Economic and incentive model behind Cardano Proof-of-Stake

The link between the digital and physical world

The economic and incentive model links the digital and physical world. The model is designed by a team. It is based on knowledge about people’s behavior and their motivation to act honestly. The design of the model is then rewritten into the source code of the protocol. The source code is available on GitHub and everyone can review it. The source code is used as an input for the creation of a full-node. You can imagine the protocol as a set of algorithms that basically describes how to react to internal and external events. Protocol lives in the digital world so by the external events we mean every related event in the physical world. For example, it is easy for the protocol to verify whether a received block, including all transactions, is valid. Verification happens fully in the digital world. However, people are able to prevent block propagation or they can intentionally change the source code to try to commit an attack. A well-designed protocol should be able to deal with all possible fraud attempts.

The majority of people accept money as a motivation for honest behavior. The link between the digital and physical worlds is based on the ability of the protocol to provide people with a physical reward. Not directly, but indirectly. Cryptocurrency needs to have something that is valuable in the physical world. ADA is a native coin of the Cardano protocol and has its market value that can be expressed in fiat money. There is a limited number of ADA coins so they are naturally scarce. To be precise, there will be only 45,000,000,000 ADA coins. As far as there is a demand for the ADA coins the Cardano protocol has a digitally scarce resource that can be used to reward people for honest behavior.

The price of ADA coins in the physical world is very important. In the digital world, ADA coins are just literally numbers. Coins sit on addresses and are owned by holders of private keys. Digital coins can have value only when it is possible to exchange them for something that has value in the physical world. Crypto exchanges serve as a place where people can sell ADA coins for fiat money.

Decentralization and security are not for free

We gradually lose faith in centralized authorities and we often cannot trust each other in the digital world. Decentralization solves the problem with trust. A public decentralized network, together with blockchain, can serve as a trusted entity for two parties that do not trust each other. It works well if both entities trust the network. Trust is valuable mainly in the globalized world of the internet. Decentralization allows us to avoid unnecessary middlemen. Security is also a very important attribute of a decentralized network since it is possible to try to commit an attack and the protocol must be able to prevent it. There are many possible attack vectors. A public network allows everyone to join the network consensus. The network consensus is a kind of democratic way to come up to an agreement among all participants running a full node. A new block can be successfully appended to the blockchain only if the majority of participants agree. A network consensus is a potentially vulnerable place that can be attacked. The prevention is based on the high cost of the attack.

Decentralization is mainly about the distribution of decision power. The quality of decentralization and security determines how much the network is trusted by users. These attributes are not for free and the network must pay for them. Cardano’s Proof-of-Stake is designed in a way that ensures high security and motivates to keep a high level of decentralization through economic and incentive models. Cardano has ADA coins that have a value so it can reward participants of network consensus for honest behavior and high-quality service. Moreover, it can motivate stake-holders to hold coins and thus maintain decentralization on a high level.

Participants of the network consensus are people operating full-node. Notice that it is the link between the digital and physical worlds. A person must be motivated by something valuable in the physical world to serve the network that exists in the digital world. It can be said that participants are employees of the network. It is important to note that the network is decentralized so it must be the network that rewards participants. It cannot be the team behind the network or someone else. The team is responsible for the design of the economic and incentive model. Once the main-net is launched the network must be independent and autonomous. Regarding the maintenance of the source code and innovation of the protocol, the network cannot be fully autonomous. The inevitable part of decentralization must be project governance and voting of stake-holders about the development of the protocol. The network should have a project treasury to be able to reward developers and researchers.

The network rewards participants for security and developers for maintaining the protocol, so there must be some source of income. The source of income is usually twofold. The Cardano network will produce new coins that will be gradually distributed as a reward. This resource of income is limited in time to ten years. The second source of income is transaction fees and fees for deploying smart contracts. In the beginning, new coins will play the main role in the reward program since there might not be processed many transactions. It is expected that after ten years there will be collected so many fees that it covers rewards. The creation of new coins will be gradually fully replaced by fee collection.

Long term sustainability of the economic model

The economic model consists of the maximum number of coins and an inflation curve. The inflation curve is basically an algorithm that emits a certain number of new coins in a given period. It is a kind of temporary network subsidy that should help to reward participants at the beginning of the network existence. Fee collection also belongs to the economic model since it is related to the income of the protocol. The incentive model is an algorithm that determines who will be rewarded for doing a good job. The network consensus works with the economic and incentive model. To be more precise, it relies on having sufficient income and it uses the incentive model for rewarding. Algorithms in full-node know what is considered as good and honest behavior. The majority of participants decide about appending a new block into the blockchain so the consensus directly determines who will be rewarded. The protocol is able to evaluate the behavior of consensus participants and reward them through the incentive model.

It is necessary to ensure the long-term sustainability of the economic model. It is relatively easy to achieve that when the network can rely on a rich subsidy via the emission of new coins. Once the subsidy budget is gradually getting depleted it can be more difficult. The income of the network gets to the point when it will be dependent fully on fee collections. As a consequence, the network can survive only in the case that the number of collected fees is sufficient enough to reward consensus participants.

Proof-of-Stake is not dependent on physical resources like electricity. Thus, the cost of operating a full-node is low. It means that fees might stay low in the distant future and there will be always collected a sufficient number of coins for rewarding. Relying on fee collection is directly dependent on the scalability of the protocol. The more transactions per second are processed the more fees can be collected. If millions of people use the Cardano protocol in the future then the fee can stay cheap.

Notice that the collected fees are not directly needed to create a security budget. The security budget of Ouroboros Proof-of-Stake is always present and protects the network against the 51% attack. Delegated ADA coins form the security budget and an attacker would need to own more than half of the delegated coins to succeed. The security budget depends primarily only on the market price of coins. It does not depend on the network subsidy and collected fees. It is a big advantage from the point of view of security since the attack is very expensive. Just try to count how many coins would you need to buy to have a chance to commit the 51% attack. It can be assumed that more than half of the coins in circulation will be delegated to pools. Moreover, the price of coins could dramatically rise if you try to buy them on the open market. Ouroboros Proof-of-Stake motivates people to own ADA coins and delegate them to pools. It is very smart. Not only it decentralizes the network as the decision power is really distributed among many stake-holders but it also creates a natural demand for the ADA coins. The network rewards not only pool operators but all stake-holders who have delegated coins to pools.

Another important social aspect of the Proof-of-Stake design is the fact that all stake-holders basically own the Cardano network. As the importance of the network rises the demand for owning a piece of it will also rise. Only ADA holders can participate in network consensus and can be rewarded for it. Moreover, they can make strategic decisions related to protocol development. You can understand ADA coins as a new kind of stock since you can be an owner of the network and ensure permanent passive income. Network subsidy coins and fee collection are used to reward all stakeholders. As we said, keeping the network running is cheap so all resources can be used to reward owners. No for paying electricity.

Network consensus

The more independent entities operate a full-node in order to create new blocks the better for decentralization. The network needs to economically attract participants from all corners of the world. Proof-of-Stake consensus does not rely on electricity so the cost of operating the full-node is similar in all countries. The well-designed incentive mechanism must motivate participants to honest behavior that is aligned with the best interests of the network. At the same time, it must distract from dishonest behavior.

The protocol works with economical incentives through ADA coin but pool operators might be incentivized by idealism, morality, desire to do the right thing, or just simply for the reason that they use the Cardano network in their business. Proof-of-Stake remains secure when more than half of the staked coins are held by honest participants. Who are the participants? There are three main groups: pool operators, stakeholders, and users. Pool operators need to have a higher amount of coins to be able to start operating the pool. Stakeholders are all users who delegate ADA coins to pools. Notice that stakeholders can independently choose a pool to which they delegate coins. It means that also stakeholders participate in decentralization and they are rewarded for it by the protocol. It can be assumed that it will be attractive for people to ensure passive income. It can be said that the Cardano consensus rewards people for keeping decentralization. The third group consists of users that hold ADA coins but do not delegate them to a pool. The users have some other usage like trading or locking ADA in another system.

To have decision power in the network consensus a person needs ADA coins. The more coins the more power. Distribution of decision power goes hand in hand with the distribution of coins among all people. The power of a pool usually consists of coins that own the pool operator and coins that are delegated by stakeholders. If the pool operator behaves dishonestly or the performance of the pool is low then stakeholders can decide to delegate coins to another pool. Thus stakeholders directly participate in the network consensus.

The incentive mechanism is modeled with an assumption of rationality of participants. Each participant acts selfishly to maximize their own return. Selfless participants are rare. Nearly all participants are self-interested and pursue strategies that reward them. The economic model, that is programmed directly in the protocol, defines rules and laws that are used to reward all participants that take part in making consensus. One of the core principles of game theory is that an ideal system is one where selfish participants, acting in their own best interests, are also, by design, acting in the best interests of the system.

The node operator’s interest is to cover costs and generate a profit. The stakeholder interest is to ensure passive income. They do it by delegating ADA coins to pools. Delegation is a cheap and effortless process. Other ADA holders might find another useful usage. The best interest of the network is to have many independent and honest pool operators, and many stakeholders that guard the operators not only in the digital world but to some extent also in the physical world.

Summary

The reward scheme is a fundamental piece of protocol security and must ensure effective decentralization under all possible conditions. The security of the blockchain cannot be ensured by the protocol itself. There is always an economic aspect and behavior of real participants that must be taken into account. The economic model and incentive mechanism are embedded in the source code and the team hopes that it is going to work forever.

Proof-of-Stake is not a wealth generator. The reward mechanism is designed in a way that motivates participants to honest behavior and ensures high security and decentralization of the protocol. The only usability brings profitability. Blockchain is not only about consensus but about real usability that will bring users. Cardano will be able to issue tokens and utilize smart contracts. Hopefully, many users find it useful and the protocol will collect a sufficient amount of fee to be able to reward participants of the consensus. Without income, there might not be sufficient ADA coins that protocol needs for the incentive model. The protocol will have 10 years to achieve mass adoption.

Source: Economic and incentive model behind Cardano Proof-of-Stake