Understanding Cardano staking

It appears to be an advantage that the function of the store of value and medium of exchange is separated since in the event of a crisis people can buy another asset and continue to use the money. If money were a store of value and there was no alternative, people would be unwilling to spend and the economy would be completely stuck. The current financial system is convenient for dealing with crises, but it is being abused by politicians. It can lead to high inflation, which tends to disadvantage the majority of the population. It is certainly good to look for solutions to this problem and the concept of decentralization can play an important role. In particular, the development of algorithmic stable coins is promising.

In our view, even if monetary policies based on decentralized technologies replace the current money, people will continue to seek investment and passive income.

Bitcoin does not generate passive income. It behaves exactly like gold. Gold is now held by just over 10% of the population globally. That’s not much, and finding an explanation is not difficult. Most of the population does not need gold. They mostly use money as a store of value. The smarter one invests. Many poor people on our planet have nothing to save and live from paycheck to paycheck.

If inflation is low and wage growth follows its trend, people have no reason to think about a store of value. In post-pandemic times, inflation is high. People know it but still, they are not rushing to buy gold. Rather, they are looking for interesting investments including cryptocurrencies. And yes, they can believe that cryptocurrencies can become stores of value. 

Cryptocurrencies can generate passive income. Cardano uses a Proof-of-Stake (PoS) consensus that allows people to get rewarded every 5 days. This reward is approximately 5% per year of the total amount of ADA coins held. That’s definitely more than banks offer you in a bank savings account. We’re talking about the number of ADA coins, not their market value. The market value of ADA coins is hard to predict and we can probably agree that it is more likely to grow. It is not guaranteed, though. 

People can hold ADA coins (or coins of another PoS project) and get new coins as a reward. If you take away the conversion of the value of the coins to a market value expressed in dollars, after a year of holding 1 BTC coin you still have only 1 BTC coin. If you hold 50,000 ADA coins for one year, you will have 50,000 + approximately 2,700 new ADA coins. 

Let’s speculate now. If the value of cryptocurrencies were stable for a whole year, you would not make any money from holding Bitcoin. If the ADA was worth $2, you would get $5,400 as a reward.

Time plays an important role in investing. Compound interest literally works wonders. Cardano automatically uses the rewards you earn for delegating to the pool. During the snapshot between epochs, all ADA coins in your wallet are used. So each epoch, an increasing number of ADA coins are automatically delegated and used to calculate rewards.

Going back to our example, if you hold and stake 50,000 ADA coins for 10 years, you can earn an average of 35,000 ADA coins in rewards. If the market value of ADA is still $2, you will earn $70,000. However, if the value increases to $10, you will earn $350,000. At this value of ADA coins, Cardano would have about the same market capitalization as Ethereum has now. This is certainly a realistic scenario. Again, no one can guarantee anything. Many factors will influence the market capitalization of cryptocurrencies.

Cryptocurrencies shouldn’t just be about speculation and trading. Staking is something new that steps out of the shadow of first-generation cryptocurrencies and offer new possibilities. From a user perspective, staking is a strong economic incentive for holding ADA coins. However, staking is also crucial for the Cardano protocol, as decentralization and security increase with the distribution of ADA coins among users. Through staking, the interests of the protocol and the hodlers are aligned.

What holders get by holding coins

The mining company mines gold and the goldsmith turns it into gold bullion that you can buy. This bullion is not dependent on the mining company. It can go bankrupt and the gold bullion will still be worth the same. There is no link between gold and gold mining. Wealthy families can own the same piece of gold for hundreds of years and can be sure that the gold will not disappear from the world because of problems with mining companies.

In the case of blockchain, the existence of coins is directly dependent on the network and its ability to create new blocks. Without the network, the coins would not be liquid. Thus, the owner of the coins is mainly dependent on the economic model, security, and decentralization of the network. If cryptocurrency holders want to protect their wealth, they must continue to monitor the state of the network, understand the underlying mechanisms, and sell coins in a timely manner if there is any danger. It can be said that holding cryptocurrencies is a relatively challenging process as it requires attention and a deep understanding of technologies.

Satoshi imagined that the Bitcoin network would be kept running by the users, voting on the evolution of the protocol through the power of their CPU. In the beginning, this was possible and even laptops can be used for mining. Mining was highly inclusive, as anyone who owned a computer and had an internet connection could easily join. Today, mining has become a centralized business and it is difficult for individuals to join. ASIC miners are expensive and in some places even unavailable. Moreover, the price of energy is so high in certain areas that mining is a high-risk business. Mining is dominated by large mining companies that have thousands of ASICs in large halls near sources of cheap energy and ideally in cold climates. This can be seen as having reduced the ability of ordinary bitcoin holders to participate in the decentralization of the network and the inability to vote on protocol development.

The dependency between coin holders and networks is high. Users of a decentralized system should, by definition, have equal status. Ideally, they should all have the right to decide on the future development of the network. Participation in mining should therefore remain as accessible as possible to the general public. In the case of Bitcoin, we are moving away from this ideal.

Staking is a mechanism that puts the power back in the hands of the people and is consistent with the principles of decentralization. In the Cardano ecosystem, each ADA coin holder can decide which pool will be responsible for producing blocks. Larger holders or groups can run their own pool. Each ADA coin represents a voting right. In the Catalyst project, people can vote on what projects should be funded from the project treasury. In the future, people will also vote on the development of the Cardano network.

You don’t need to buy expensive hardware for staking, you don’t need to be constantly connected to the internet, and you even consume almost no electricity. Each new ADA coin holder automatically increases the decentralization of the network, and consequently its security. Staking must be seen in the context of power distribution, which allows you to better protect your coins. ADA coin holders are the owners of the infrastructure they use. This is a very powerful concept. 

Imagine if you had similar rights at Facebook/Meta and could decide where to direct further development, how to split the profit, or had requirements for functionality. Does it bother you that Facebook is misusing your data? Probably yes, but you can’t do anything about it because in IT companies the CEO always makes the decisions. We use social networks voluntarily and nobody forces us to use them. However, Facebook has such a large network effect that there is virtually no alternative. One possible solution is to distribute power among users. Cardano is a platform that has no CEO and people will make the decisions. Until an individual buys 51% of ADA coins, he will not be dominant.

If all the benefits of decentralization are to be preserved, including censorship resistance, free use without permission, and the inability to prevent spending your coins, it is imperative that the infrastructure is owned by the users themselves. Once the network is centralized and there are only a few pool operators, it may be relatively easy for governments to force them to filter transactions, prefer some, or block some addresses. If something like this happens, you can never be sure that your transaction will make it to the block. You might not be able to spend the coins.

From the network’s point of view, it is beneficial if it is kept running and decided by those who are most motivated to do so. PoW miners are mercenaries looking to make a profit. They may be somewhat indifferent to the fate of the network. In the case of voting, it is in their interest to make a decision that does not harm them economically. It may be that they will put their interests ahead of those of the coin holders. Staking is a nice solution for this situation since in the Cardano network every ADA holder is a kind of miner with voting rights. There is no separation between miners and holders.

If cryptocurrency coins are to exist for tens, maybe hundreds of years, decentralized networks must also exist. For networks to survive, the ability to evolve and respond to changes in the external environment is an absolute necessity. Networks are essentially just software that teams must maintain. Being able to influence the evolution and vote on the future is a way to maintain a high level of decentralization and not let the team have too much power.

Bitcoins are like gold. You only hold the value you can spend. In terms of decentralization, you have no other rights and you don’t even participate in it. It will always be easier and less risky for people to buy ADA coins than to buy hardware and paying for energy costs. Staking is thus more inclusive than mining. In the case of ADA coins, you also hold the value. But in addition, you have proportional control over the network. ADA coins themselves have a market value just like BTC. Staking, however, allows you to increase that value. Users are rewarded by the Cardano protocol for delegating ADA coins and it doesn’t matter if they participate in voting or not.

Holding coins for a long time reduces the supply and thus increases the market value. Assuming, of course, that there is demand for the coins. Cardano has a similar monetary policy to Bitcoin. The number of coins is capped, most of the coins are in circulation and the rest will be gradually released into circulation. Cardano does not have never-ending inflation of coins. The demand for the coins is dependent on the value and utility that users get. ADA coins give users control. Cardano as a platform offers many opportunities for developers whose services can attract new users. As a result, the network effect can grow fast.

The growth of Bitcoin’s network effect is based largely on the narrative of a store of value. In many cases, however, other cryptocurrencies are perceived similarly. It is common for narratives to change. Even ADA coins can be perceived as a store of value if their value increases over time and then stabilizes. Narratives may vary across projects and it is clear that SC platforms are pursuing a different mission than Bitcoin. History shows that the adoption curve of relevant blockchain networks is very similar. Ethereum has at least caught up with Bitcoin in adoption rate, if not already surpassed it. Cardano appears to be on a similar trajectory. If a community decides to push a narrative, chances are they will push it. The adoption of a blockchain network is driven by the community from the bottom up.

From the user’s perspective, staking has two major advantages over mining. Staking provides you with passive income and allows you to partially own the infrastructure you use. ADA holders control not only their wealth but also their freedom through a decentralized digital infrastructure. Staking fulfills Satoshi’s vision by allowing people to hold decentralization and power in their hands.

The high level of decentralization both at the network level and at the project development level is a big challenge. All systems tend towards centralization. Pareto’s 80/20 rule is also applicable to the quality of decentralization. It is possible that 80% of the network will be controlled by 20% of the participants. There is no other way than to accept reality and try to repeatedly come up with ideas to address this situation.

Where do the rewards come from?

How is it possible that Cardano can reward all stakers and Bitcoin rewards only miners? Cardano, just like Bitcoin, will release new coins into circulation until it hits a defined cap. The network’s security and decentralization costs are paid for through these newly released coins plus collected fees. As the number of newly released coins will shrink over time, it is expected that they will be replaced by user fee collection.

Public blockchain networks are essentially like companies. They have reserves (new coins), revenues (fees), and expenses (rewards, treasury, etc). Every company strives to maintain the same quality of service and reduce costs. Reducing costs means higher profits and the ability to reward shareholders more. Blockchain networks are no exception to these general principles.

Ensuring the security of PoW networks is very costly, as a certain amount of power must be consumed to reach a consensus. A large part of the reward for the mined block is used to cover the costs. A smaller part is used as a reward for the miners. Bitcoin has no mechanism similar to staking to redistribute the reward among coin holders. It would not even make sense, since by holding bitcoins, holders do not directly participate in security or decentralization. Even if bitcoin had a mechanism for reward distribution, the reward would not be high, as the cost of running the network has to be covered in the first place. Notice that users participate passively in security by holding the coins, which increases their market value.

Cardano’s network operation is roughly 50,000 times more efficient than Bitcoin’s network. The whole concept of decentralization is built on different principles than Bitcoin. Cardano rewards everyone who participates in decentralization and security. To participate, users only need to delegate coins to a pool and possibly change the decision if the chosen pool is not producing blocks of the expected quality or is cheating. With lower operating costs, new coins and fees collected can be redistributed to more people.

It is important to note that networks with a capped number of coins will depend primarily on fees collected in a few years. Newly released coins (epoch rewards/block rewards) will play an increasingly minor role in total reward. Thus, networks must provide useful services at the first layers or they will not have sufficient funds to cover the costs of operation. 

Bitcoin miners are essentially employees of the network and receive rewards from pool operators as they construct the blocks and use their reward addresses. Pool operators take a cut from the block rewards and the rest is distributed to miners. In the Cardano network, pool operators are also employees. Moreover, all ADA holders who delegate coins to pools also deserve rewards. The Cardano network first rewards pool operators, then rewards all delegators. The entire process of reward distribution is directed by the Cardano protocol.

The reward for ADA delegators is important as it encourages coin holding. Coins must have a market value as this provides security (protection against 51% attack). People are motivated to hold scarce coins if it generates passive income for them. As mentioned earlier, holding ADA coins increases market value (it is basically a principle that is valid for all coins). So the rewards are not for free, as people sometimes think. Rewards are for work done for the protocol. Coin holding itself is an important activity in PoS networks.

Some people might argue that PoS is not safe and that the only safe consensus is PoW. At the time of writing, PoS has been running for about a year and a half and no hacks have occurred. Both mechanisms are based on cryptography. Now, I’m going to simplify this a lot. PoW is built on solving a cryptographic problem that is energy-intensive. PoS is built on the distribution of keys that authorize the creation of a block. Further, it is based on a clever mechanism that points to a node in a given slot that gets the right to create a new block. Cryptography is secure and mathematically verified in both cases. The attack vectors are different. Cardano’s PoS is undergoing an important test of time. The longer it works, the more people can trust it. So far, so good.

Cardano security grows with the number of key holders. However, this is consistent with the requirement for a high degree of decentralization and the distribution of ADA coins. In other words, the higher the adoption, the more decentralized and secure Cardano will be.

To ensure the high security of the Cardano network, it is desirable to have a high number of pools operated by independent entities. This has been relatively successful so far. Over time, the economic requirements for operating pools will decrease, which can increase the number of key holders. Delegators should choose pools wisely to encourage decentralization. They should definitely not leave coins on centralized exchanges, as this harms decentralization and gives up their voting rights. The point of decentralization is to avoid trusting third parties, so as awareness and DEXes grow, so will decentralization.

People’s desire to speculate, get rewarded easily, create passive income, make decisions about their freedom, try new things, or hold scarce resources, all of which help Cardano networks to become more decentralized and secure.

What to do with coins

Staking on Cardano has superior features. ADA coins are not locked for a specific period of time during staking. Users can use the coins at any time to pay or use them in DeFi services. Another advantage is that owners cannot lose ADA due to misconduct on the part of pool operators. Cardano does not have slashing, i.e. a penalty for fraud or poor quality block production. ADA holders have complete freedom in terms of using the coins even when coins are staked.

What are cryptocurrency coins for? People mostly use them for long-term holding. Especially in the case of bitcoins, this is the main use at the moment. People can use cryptocurrencies to pay for goods and services. Many companies offer crypto credit cards. Payments are quick and easy but at the cost of having to trust third parties. If you want, you can pay with almost any cryptocurrency today, as long as the third party supports it.

Staking expands the use of ADA coins to provide a regular passive income. But it doesn’t stop there. Cardano is a platform, so you can issue tokens on it and use DeFi services. These services are essentially trying to replicate the capabilities of the traditional finance world. This expands the possibilities of using ADA coins.

If you want to profit from holding coins and tokens, you can become a liquidity provider and provide them to AMM exchanges (exchanges that use the Automated Market Maker model). AMM exchanges need liquidity to meet the needs of traders. Traders pay for the fulfilled swaps. A portion of the fees is used as a reward for the liquidity providers. Some DEXs may offer higher rewards than the Cardano protocol.

But higher profits are not for free. In the case of staking, you only trust the decentralized network and the code from the IOG team. If you lock coins into the DeFi service, you have to trust the smart contract written by a given development team. You have to trust that there is no bug in the contract code and that you will not lose your coins. A security audit is a must. Some DeFi services can use your coins for their functionality and at the same time, the coins can be staked. You don’t miss out on staking rewards and the total reward can be well over 5% per year.

Other financial services related to loans, insurance, investing, saving, and other businesses will arise on Cardano. Coins can be used as collateral to create stable coins. Thus, the use of coins will grow and with it, the opportunities to profit will grow.

In all DeFi services, the native coins of the platforms are used the most. In the case of Cardano, it will be ADA coins. This is because these coins are used to pay for network usage fees. NFTs or other tokens are paid for with ADA coins. ADA coins are a means to decentralize the network and the protocol pays rewards to them. It is unlikely that ADA coins will be replaced by, say, bitcoins in the Cardano ecosystem.

The reality is that if you want to use bitcoins in the DeFi service, you have to tokenize it (wrapped bitcoin) and then use it on the platform. The Bitcoin protocol offers no way to use bitcoins at its first layer other than to send them from address to address.

Do the first layers have a future?

It is possible to entrust the coins to third parties that offer financial services related to rewards. Through such third parties, you can lend ADA or BTC coins and receive the reward. But the question is whether this makes sense. The first layers will always be the most secure and decentralized networks. On the other hand, it’s clear that they won’t have the capacity to serve the entire world for a long time yet. We don’t think that resigning to decentralization and entrusting cryptocurrencies to centralized third parties is the ideal solution. The teams of all major projects are working on second layers that retain elements of decentralization and scale better at the cost of less security. This is definitely the right direction.

It is conceivable that in the next decade, most of the coins will be kept in different second layers that will have their own economic models. The operators of those second-layer nodes will economically benefit. If you put BTC into the Lightning Network (LN), you can do an almost infinite number of transactions, and you pay the fees to those who operate the LN nodes. The Bitcoin network only has fees for opening and closing the channels. 

Imagine creating a network where you can keep coins for a year without having to use the first layer. The Cardano network will be able to operate with tokenized bitcoins so it is such a layer as well. All first layers could potentially suffer economically. As we have already explained, the first layers will become increasingly dependent on fees in the years to come. However, the drive for greater user convenience and lower fees plays against the first layers. People want to pay the minimum fees for web-like services. They want fast and “free” services without waiting for blockchain settlements. That is the reality. 

Notice, that coins and tokens are created on the first layers and necessarily need it as a controller of last resort. However, the tendency is that coins will be used in higher layers. The second layers need the first layers to continue to exist, but the selfish economic interests of the node operators may ignore this need. While we are still at the beginning and the situation is not serious, it is up to the teams to address the situation. The obvious solution is to link the economic interests of the first and second layers. Furthermore, it is necessary to increase the efficiency of the first layers (reducing the cost of long-term sustainability while keeping the same quality of key features) and to expand functionality.

For the first layers to remain relevant, important things must happen to them that people will be willing to pay for. Cardano is built in such a way that the first layer retains an important function within the entire future ecosystem. Issuing tokens, executing Plutus scripts, being able to issue certificates, being able act as a decentralized public key infrastructure, interoperability, and the ability to be a reliable base for side-chains, all of these are important functions for long-term economic sustainability.

It is a big unknown if the first layers can get by with a transaction-only system that does not scale globally, is slow, and transactions can be expensive. Public blockchain networks are new and we have no historical experience. Therefore, it is difficult to predict the future. We do not know whether networks can rely on a network effect based on faith or on real utility based on Internet communication between participants. It is likely to be a combination of both. We can rely on basic economic principles in our reasoning. Only utility ensures profitability. Only profitability can ensure long-term economic sustainability.

Just as an unprofitable company can fail, a decentralized network can fail if it loses its security or decentralization. With the loss of these key parameters, the network will lose users and thus revenue.

The first layers will always be the most decentralized and secure. It’s up to the users to decide if they want decentralization and are willing to pay for it. People aren’t interested in running full nodes, and it’s safe to assume that it will never be more than 1% of the population. This is where we need to innovate. People need light clients with the security of full nodes. People will keep their wallets on their laptops and on their mobile phones. The future of decentralized services will probably not be based on downloading the entire blockchain but on modern cryptography that ensures P2P interaction.

Game-changers are trustless services, not centralized services holding the coins of decentralized first layers. The closer we get to decentralization and the higher the adoption, the better. If you stake ADA coins from your own wallet, you are directly supporting decentralization. Staking can be seen as an opportunity to make one’s stance against centralized authorities and to vote for a paradigm shift. ADA coins are the key to freedom. Only the people can decide the future of the first layers.

Decentralization, trust, and greed

The success of all cryptocurrencies will be primarily based on greed. Greed has been a major driving force for the growth in the value of bitcoins. People’s desire to own coins for any reason is an important component of adoption. Greed helped the IOG team to design a suitable economic and security model of the Cardano network. It is wise to base decentralization and security on adoption, or more precisely on the distribution of ADA coins since greed is a significant facilitator. These key features will grow together with adoption. Note that in PoW networks, greed only affects security as the market value of coins can increase, but coin distribution has no role in decentralization.

Decentralization is a powerful concept that has a lot to offer to society and is not necessarily directly related to greed. The right to greater privacy, access to financial services, financial and social identity, transparency, fair treatment, low fees, the immutability of the rules of the game, etc. have nothing to do with greed. They are legitimate requirements valid anywhere in the world and there is no relation to speculation to the growing value of coins. People have these requirements when interacting with each other, including when interacting with authorities or businesses. Unfortunately, these requirements are not 100% enforceable, verifiable, or achievable. People can very easily abuse their position of power. The blockchain industry is about the ability to secure and improve these key requirements. In fact, to achieve this, we need to expand the possibilities of decentralization. P2P communication needs to be improved to rely more on technology and less on people.

Decentralization addresses a very fundamental feature of society, and that is trust. People are losing trust in institutions, governments, banks, and the management of big IT giants. It is the abuse of power and the inability to enforce the aforementioned requirements that lead to the loss of trust. People are naturally looking for solutions to problems, and because we live in a digital age, we are looking for solutions at the level of network protocols. Decentralization can be seen as the ability to define new rules that no one is able to change and that the networks will automatically and completely fairly supervise. People as owners of the networks will not let individuals change the rules. Transparency and the ability to audit the ledger are also important. Even if someone gains a majority in the system and tries to change the rules or abuse their powerful position, everything will be immediately exposed.

If someone wanted to violate trust, they would have to spend a huge fortune to buy large numbers of coins in order to control the majority of a decentralized network. However, people’s greed and desire for passive income from staking give an attacker little chance. Moreover, the question is whether the desire to control the network is worthwhile when fraud can be detected quickly via on-chain analysis. 

Notice that staking is not just about greed in the sense of wanting a reward, but also about maintaining decentralization and thus maintaining the balance of the system.

In every ecosystem, there will be whales and power-hungry humans. The more economically or socially important a network is, the greater the desire to control it. The existence of alternatives and the possibility of people switching to another network will be part of the protection against the abuse of power. Users of a network must be able to verify that they are in control of it in order to trust it. On-chain data will be used for this purpose.

If decentralization is ensured, technological progress will bring new opportunities for utilization. These possibilities can provide the above-mentioned and important requirements for people. For example, the right to financial identity and the availability of financial services. Cardano is a global network and is available in all developing countries, provided the internet is available. Westerners can be greedy and desire to stake large amounts of ADA coins. People in developing countries crave the use of financial infrastructure that local authorities cannot abuse or prevent them from using. 

Staking can be seen to some extent as a humanitarian gesture towards developing countries. Of course, people in developing countries can also stake ADA coins if they can economically afford it, but the primary concern is the existence of financial infrastructure. What is important to Westerners, for example, is transparency in corporate processes, or alternative financial services with lower fees or fairer terms.

It may seem a little strange that we need to be greedy to improve mentioned requirements, but it can be seen as an act of taking power back into our own hands. The more people get greedy, the more decentralized Cardano will become. A decentralized network is about the dispersal of power and the economic difficulty of gaining control. That’s why we need to build blockchain networks from the bottom up and allow every individual on the planet to own at least a small share. Staking is not just about network consensus and block production. More broadly, it’s about building an infrastructure that can be much more universal. All you have to do is buy a few ADA coins and you can get that share of the decision-making. 

Once Cardano is sufficiently decentralized and adopted, it is only a matter of time before it has a greater financial and social impact. In general, any network must have a strong base in people, i.e. the community, as this is the only way to disrupt the current power structures.

Conclusion

It is appropriate to see staking in all its colors and shades. Behind rewarding delegators through staking is the well-thought-out design of the Cardano protocol. It’s natural that most people greedily desire rewards but it’s good to know that this is related to decentralization and the ability of users to own key infrastructure. If we want to change our society and use decentralized technologies more for our well-being and greater freedom, we need a suitable decentralized platform in the first place. On this basis, we can expand the possibilities of decentralization and build new P2P services.

Staking on Cardano was deliberately designed to be inclusive. Everyone must be given the chance to earn a reward and the opportunity to participate in voting on their future. Current financial services are exclusive, inaccessible, or incomprehensible to the general public. Staking is available everywhere in the world and there is no need to ask permission from anyone.

Once we have embarked on the path of decentralization, it makes no sense to compromise and entrust cryptocurrencies to centralized third parties. The financial and social services of the future must be decentralized. It is easy to lose direction for the sake of a better user experience, but history shows that it is important to insist on principles and get back on track.