How to ideally distribute power and to whom
A decentralized network is dependent on many individuals that operate nodes. Nodes are responsible for creating blocks, verifying blocks and transactions, and some other things. In the article, we will talk about consensus power since every blockchain network needs to come to a mutual consensus among nodes in order to append a new block into a blockchain. Having a consensual power means that operators of nodes can decide about including transactions into a new block and at the same time be eligible to get a reward.
It is necessary to distribute consensus power to all participants in a way that there will not be centers of power. Centers of power are dangerous for many reasons. For example, a centrum can be attacked either by hackers in the digital world, or node operators can be found by anybody in the physical world. When a big center is not suddenly able to produce blocks then the processing of user transactions might be delayed.
A decentralized network must be resistant to external attacks but do not forget that it must also resist internal attacks. For example, when there are a few big centers of power in a network, then it might be relatively easy for these operators to collude and dictate rules and conditions to other smaller participants. Security and decentralization are related attributes of a public network. The more small individuals and fewer centers a network has the more secure is the network. Put it simply, when there are no centers in a public network then there is nothing to be attacked externally or misused internally.
The power, for example, the right to produce new blocks, should be distributed equally to as many participants as possible. This general statement has a few limitations, though. The right to produce blocks should not get everybody for free. If it was the case then it would be relatively easy to misuse the power in order to attack the network. An open decentralized network should not have an authority that would approve who can participate in the production of blocks. Everybody can freely join and leave the network. Thus, there is nobody who would check the identity of participants and could decide who is good and who is bad. The incentive mechanism of a network must reward good participants and discourage bad participants.
Who is interested in the production of blocks? Block producers are usually awarded for the job so many participants can be potentially interested. It can be a mix of small entities joining the network for ideological reasons, businessmen that just wish to earn money, or even attackers that want to hurt the ecosystem. In the ideal case, the network should support the existence of many small individuals and do not allow the existence of centers of power. It is not possible to reach the ideal state since the digital and physical worlds are separated. It is not possible to protect a network against the Sybil attacks without a central authority. To be honest, it would be difficult even with the central authority.
Both PoW and PoS networks use a precious resource to distribute consensus power. Let’s have a look at the differences.
The power in a network is related to a precious resource
Cardano is a proof of stake (PoS) network that uses native coins ADA as a precious resource. Bitcoin is a Proof of Work (PoW) network that uses electricity as an expensive resource.
ADA is a scarce resource and the coin issuance is capped to 45,000,000,000. The consensus power can be retrieved by buying ADA coins. If we do not consider Lovelace then theoretically every person living on the planet can own a piece of consensus power in the Cardano network by buying a single ADA coin. It is just a theory, though. At the moment of writing, there are nearly 90,000 delegators (one entity can have more wallets) that can delegate ADA coins to let’s say to 500 pools that produce blocks in every epoch. Pools are responsible for the production of blocks in the Cardano network so they need to have consensus power.
In other words, pools need to have a sufficient stake to be able to retrieve the right to produce blocks. The Cardano protocol assigns the right for the block production proportionally based on the stake of pools. Operators can buy ADA coins to reach the needed threshold. It is expected that many operators will not be able to buy a sufficient amount of ADA coins to be able to produce 100% of blocks in an epoch. A few tens of millions of coins are needed for that. To be more precise, a pool needs to have approximately 32,000,000 coins in Q1 2021 to be able to produce 100% blocks. Luckily operators do not need to buy such a big amount of coins. Other holders of ADA coins that do not operate their own pool, can delegate coins to an existing pool. Using native coins in a consensus has a big advantage since the consensual power can be distributed to all holders of coins. It can be said that Cardano will be more decentralized and secure the more people will hold ADA coins and use them for staking.
Bitcoin was originally designed without pools but the evolution of decentralized networks shows that they are usually necessary. Bitcoin pools are responsible for the production of blocks similarly as in Cardano. The consensus power is also proportional and it is based on hash-rate. The higher hash-rate is delegated to a pool the more blocks the pool produces over time. Miners are entities who decide to which pools they delegate their hash-rate. It is a very similar process to the delegation of coins to a pool in the Cardano network. Bitcoin pool operators can also be miners at the same time.
There are 10 major pools in the Bitcoin networks that together have nearly 96% of hash-rate. We have information about the current size of hash-rate but no further information about miners. We just know that 65% of the hash-rate is delegated from China since the electricity is cheap there. The Bitcoin protocol does not care about its own decentralization and security regarding entities that produce blocks. To put it simply, there is just one simple rule. When a new valid block is proposed by any pool and the computation puzzle is resolved then the block is appended to the blockchain. The pool operator gets the block reward and proportionally rewards the miners.
Advantages and disadvantages of using native ADA coins
The most significant difference is that electricity is a physical resource and native coins a digital resource.
Using native ADA coins for the distribution of consensus power has the advantage that it is a very cheap process with regard to electricity consumption. Cardano pools must be registered so the protocol is able to proportionally assign slot leaders based on the size of pool’ stakes. Another advantage is that the distribution of power is a piece of information that is stored in the blockchain. Pools and delegators can be easily found by anybody. The quality of decentralization is under the control of the whole community and can be easily tuned via voting. Due to the quick selection of a slot leader, a new block can be produced within a second.
Electricity is not a scarce resource but an expensive and infinite resource that must be consumed in order to produce blocks. Bitcoin pools compete among each other in every cycle to produce a new block. The right to produce a block is not assigned by the Bitcoin protocol to one pool in a given cycle, as it is in the case of Cardano. The competition is based on electricity consumption. The difficulty of the PoW computational puzzle is regularly updated in order to last approximately 10 minutes. As the total hash-rate gradually rises every year the puzzle gets more difficult over time. The disadvantage of that approach is that it is based on the infinite expensive resource and the price of BTC coins determines the size of the hash-rate. Thus, the higher the price of BTC is, the more electricity is consumed. In the PoS networks, the price of native coins has no impact on electricity consumption. As we said, it is not necessary to register as a pool or a hash-rate delegator within the Bitcoin protocol. It is impossible to make some restrictions on the protocol level in order to consume less electricity or increase decentralization. There are no parameters that would allow the community to tune it. It is not smart if you consider how far the price of BTC coins can rise and how much electricity can be consumed in the future. It is useless to consume a higher amount of electricity since the security of the Bitcoin protocol is very high at the current level. In our humble opinion, the Bitcoin team should care more about the quality of decentralization than about security. Generally speaking, the security of a decentralized protocol is low when there are a few centers that dispose of high consensus power.
Tuning the protocol is a very useful thing. For example, when it is needed to ensure that every pool operator has its own skin in the game then it is possible to tune the Cardano protocol to achieve that. The Cardano protocol can give higher rewards to pools that have higher pledges. Delegators will care about their profit so they will probably choose a pool that offers a higher ROI. Thus, operators will need to provide higher pledges and thus, they will less likely try to commit an attack on the network. In PoW networks, a pool operator does not need to be a miner. Theoretically, the Bitcoin pool operator does not need to have its own skin in the game. For both Cardano and Bitcoin operators, it is not smart to destroy a profitable business but in the case of Cardano, the protocol has higher control over participants. So not only the pledge but also the size of the pools can be economically regulated by the protocol.
In both cases, the consensus power can be bought for money. Thus, we will see whales in Cardano and Bitcoin ecosystems and it will be hard to prevent it. However, there are differences, though. ADA is a scarce resource and if an individual possesses 0,01% of the consensus power now, it will be true in the next decade. The circulation supply of coins will grow in a deterministic way and every stake-holder can earn new coins via staking. It cannot be said in the case of Bitcoin. If you had an ASIC miner let’s say 5 years ago then mining could be a relatively profitable business regardless of the country the miner lives in. It is not true today. The hash-rate constantly grows so to operate a single ASIC miner for example in the middle of Europe is not profitable any longer. The consensus power of small miners degraded over time. Mining is a big business nowadays and only a few entities are responsible for that. It is much cheaper to participate in the Cardano staking than to become a Bitcoin miner. All you need for staking is to buy a few ADA coins and install a wallet (HW wallet is a preferred option). It is a kind of risk to buy an ASIC miner and try to mine BTC. ASIC miners are quite expensive and get obsolete within a short period of time.
Notice that BTC coins are used as a reward for miners but they do not play any further role in the process of decentralization. Owners of BTC coins have no consensus power. Cardano can get organically more decentralized together with the higher distribution of ADA coins. It is not the case right now but it can possibly happen as a side effect of the higher social and economical importance of the network. Holding ADA coins generates a passive income so it is smart to participate in staking. People will be more attracted by the option when the network will be more used and staking will be work reliable for a longer time. Having ADA is an active investment and even if the price of ADA coins is relatively stable, holders will get the reward every 5 days. Moreover, holders of coins can actively determine who will be responsible for the production of blocks and participate in voting about the distribution of coins from the project treasury. Having ADA is like having shares of a successful company. Staking is available all around the world and it does not depend on the consumption of electricity. Thus, it will not be geographically centralized just because a resource used for the distribution of the consensus power is cheaper in some countries and expensive in other ones. Demand for ADA coins can be very high when the Cardano protocol succeeds in its mission and becomes the global financial and social machine.
Using native coins in the distribution of the consensus power has also some negatives and risks. One of them is a fact that people will keep their coins on exchanges. Thus, the consensual power will have the owners of the exchanges, not the real owners of the coins. Exchanges are not motivated to commit and attack the network since they would destroy their own business. However, the coins can be stolen by a hacker that could be motivated to use the coins for the attack. Exchanges can be centers of power and people should be aware of that. Staking with an exchange can seem simple and easy but it also puts the whole network in danger. The biggest exchanges like Binance dispose of a big amount of coins and they are able to operate a few pools.
Another risk, that is far away at the moment, is the potential possibility to use ADA coins somewhere in a DeFi service that provides a higher reward than staking. Thus, it is theoretically possible that only for example 30% of coins in circulation would be used for staking and the rest would be locked in plenty of DeFi services. The security of the Cardano protocol would directly depend on the security of these services. We think that staking will be the most attractive possibility of how to ensure a passive income in a secure and stable way. When it should be an issue in the future we believe that new mechanisms can be introduced to mitigate the risk. In the Bitcoin case, it does not matter who holds BTC coins since when miners get their rewards and pay for the electricity the coins have no further role in the network consensus. On the other hand, this fact itself does not help to have a more decentralized protocol that would be without centers of power.
Long-term sustainability is another important aspect that must be taken into account. When a protocol has a capped supply of coins, then it will depend mostly on transaction fees sooner or later. Users of the protocol expect that fees will remain low in the future. Thus, protocols will need to process many more transactions than nowadays and it must happen on the first layer. It will be generally easier for PoS networks like Cardano than for PoW networks. It is expensive to keep the PoW network running since miners will always want the same amount of money to keep the hash-rate on a high level. If the market capitalization of Bitcoin went to the moon then it might not be a problem for many years onward. However, the opposite is also true. The possibility to succeed in a 51% attack depends directly on the price of BTC coins. If the reward was low then also the hash-rate would be relatively low. The price of ADA coins is important also in the case of Cardano. To try to commit the 51% attack, an individual would need to possess more than half of the ADA coins that are used for staking.
As you can see, the precious resource influences many properties of protocols. It cannot be said which approach is better. Bitcoin has been running for more than a decade. PoS networks do not have such a long history and have not attracted so many users. It is probably going to change in the next decade. Cardano allows people not only to hold the coins but also ensure passive income. It can be a very attractive option in the future and it helps to decentralize the consensus power. Moreover, decentralized applications bring services that bring people and institutions useful functionalities. We definitely need to use blockchain to improve our lives and it will not probably happen via holding coins and passively waiting for what is going to happen. We need to actively shape the future and Cardano will help us.