Bitcoin. The differences are as follows. Bitcoin rewards the pool immediately for each newly produced block, and the reward is fixed (every four years the rewards are halved). The block reward goes to the pool address and the pool operator manually sends a portion of the reward to miners based on the hash rate they provided.

Cardano, like Bitcoin, has two inputs for block production rewards. Part of the reward comes from the reserve and part is made up of fees. As the reserve gradually empties over time and the number of coins approaches zero, it will be necessary to collect enough coins for rewards via fees.

In the figure, the rectangle showing the reserve is intentionally larger than the rectangle showing the fees, but the ratio reverses over time. The size of the fees collected determines the quality of the security of blockchain networks.

If not enough coins are collected in fees (and their market value will be low), the security of the networks will also be low and they may collapse due to a phenomenon called security budget depletion.

Cardano transfers ADA from the reserve every 5 days and the amount is defined by the parameter p. The parameter p is currently 0.3%. The reserve shrinks more gradually and there are no sudden shocks as in Bitcoin, where rewards are halved every 4 years.

ADA coins from the reserve and from fees are moved into the virtual reward pot. The T parameter defines how many ADA coins will go into the project treasury (currently 20%) and how many will be used for staking rewards (80%).

Cardano moves ADA coins from the reserve and from collected fees to the project treasury in each epoch. At the time of writing, there are 1,200,000,000 ADA in it. The figure indicates two expenditures that are covered by the project treasury, namely the Catalyst projects and, in the near future, expenditures related to the Voltaire era.

Most of the ADA coins, 80%, will be used for staking rewards. This includes rewards for staking pool operators (SPOs) and also for stakers. Note the Cardano protocol rewards pools fairly based on performance. It then calculates the reward for the pool operator based on the pool settings. Each SPO sets a fixed fee, margin, and pledge (ADA coins of the operator). The remainder of the pool reward is divided proportionally among the stakers based on the number of coins they have delegated to the pool.

What many stakers don't know is that some of the staking rewards are not used (consumed) for block production rewards and go back into the reserve. Cardano evaluates the performance of the pools (missed blocks, slot battles, etc.), the distribution of stakes, and a few other things and adjusts the size of the rewards accordingly (shown in the figure by ő∑). There's something called the potential maximum reward rate that Cardano can pay out each epoch for the block production. If certain conditions are not met, only a portion of the reward is paid. Thus, part of the bet reward is claimed and part is unclaimed.

The Cardano Protocol is designed to economically incentivize the quality of decentralization. The protocol defines the optimal number of pools that should exist. Currently, the parameter k specifies that it should be 500. Ideally, there should be just 500 pools that will be saturated.

The reality is that there are 3,200 pools registered, with approximately 1,200 pools minting at least 1 block every epoch. Let us add that a pool is only eligible for a reward if it mints at least 1 block in an epoch. From a protocol perspective, decentralization is not as expected.

Obviously, there are not exactly 500 pools in the ecosystem that are 100% saturated. Instead, there are pools that have low saturation and produce blocks irregularly. On the other hand, some pools are oversaturated. Some pools have stakes but do not produce blocks. The total epoch reward (the potential maximum) is reduced for all deficiencies that occurred in the epoch.

It can be said that Cardano has income and expenses. The expenses are not only the rewards for block production as we know it from the first generation of cryptocurrencies but also the expenses for governance. This is an extra expense and in the future, there is a risk that governance may be too expensive for the protocol if an excessive number of people participate. Let's not forget that the project treasury is a finite resource that will one day depend mainly on the fees collected. Cardano may find itself in a situation where block production and governance groups are fighting for resources.

Currently, the ratio between staking reward and project treasury is set at 80 to 20. We will see if this needs to change and how significant governance will be compared to core infrastructure. ADA coins in the treasury should be used rationally.

Transition to a circular economy

In each epoch, the number of coins in circulation increases as the reserve gets gradually depleted. There are approximately 9,400,000,000 in reserve and 35,600,000,000 ADA coins in circulation. Cardano currently still has plenty of coins in reserve to use for rewards. But that's about to change. In 2030, there will only be approximately 2,000,000,000 ADA in reserve. We'll show below that under certain assumptions maybe more, but let's not consider that alternative just yet.

Currently, approximately 28,000,000 ADA are moved from the reserve to the virtual pot each epoch. In 2030, it may be only 6,000,000 ADA, almost 5 times less than today. If the protocol parameters are not changed, 4,800,000 ADA will be used for the staking reward and 1,200,000 ADA will be moved to the project treasury. Will that be enough for the rewards or not? And what will happen in another 10 years?

Obviously, it will be necessary for Cardano to be able to collect more coins through fees. In other words, the lower income from the reserve must be offset by a higher number of coins collected in fees. A circular economy must emerge where the fees collected are sufficient to reward block production and governance (including protocol development fees).

It is not possible to define the exact number of ADA coins that will be needed for rewards because it is not possible to predict the market value of the coins, the number of users, the network features that users will be willing to pay for, etc. But we don't mind, because we can imagine it in dollar terms.

The reality is that the cost of running a pool, making decisions, or participating in protocol development, is a value measurable in dollars and comparable to the normal salaries and associated costs for similar activities. The Cardano network's revenue, i.e., fees, can be viewed the same way. The fee must always make sense in context and not be exorbitant. People will be willing to pay a reasonable fee for transferring value, minting tokens, or using the app.

Currently, the incentives of the Cardano network are sufficient for block production. In dollar value, approximately 10M USD from the reserve and 35,000 USD (100,000 ADA) from collected fees are being moved into the virtual pot.

Currently, the cost of governance is negligible as only Catalyst projects are paid for by the project treasury. However, this will change and ADA from the treasury will be depleted at an increasing rate as protocol development and governance become more decentralized.

We can think of 8M USD to be distributed each epoch as a reward for block production and 2M USD to be used for governance. If the parameter k were changed and Cardano preferred to have 2,000 pools in 2030, out of 8M USD, each pool (SPO and all stakers) would have approximately 4,000 USD per epoch. It is 24,000 USD per month. If a pool operator took 10% of the reward, they would have 2,400 USD per month.

Will 2M USD per epoch, or 12M USD per month, be enough for governance? If everyone who is paid from the governance budget received an average of 3,000 USD per month, Cardano could employ 4,000 people.

The key question remains to be answered. Will Cardano be able to collect 10M USD per epoch in fees in 2030 (regardless of how much ADA is it)? Converted to a day it is 2M USD.

Approximately 50,000 people use the Cardano protocol daily. The number of wallets, or users, is approximately 4 million, but not everyone uses Cardano every day. If it were 5,000,000 people, Cardano would make the required amount. The average fee would be 0.4 USD. Is this fee for using the first layer reasonable or not? We can't say that either. But it is very likely that people will use the second layers on which the fees will be significantly (easily ten times) lower. First layers generally won't have it easy in terms of securing income.

To add context, for a blockchain to handle 5,000,000 transactions per day, it must be able to process approximately 60 transactions per second on average. This is an achievable goal for Cardano over a 5-year horizon, considering PoS Leios (input endorsers).

Is a 100-fold increase in the number of users realistic in such a short period of time? The first layer of Ethereum is used by 500,000 people a day despite they are moving to second layer networks. It is realistic that in the next 10 years or so, 10x or more people will be using Ethereum, i.e. 5,000,000 a day.

1% of the planet's population is 80M. Cryptocurrencies are held by hundreds of millions of people. How many will that be in 10 years? If all people not only held cryptocurrencies but started using them at the first layers, we would get to tens of millions of on-chain transactions per day very easily.

In the near future, could Cardano be used by 10 times or even 100 times more people per day than today? That will depend on many circumstances. If the number of users of blockchain services grows, so will probably Cardano. We believe Cardano can get to 500,000 users per day (to where Ethereum is today). Growth may be faster if demand for blockchain services in general grows. The success of Bitcoin and Ethereum will translate into the success of other relevant blockchain networks. It will also depend on whether HODL continues to dominate or if people's behavior changes and they start using DeFi services more.

Cardano certainly has a chance to gain more market share. But even if it only had a 10% share, it could still be on the order of hundreds of thousands to units of millions of transactions per day over 10 years.

Let's not forget that there will still be about 2,000,000,000 ADA in reserve in 2030, so Cardano doesn't have to rely solely on fees collected. Approximately 6,000,000 ADA will be released each epoch for rewards. If the market value of ADA coins grows, it will greatly help the budget in the future. Suppose the market value of ADA coins was 2 USD in 2030. Cardano would have 12M USD available in each epoch, about what is needed today to maintain the Cardano network.

We can conclude that the rewards budget will be sufficient if approximately 500,000 users per day use Cardano in 2030. It would be 10x more than today and it is a reasonable estimate. We can also suppose that the market value of ADA would be at least 2 USD. The growth of the network effect will inevitably affect the market capitalization of the project in the same way as for other projects. Expecting a 6-fold increase in capitalization with a 10-fold increase in users is a conservative estimate. If the average on-chain fee was 0.4 USD, Cardano would earn 1M USD in fees per epoch. While it is difficult to predict the future, it can be assumed that Cardano will still be largely dependent on reserves in 2030.

Conclusion

We mentioned in the article that a part of the staking rewards are unclaimed and returned to the reserve. The reserve is being depleted at a much slower rate than initially anticipated. It was estimated that there would only be approximately 8B ADA in the reserve in Q1 2023, but in fact, there is 9,4B ADA. If this trend continues, there may be 3.5B ADA in reserve in 2030 instead of the estimated 2B ADA. This is positive in the sense that there is more time for the Cardano ecosystem to develop and be adopted. On the other hand, it is possible that decentralized governance will change protocol parameters or other rules and ADA coins will be consumed more quickly from the reserve.

From a governance perspective, it is good for people to have a basic understanding of monetary policy and the incentive model. It's surprising how many people in the Cardano ecosystem (including prominent influencers) don't know about the existence of project treasury. Yet it is extremely important as Cardano will be a self-funding ecosystem that will be independent of VC funds.

Decentralization is not only about block production but also about project management. It is impossible to maintain a global network on a voluntary basis if that network will protect the assets of hundreds of millions of people. At the very least, it is irresponsible. The quality of people's work must be properly rewarded. Obviously, VC funds will want to control blockchain projects and it will not always be transparent. Cardano is one of the few projects that has avoided VC influence from the start and has the plan to remain economically independent going forward. The IOG team's influence on Cardano will be gradually reduced in the Voltaire era for the benefit of the community. Without the project treasury, this would probably not have been possible.

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