Understanding Cardano Monetary Policy

Cardano has a reserve from which new ADA coins are released into circulation every epoch. Coins from the reserve, along with transaction fees, are used for staking rewards and filling the project treasury. This article will focus on the monetary policy of the protocol and the reward mechanisms that keep the network running.

Monetary Policy

Monetary policy refers to the protocol rules that govern the creation, distribution, and management of ADA within Cardano. It includes aspects such as the total supply of ADA, the rate at which new coins are released from the reserve, the filling of the project treasury, the collection of fees, and the mechanisms for the distribution of staking rewards.

Cardano’s monetary policy aims to keep the protocol sustainable in the long term, ensuring its decentralization, security, and ability to evolve. Two key issues are addressed: the necessity to offer rewards for people who participate in the network operation (pool operators, staking rewards) and the filling of the treasury (Catalyst, research and development of the protocol).

People need to be economically incentivized to maintain the network. The protocol regularly pays out rewards, called staking rewards, every 5 days between the transitions between epochs.

During the transition between epochs, the protocol takes a new snapshot that captures the stakes of pools (block producers) including delegated ADA to them. The state of stake distribution captured by snapshots is used in epochs. This affects the random voting of slot leaders, i.e. pools, which get a chance to mint new blocks (and thus get a reward for themselves and stakers).

During the epoch, the distribution of stakes changes. Snapshots are kind of fixed points in time.

The reserve contains the coins held by the Cardano protocol. These coins are yet to enter circulation.

The transition between epochs is the point where the state of monetary policy changes. The number of ADA coins in circulation increases, i.e. the circulation supply increases, because the Cardano protocol pays out staking rewards. In addition, the project treasury is filled. Part of the ADA coins is taken from the reserve.

Staking rewards for delegators (stakers) and stake pool operators (SPOs) come from two sources: transaction fees and monetary expansion. A certain percentage of the pot is sent to the treasury, and the rest is used as epoch rewards. We will talk about the pot in more detail later.

Future improvements of Cardano are to be greatly influenced by its community, which needs to be incentivized through rewards to participate in Cardano’s development. ADA coins from the project treasury will be used for this. Stakeholders will gain control of the Cardano treasury in the Voltaire era.

Cardano has a reserve that is gradually depleted and one day it will be completely depleted. Cardano has a steady income through transaction fees. Protocol expenses are staking rewards and activities funded by the project treasury.

Genesis Block

The Genesis block of Cardano was created on September 23, 2017.

Cardano has a capped number of ADA coins. There will only be 45,000,000,000 ADA coins. It has been decided that Cardano will not have tail inflation. Once all ADA coins from the reserve are released into circulation, no new coins will be created. ADA coins are digitally scarce because their quantity is capped, similar to Bitcoin.

Monetary policy was largely defined by the initial distribution of ADA coins.

The initial distribution of ADA took place in Asia in four stages between October 2015 and the start of January 2017. This distribution, essentially a pre-launch sales event, was the first in the cryptocurrency industry to set Know Your Customer guidelines and an audit was performed on the distribution process.

It is worth mentioning that VC funds were deliberately left out of the public sale.

During the public sale, 57.6% of ADA coins were sold. Cardano Foundation received 1.4%, IOG 5.5%, and Emurgo 4.6% of ADA coins. 30.9% of ADA coins were put into the Cardano reserve. It was 13,888,022,853 (roughly 14B) ADA coins.

Cardano has a fair distribution of coins when you consider that 88.5% of the supply includes public sale and reserve. The 3 founding entities together obtained only 11.5% of the supply.

The Cardano reserve is gradually depleted between epoch transitions. At the time of writing (November 2023), there are 8.66B ADA coins in reserve.

Reward Mechanism

Periodically, a so-called virtual pot is filled with ADA coins every epoch. A virtual pot has two income streams and two spending streams.

Income consists of monetary expansion and all the fees that the protocol earned in the epoch. Expenses are staking rewards and project treasury. The mechanism is controlled by protocol parameters.

The rate of monetary expansion is set by the parameter ρ. It is set to 0.3%. Every epoch, 0.3% of ADA coins are taken from the reserve and put into the virtual pot. The amount of collected transaction fees may vary from epoch to epoch. The more people use the Cardano network, the more transaction fees are collected.

The T parameter defines how much % of the virtual pot will be put into the treasury and how much will be left for staking rewards. The T parameter is set to 20%. So 80% will be left for staking rewards.

In the picture you can see how the virtual pot is filled with ADA coins (green arrows) and then the use of coins (red arrows) for staking rewards and filling of treasury.

During the epoch, the circulating supply is stable. It consists of coins held by stakeholders and coins in the treasury. During the transition between epochs, the circulating supply increases. ADA coins are being moved from reserve to circulation. The number of coins in the treasury will increase and all stakers (including SPOs) will receive staking rewards.

Note that fees only circulate and do not affect monetary expansion. Cardano redistributes the collected fees between stakers and treasury according to the T parameter.

Circulating supply is not increased by exactly 0.3% of ADA coins taken from the reserve every epoch. Staking rewards are not paid out in full but according to the performance of the pools. In other words, the conditions for achieving the maximum possible staking reward are not met, so a significant part of ADA coins is returned to the reserve.

Cardano evaluates the performance of the pools (missed blocks, slot battles, etc.), the distribution of stakes, the saturation of pools, the number of pools, and a few other things and adjusts the size of the rewards accordingly. In the figure below, this is indicated by the symbol η.

There's something called the potential maximum reward 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 staking reward is claimed (it increases the circulating supply) and part is unclaimed (it is returned to the reserve).

The reserve is being depleted more slowly than the team initially anticipated. By mid-2023, the team predicted that there would be approximately 7B in the reserve. The reality is that there were roughly 9B in the reserve.

If we put all the described mechanisms together, we get the following picture. Throughout the epoch, the virtual pot is filled with collected fees. 0.3% of the reserve is added to the virtual pot. The virtual pot is then completely emptied. 20% of the virtual pot is put into the treasury and 80% is the maximum possible staking reward. Part of the staking reward is claimed (it is obtained by SPOs and stakers) and part is unclaimed (it is put back into the treasury).

When the virtual pot is emptied, the circulation supply of ADA coins increases.

This cycle repeats itself every epoch. However, with each successive epoch, there are fewer ADA coins in the reserve.

In the picture, you can see the transition between two epochs. Unclaimed rewards are omitted for simplicity. The growth of the circulating supply is also omitted. Note that there is one reserve and one treasury in the system. The protocol takes ADA coins from the same reserve and moves them to the same treasury. However, the number of stakers and SPOs who are entitled to staking rewards can change every epoch.

In the picture, you can see how Cardano divides the rewards (claimed staking rewards) between SPOs and stakers.

During the calculation of rewards, the Cardano protocol proceeds in this way (simplified). First, the rewards for pools are calculated. It is based on the stake and performance of the pool in the epoch. The stake of the pool is (usually) composed of ADA coins of the operator and all stakers.

The protocol first calculates the reward for the pool operator and then for the stakers. The operators set their rewards through two parameters that define a fixed reward and a variable reward (margin). After subtracting the reward for the pool operator, the protocol takes the rest of the reward and calculates proportional rewards for the stakers.

Conclusion

There are fewer ADA coins in the reserve each epoch. The reserve is gradually being depleted. You probably wonder what will happen to staking rewards in a few years when the reserve is significantly lower than it is today. Staking rewards will be more dependent on the amount of collected fees. Today, they make up only a small part of the total reward paid out. In theory, the more the reserve is depleted, the more users should pay fees. In practice, this does not happen yet. If Cardano or any other blockchain is to survive in the long term, it must be profitable. That is, to have sufficient income to be able to pay for its operation, security, and maintenance. This is a challenge.