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Staking on Cardano doesn't need third parties

Published 22.2.2023

Staking on centralized exchanges is very disadvantageous for coin owners. They bear most of the risk associated with the loss of coins and let third parties profit. Yet the exchanges carry minimal risk and the CEO may decide to handle the coins differently than promised. With the advent of regulation, particularly in the US, Staking-as-a-Service (SaaS), provided by exchanges, is becoming more problematic. People should understand that ADA coins are the key to decentralizing Cardano. The project is deliberately designed so that people do not need unnecessary and unreliable intermediaries for financial transactions. It is not even necessary to rely on regulators and laws for staking. Staking is a financial operation. It should ideally be a Peer-to-Peer business between a staking pool operator (SPO) and a delegator. Believe that in the past CeFi services went bankrupt while DeFi and the protocols worked exactly as they had written in their source code. Let's take a look at the biggest differences between using a SaaS service and delegating ADA coins from your own wallet.

TLDR

  • The design of the protocol is deliberately devised to allow it to support its own needs as well as the needs of stakers and SPOs.
  • ADA holders that stake coins on centralized exchanges give up control not only of the coins but also of the Cardano network.
  • Regulators are tasked with protecting the assets of people who entrust them to a third party. ADA holders don't need third parties for staking.
  • ADA holders should realize that if there is any attack on Cardano through the exchanges, they will be the ones who lose their property.
  • The ADA holder decides what pool they delegate to, can vote in Catalyst, can participate in ISPO, can use DeFi, and can spend coins at any time.
  • Exchanges only ever do what is profitable for their own business and have no economic interest in supporting the Cardano ecosystem. ADA holders can support the ecosystem.

Who participates in staking?

The most important participant is the Cardano protocol which pays the rewards to SPOs and stakers. The design of the protocol is deliberately devised to allow it to support its own needs as much as possible. It is also designed to provide sufficient incentive for participants to behave honestly and in the interest of the protocol.

The biggest needs of the protocol are decentralization, security, governance, sufficient computer resources needed to run the network, etc. It is important to remember that the existence of the network depends on volunteers who can provide everything the protocol needs for ADA rewards. There is no need to rely on third parties. Staking is a peer-to-peer business between the protocol and the SPOs (if you accept that the protocol can be considered an autonomous entity). The same is true of the relationship between SPOs and stakers.

SPOs provide Cardano with everything it needs by running its own nodes. Their biggest responsibility is to mint blocks. For this, they receive ADA rewards. There is competition between the SPOs. The number and size of SPOs affect the decentralization of the network (and also the distribution-ness).

Stakers delegate ADA to the chosen pool. This affects the total stake of each pool and determines how many blocks are minted by each of them. It's a very similar process to delegating a hash rate to Bitcoin pools. Stakers only need a wallet to do this. They do not need to run their own Cardano node. ADA coins are a tool to decentralize the Cardano network. Therefore, it is important that ADA holders own private keys. It is the ADA holders who decentralize the Cardano network the most, as they hold the largest stake.

Centralized exchanges offering SaaS services are another participant in staking. Needless to say, an unnecessary one. They offer staking services and to do so they need to get ADA coins from their owners. ADA holders thus give up control not only of the coins but also of the Cardano network.

Exchanges have two options. Either they can delegate ADA coins to existing pools, or they can become SPOs. They want to be in control of things, which is why they usually run their own staking pool. It's also economically advantageous for them.

Remember, it's a business. Exchanges have costs associated with running nodes. They, therefore, take their cut from ADA holders. It stands to reason that ADA holders using the exchange should get smaller rewards than if they used their own Cardano wallet and delegated coins to their chosen pool. If the exchanges are offering bigger rewards for staking than the Cardano protocol, it's very suspicious. It may be just temporary marketing, or the exchange may be doing a different business with the coins than it publicly declares. It doesn't make economic sense for an exchange to subsidize rewards out of its own pocket.

Regulators are another indirect participant in staking. They do not hold ADA coins, so they have no direct control over Cardano. They can influence the functioning of centralized exchanges.

Exchanges are custodians of clients' coins. They may therefore be subject to regulation in a particular jurisdiction. It seems that SaaS will be a regulated business. It makes sense since ADA holders are giving up control of ADA coins and have to trust a third party.

Blockchain technology allows you self-custody of coins and tokens. Self-custody, together with a decentralized protocol that allows the transfer of value between participants, is what is innovative. Above this basic building block, DeFi is emerging. It can be difficult for regulators to prevent people from owning private keys. It will be just as hard for them to stop a decentralized network. But what they can do, and have in their job description, is regulate third parties who hold someone else's property.

Did you know that 5 entities are involved in staking? It is the protocol, SPOs, stakers, centralized exchanges, and regulators. The last two entities are unnecessary. In theory, we could include some DeFi services that offer to stake ADA in this list. However, we will not consider this option in this article.

Differences between SaaS and staking from your own wallet

The biggest difference is in the ownership of private keys. If users hold the coins, they are in control. They can use them at any time, decide which pool to delegate to, vote through the coins and get extra rewards. They can also participate in the ISPO if they so choose. Cardano does not lock the coins when staking, so users are completely free in how they handle the coins. They can use them in DeFi, for example in services that offer rewards from staking and further for providing coins. Importantly, users cannot lose coins if they protect their SEED well and follow the other rules associated with using the wallet.

Cardano has liquid staking and there is no reason to use a third party. Stakers can literally delegate a few ADA coins. There is no need to put together coins of multiple users to reach some limit defined by the protocol. Ethereum for example requires 32 ETH as a minimum for staking. Cardano has nothing like that.

If the ADA holder sends the coins to the exchange, it relinquishes all control. The exchange becomes the custodian of coins and may be subject to regulation.

The exchange is the owner of the coins and decides what pool it delegates the coins to. If it goes out of business, the owner may lose the coins. The exchange can unexpectedly freeze withdrawals of assets and subsequently go bankrupt. It may be that liabilities to third parties will be preferred over returning the coins to the owners. Many CeFi services bankrupt in 2022 (and earlier). I hope that was a warning sign to you.

Let us add that the exchange may have good intentions. Centralizing coins in one place is a honey pot for hackers. The coins may be stolen. It happened in the past that the CEO mysteriously disappeared and with him the coins from the exchange. Who is responsible for such cases? If the exchange does not have sufficient reserves and goes bankrupt, the owners of the coins will be out of luck.

The Exchange is also the owner (and custodian) of the rewards for staking. Users must trust the exchange that it actually receives the rewards and that the user can withdraw them at any time.

Some protocols, such as Ethereum, allow the removal of coins for behavior that does not conform to the rules. This is a form of punishment (called slashing). What happens if an exchange messes up and loses coins? Who is responsible? Is regulation appropriate?

In terms of protocol, exchanges are a necessary evil. Exchanges can hold larger quantities of coins and therefore they are big centers of power. It's unlikely, but the theoretical possibility exists that the coins could be misused for some sort of attack. It's always best for the protocol when coins are held by the maximum number of users and there are no whales. There will always be whales. Voluntarily giving coins to exchanges and making them whales is not smart at all. ADA holders should realize that if there is any attack through the exchanges, they will be the ones who lose their property.

Keeping coins in your own wallet is important for decentralization and the ecosystem. Choosing a pool to delegate coins to directly supports that pool operator who can do useful work for the ecosystem. Exchanges only ever do what is profitable for their own business and have no economic interest in supporting the ecosystem. It is up to the ADA holders to realize this and take responsibility into their own hands. Delegates are also rewarded for careful pool choice.

More decentralization is good for the reputation of the project. If most of the coins were staked from the exchanges, it would essentially mean that several of them have a significant stake in the decentralization of Cardano. The better the reputation of the network, the more new people will join.

ADA holders should view staking as an option similar to PoW mining. Both of these processes decentralize the network. However, PoW mining has high upfront costs and is a risky business. Staking is economically accessible to everyone on the planet. Once you hold a stake you have it forever and that includes the right to a reward. It is pointless to share the reward with a third party. Blockchain networks were created to do without unnecessary and unreliable third parties. Let's strive for that when staking. Every ADA holder can participate in the decentralization of Cardano.

Regulators are very likely to restrict the operation of centralized entities and this will have an impact on SaaS. Cardano is prepared for this and does not need third parties to operate. If regulators ban SaaS, it would ultimately be beneficial to Cardano because it would force people to use their own wallets. Are the regulators helping us? I don't dare say, but in principle, yes.

Regulations can force exchanges to behave fairly and may prevent fraud. But it certainly cannot be relied upon. Audited source code will always be more reliable than wealth-seeking CEOs and regulations that can be circumvented or cheated.

Conclusion

Cardano is a decentralized protocol and only needs SPOs and stakers to function. Centralized exchanges and regulators are unnecessary entities for staking. Unfortunately, most of the coins of perhaps all cryptocurrencies are held by centralized exchanges. Some people are afraid to manage their own private keys. This is a big challenge for the entire sector. For PoW projects, this is not such a big problem in terms of decentralization, as ASIC miners and energy are used instead of coins. For PoS projects like Cardano, it is important that the coins are held by their real owners.

All those who seek to change the current financial system should stop using it for financial processes that can be done in a completely decentralized way. This is true for staking the ADA.

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