How to Align Incentives with Blockchain Interests

Each blockchain network has a budget from which it pays those who provide it with resources. When the team fails to align incentives with the needs of the network, there is some inefficiency or degradation of the quality of key features. There must be many block producers in the network, as this makes it possible to execute smart contracts, increase scalability, or improve the finality of transactions.

What Resources Does the Blockchain Pay for?

You will understand the topic well by comparing Bitcoin and Cardano, as both blockchains have significantly different needs.

Different networks have different resource requirements based on their mission and preferred characteristics. The preferred features of Bitcoin are security and decentralization. Scalability is addressed through the Lightning Network. Cardano is a platform, so in addition to security and decentralization, it must also scale well. In addition, the execution of smart contracts requires higher processing power (CPU).

Blockchain will only have the required resources in sufficient quantity if they pay for them. The resources are provided by volunteers and they usually do it for selfish economic interests.

It is important to note that if the incentives are not set up appropriately and are not well aligned with the protocol design, it can result in inefficiency or degradation of the system. This can also happen due to some change in the environment or community preferences, technology obsolescence, economic reasons, or other reasons.

What resources does Bitcoin pay for and what properties does it affect the most?

Bitcoin pays the miners, so it covers their costs for ASICs and electricity. This affects security the most (more precisely, protection against a 51% attack) and only partially decentralization.

Miners do not need to run full nodes. Full node operators have no economic incentive to run them. Only pool operators are indirectly incentivized to operate nodes. They pool the hash rate of miners and can charge a fee (pool fee) for their service. Paradoxically, the two dominant pools have zero fees.

Bitcoin's economic incentives do not support decentralization at the level of block producers. Decentralization occurs only between miners (let's neglect the centralization of mining for now).

Are the incentives set up correctly?

Bitcoin was originally designed well because all users were supposed to be miners. They could mine BTC from their home computers, so they would be economically motivated to run a full node. They sometimes had a chance to mine their own block. However, as the number of users grows, the chance would decrease (let's not get into that now). Bitcoin therefore paid for security and decentralization. There could be a large number of nodes in the network, including many block producers. With the advent of ASICs, two groups emerged, miners and full node operators. Miners started delegating the hash rate to a few pools (nodes). BTC holders are essentially a separate third group. So there was a change in the environment that negatively affected decentralization.

How much does this affect Bitcoin's mission?

That's a tricky question. Bitcoin should be as decentralized as possible in terms of block production, but if the community doesn't mind and is happy with decentralization at the miner level, that's fine. Bitcoin is not a smart contract platform, so it does not need processing power (and other resources) to execute smart contracts. Bitcoin has no ambition to scale on the first layer or to achieve faster finality of transactions (and blocks), so resources (nodes) are not needed for that either.

Bitcoin can (theoretically) only work with a few dozen pools and miners. Full nodes are not required to hold BTC.

If Bitcoin is primarily supposed to be well-secured, it may seem that the incentives are set well. However, the network will not have more block producers, i.e. nodes whose computer resources the network could somehow use.

How is Cardano different?

Cardano is a smart contract platform and the team has ambitions to significantly improve scalability, so the network needs more resources. Therefore, Cardano must directly pay for its decentralization, i.e. for the operation of block producer nodes.

Through the protocol parameter, it is possible to set the preferred number of pools in the network. The economic incentives are set so that staking rewards will be highest if there is a preferred number of saturated pools in the network. The reality is that there are more than double the number of active pools, so not all of them are fully saturated.

Cardano pays rewards directly to pool operators, but also to stakers. Stakers do not contribute any resources to the network, so they only get rewarded for decentralization (for delegating ADA to pools). Pool operators provide their node, i.e. the resources for which they have to pay (hardware, energy, internet connection, time, etc.).

Due to the larger number of nodes compared to Bitcoin, Cardano has sufficient resources to execute smart contracts and also to increase scalability or improve the finality of transactions.

Note that a regular full node in the Bitcoin or Cardano network cannot participate, for example, in the faster finalization of transactions, because without economic incentives (and skin in the game) it cannot be ensured that the full node will be operated reliably. In addition, it is always necessary to think about security.

In the Cardano network, stakers could theoretically run a full node and somehow actively contribute their resources to the network. However, this is just a theory now. In the case of Bitcoin, active participation is conditional on running ASICs (not by holding coins).

We can state that Cardano directly pays for security, decentralization, and scalability, as economic incentives ensure that there will be a sufficient number of nodes in the network.

The first Generation of Blockchain is very Inefficient

The consensus of Bitcoin and Cardano are very similar and it must be said that they are similarly inefficient in terms of resource usage. Cardano uses a Nakamoto-style consensus, which means that it follows the longest chain rule and achieves probabilistic finality.

Both Bitcoin and Cardano work in such a way that in each round one node produces a new block and submits it to the network. All other nodes in the network subsequently validate this block. Block finality increases with each newly appended block.

Blockchains basically differ only in the way the lottery takes place. In the Bitcoin network, all pools fight to mine a block at the same time by solving a complex PoW task, while in the Cardano network, one node (slot leader) is drawn through VRF cryptography.

Most of the time the nodes do almost nothing. They can forward transactions and put them in the mem-pool. They cannot do anything related to block production. Only one node can do this in each round, despite the fact that it is a very simple task that it can complete within 1 second. Other nodes basically get one block per round (ideally), which they also validate within 1 second.

It is a slight exaggeration to say that nodes in the Bitcoin network are basically idle for 10 minutes. Cardano produces blocks on average every 20 seconds, however, nodes are also idle most of the time.

What happens when a new block producer node is added to the network? It will only increase decentralization (and will increase the demands on communication and synchronization). Unfortunately, scalability, transaction finality, network throughput, or capacity will not improve. The resources of the new node cannot be used efficiently.

Bitcoin pays a huge amount of money for computing power, but that doesn't help it at all when it comes to scalability. Money is consumed only by PoW.

As we described above, Cardano has a large number of nodes (resources) at its disposal, but it also does not use them efficiently. But that is about to change.

One of the planned improvements is called Input endorsers.

The input endorsers improvement aims to improve the scalability and efficiency of Cardano by separating transaction selection from block production.

Input endorsers are randomly selected nodes based on their ADA stake, who are responsible for selecting and endorsing transactions from the mem-pool and propagating them through the network. All nodes can then process these endorsed transactions before the block producers bundle them into blocks. The blocks only contain references to the endorsed transactions, which reduces their size and complexity.

It is important to know that this solution can be implemented only because there are more nodes (pools) in the network. They can validate transactions that require the execution of validator scripts. The workload is distributed among all available nodes. Resources will be used efficiently.

Note that with plenty of nodes, it is possible to maintain a high degree of decentralization while increasing scalability. It is therefore possible to solve the inefficiency of the system. Each newly added node will bring resources that can be used more efficiently.

However, input endorsers increase complexity (higher demands on communication and synchronization). So it is not the case that nodes can be added indefinitely and efficiency will always increase. At some point, the complexity of mutual communication will prevent a new node from being meaningfully added.

In the case of Bitcoin, a similar solution could not be implemented for many reasons related to the POW lottery. But it wouldn't make sense mainly because of the small number of block producers and centralization. Only about 10 pools would endorse the transactions and two of them would have the main say.

Note how economic incentives affect the ability to improve the system.

Conclusion

The article had the ambition to explain the relationship between economic incentives and the resources available to the blockchain. Incentives directly affect the properties of blockchains. We wanted to explain the basic principles. However, the topic is complex and it is impossible to describe all the nuances.

Economic incentives determine the relationships between block-producer node operators and networks. Teams can set the incentives in the best possible way before the network is launched, but there may be events that require changes to the economic model. I daresay it has already happened in the case of Bitcoin. In the future, this may also happen in the Cardano ecosystem. It is not possible to prepare networks for all future changes in environment or needs, as these cannot be predicted. Therefore, we believe that the ability to adapt to new conditions through on-chain governance (or another form) is extremely important.