The decentralization of block production depends on a feature that is not often talked about, inclusiveness. Inclusiveness refers to the ability of a wide range of participants to contribute to the process of validating transactions and creating new blocks in a blockchain network. In the article, we will compare PoS and PoW networks.
Why is inclusivity important?
Decentralization is a basic requirement for any blockchain network. Let's define it for the context of this article.
Decentralization is the process of allowing essential network functions (such as block production) to be distributed among a wide range of participants. This process should prevent the occurrence of a single point of failure. Decision-making power must not be concentrated in the hands of a few entities. Ideally, incentives should be set to continuously encourage the growth of decentralization.
Note that decentralization is not a static property, but a dynamically changing one. It can get better or worse over time. In the context of the article, we defined it as a process. This is because it is constantly changing according to the decisions of each participant.
The quality of decentralization depends on many factors. In particular, the incentive model and inclusiveness are essential.
An incentive model is designed to motivate participants to contribute to the network. It is a reward mechanism that financially motivates participants to provide services that are in line with the network's needs. It influences the behavior of network participants and has a direct influence on their choices.
The opportunity to receive a specific reward for a certain effort, cost, and risk directly affects participants' choice to join, not to join, or to leave.
Inclusiveness refers to the ability of participants to contribute to the process of validating transactions and creating new blocks in a blockchain network.
The more inclusive a network is, the more decentralized it can become, as power is distributed among a larger number of participants.
Notice that inclusiveness, decentralization, and the incentive model are interconnected concepts. A well-designed incentive model can encourage active participation, thereby promoting inclusiveness and decentralization.
Why is decentralization a big challenge?
Simply put, the quality of decentralization is determined by the ability to join cheaply (with a minimal entry barrier), with minimal effort and risk. A participant is likely to be happy to participate in decentralization for a fair reward.
The following assumptions are therefore associated with the growth (or at least the preservation) of decentralization:
- The number of participants will increase (or at least not decrease). Ideally, everyone will have a similar share of power.
- There will be no concentration of power in the hands of a few large entities (whales).
- The incentive model is economically sustainable in the long term (it does not change too much).
In practice, it can be very difficult to ensure this. Let's see several reasons why it is very difficult to ensure high decentralization.
The desire to gain control over the network is natural and grows with its adoption (popularity). Money can buy power. The rich have a greater chance of gaining control than the poor.
Incentive models of networks change over time as the number of coins in circulation changes, reserves are gradually depleted, networks become more dependent on the number of fees collected over time, etc. Gradual changes in the incentive model (monetary policy) can affect inclusiveness.
Let's think about how inclusive Bitcoin, Cardano, and Ethereum are.
Inclusivity of Bitcoin
Let's start with Bitcoin.
Bitcoin was an inclusive network at the very beginning when there were no pools and ASIC hardware. Anyone who wanted to mine BTC could join mining through a personal computer.
Almost everyone had a computer, so the entry barrier was minimal. Each user was simultaneously an active participant in the network consensus. However, it was necessary to cover the electricity costs. PoW mining is associated with risk, as it may not be profitable. In such a case, it is necessary to stop mining for economic reasons.
Once the first pools and ASIC miners appeared, it had a significant impact on the decentralization of Bitcoin. Pools are new entities that have become block producers. Previously, it could be any individual miner. Miners have become hash rate delegators.
As mining became professionalized, the vast majority of BTC holders ceased to be miners. Large mining companies began to emerge, which today have hundreds of employees.
Today it is not profitable to run a single ASIC miner. It is more profitable to run a smaller mining company. However, this is only possible in some regions.
In the case of Bitcoin, large companies have the advantage of economies of scale. This means that with a higher number of ASIC miners, the cost of operation decreases. It is easier for entrepreneurs to negotiate discounts with suppliers of hardware and electricity. As a result, they can expand their business faster than small miners.
The operators of the two dominant pools, Foundry USA and AntPool, offer zero fees to mining companies.
In the context of inclusivity, we need to be concerned with how easy it is for new participants to set up a new pool and start mining.
If two dominant pools offer zero fees for big miners, it is very difficult to start a new pool and be competitive. There are infrastructure costs associated with running a pool. The operator of the newly established pool must attract miners. However, miners are financially motivated to delegate the hash rate to the pool from which they will receive the largest rewards and at the same time regularly. Small pools cannot compete with that.
Let's look at mining.
The cost of acquiring an ASIC miner is in the thousands of USD ($1.5K - 3.5K). Furthermore, the miner has to cover the cost of electricity. In addition, it is necessary to find a room in which the ASIC hardware will be located. ASIC hardware is noisy and requires good cooling. In a bear market, mining may be temporarily unprofitable and the miner must wait to sell BTC to a bull market. This is a relative risk factor.
Mining requires a high entry cost at the beginning and calculation is necessary. It is possible that PoW mining will not be profitable in the given region under the given conditions. For many people, it is more convenient and safer to buy BTC than to mine it.
Wanting to own coins but not being able to participate in the consensus is untapped potential from the point of view of decentralization.
BTC mining is highly exclusive. It is almost impossible to start a new pool, i.e. to become a block producer. Becoming a hash rate delegator (miner) is unaffordable for many participants. Mining is concentrated in large halls in the hands of several companies.
The exclusivity of mining leads to a reduction in the decentralization of Bitcoin. We can observe this trend for several years. A trend reversal is very unlikely to happen without changes at the protocol level.
Simply put, 20 pool operators are responsible for the content of the block. Two of them are dominant (together they produce more than 50% of the blocks). Pool operators are dependent on the delegated hash rate. Much of the hash rate is in the hands of a few large mining firms.
It can be said that the decentralization of Bitcoin is declining not only because of the phenomena and characteristics described above but also because it is the most successful project. As the project's potential for success grows, so does the desire to gain control over it.
We will see the same tendencies if PoS networks succeed.
Inclusivity of PoS networks
The fundamental difference between PoW and PoS networks lies in the difference in the resources that participants must own to be able to participate in the consensus.
While becoming a consensus participant in the Bitcoin network requires hardware and paying electricity costs, participants in the Cardano consensus need to own ADA coins.
It can be said that in PoS networks, all coin owners can be active participants in the consensus. There is no division into coin owners and consensus participants as with Bitcoin. From the point of view of inclusivity, this is an advantage.
The desire to own coins is fully exploited, as the distribution of coins increases decentralization.
Each ADA holder may (but may not) be a resource delegator to the chosen pool. Cardano does not define a minimum number of coins necessary for delegation. It is possible to become a minority participant of the consensus for literally a few dollars.
To delegate ADA coins to the pool, you just need to have your own Cardano wallet. Delegation is a relatively easy process that does not require high technical knowledge or running your full node.
Cardano has a liquid staking at the protocol level. Users are not forced to use third parties to be able to spend ADA coins whenever they want. They can always keep the resource (coins) with them in their wallet, so they still have control of Cardano in their own hands. The protocol will send staking rewards directly to their wallets (pool operators do not influence the reward process).
Similar to Bitcoin, Cardano uses the concept of pools. The difference is that Cardano works with this concept at the protocol level.
The pool operator cannot set zero fees. The minimum fixed reward per epoch is now 170 ADA coins. Furthermore, there is the concept of pool saturation, which makes the emergence of dominant pools economically impossible. There are dominant pool operators (operating multiple pools) in the network. However, none has such a fundamental dominance as in the case of Bitcoin.
Minimum fees and pool saturation increase inclusivity, as they economically support a competitive environment. Although it is not easy to start a new pool and attract ADA delegators, it is relatively achievable.
Staking is generally much more inclusive than mining, so PoS networks have the potential to achieve much more decentralization than PoW networks (however, even PoW networks differ and some use ASIC-resistant mining).
Regarding the economy of scale phenomenon, Cardano rewards large and small stakers proportionally. Any ADA coins received as a reward are immediately used for staking (coins will be counted in the next snapshot). Small and large stakers expand their business proportionally.
Ethereum differs from Cardano mainly in that it does not have native liquid staking and it does not use the concept of pools natively.
It is necessary to own 32 ETH to run your validator. Those who hold smaller amounts of ETH can stake through third parties. This also applies to those who have more than 32 ETH, but do not want to run their validator for various reasons. Running a validator requires technical knowledge, a reliable Internet connection, etc.
This leads to the concentration of ETH coins in either centralized exchanges or smart contracts.
Although from the point of view of inclusivity, much of what applies to Cardano applies to Ethereum, the difference in PoS implementation directly affects the quality of decentralization.
Block production in the Ethereum network is controlled at any given time by those who hold ETH coins (not those who hold third-party staking tokens).
Although some third parties require a certain minimum of ETH, say 0.01 ETH, the entry barrier is still significantly lower in dollar terms than in the case of Bitcoin.
Although it can be relatively difficult to establish yourself as a new third party providing liquid staking (like Lido or Rocket Pool), it is easy and affordable to become a staker. I dare to say that it is easier to try to become a pool operator in the Cardano network (just run a full node and attract stakers).
In general, staking only requires buying coins and delegating (or running a validator). Staking can be terminated relatively quickly and without loss through the sale of coins. Of course, it is necessary to neglect the volatility of native blockchain coins, which is a risk factor for both PoW and PoS networks.
PoW mining is riskier because, in a bear market, the miner can go into a loss and owe for energy and possibly for the loan he took to purchase ASIC hardware.
In the article, we neglected full node operators who also verify new blocks and all transactions that appear in the network. In the article, we dealt only with active participants who have a share in decision-making power, not passive participants. Active participants must hold the resource (protection against Sybil attacks).
The difference between PoS and PoW networks is also interesting from a governance point of view. The resource holders have the most significant influence. It is easier to establish on-chain governance with PoS networks because there are a large number of stakers. This can be more difficult with PoW networks as the number of miners is decreasing and large miners are expanding their business at the expense of small ones.
In the article, we mentioned the risks preventing the achievement of a high degree of decentralization. Probably the biggest of them is the ability to buy power with money. Unfortunately, this cannot be prevented with either PoW or PoS networks. This needs to be the subject of further research.
If teams want to increase decentralization, they must address the question of how to increase inclusivity, which may require changes in the reward mechanism or monetary policy. These changes are better made with community support. Without well-established governance, it may not be possible to implement such changes.