With a research-first driven approach, Cardano has evolved out of the scientific philosophy and is establishing itself as one of the most accurately engineered platforms. The decentralized public Blockchain of Cardano is based entirely on a Proof-of-stake (PoS) algorithm and not on the Proof-of-work (PoW) algorithm.
Why Proof-of-stake (PoS)?
The PoW algorithm requires heavy computational power and expensive hardware and is also prone to a 51% attack. If a group of miners controlling more than 50% of mining hash rate comes together, they could exploit the whole Blockchain ecosystem. So if the top 3 mining pools in the world merge, there can be a 51% attack. This problem is almost eliminated with the use of PoS algorithm called Ouroboros in Cardano.
In Ouroboros, the Blockchain is managed by the asset-holders who are reliably and randomly elected to lead. This drops the need for an energy-hungry PoW or other blockchain protocols as only the computational power of the selected stakeholders are required. However, for efficient working of the PoS blockchain, there are few burdens on the stakeholders. First of all, a vast number of stakeholders have to be online. Second, there should a stable and fast network connectivity while creating PoS blocks and collecting transactions. This makes sure that there are absolutely no network delays in the Blockchain.
Do we need stake pools?
Similar to Pareto Distribution, in a PoS protocol, the plan of running reliable server nodes can be an option for only a small and rich subset of stakeholders. So, most stakeholders who don’t put sufficient stake are not allowed to run such services and contribute to the maintenance ledger. This problem can be addressed using the creation of the stake-pools. Stake pools facilitate multiple stakeholders to combine their stake, form a single entity and run the PoS blockchain with the total stake. This would make it possible for everyone to run server services.
Any stakeholder can desire to be a stake pool manager and is responsible for the overall processing of the transactions. But, they will not have the authorization to spend their pool stake. Also, the members are free to reallocate their stake into another pool whenever they want. This implies high flexibility and security of the stake.
The incentivization mechanism?
Contributing to the PoS ledger maintenance is not as costly as PoW protocols but it incurs significant costs. Due to this, the members are incentivized for setting up reliable server nodes by the stakeholder community who use the ledger. This includes the transaction fee used for processing the transaction.
This is quite similar to the Bitcoin PoW protocol. They have both incentivization and pools just like PoS. But still, there are differences. In PoW, the incentivization is for creating blocks and pools are for increasing their computational power. As higher the computation power, higher is the chance for the miners to create a new block and earn incentives. Also, the work required to produce a new block can be distributed among various pool members using Partial PoWs mechanism.
PoS can also be employed with a similar incentivization mechanism but the question is whether a bitcoin centric mechanism would result in desirable system configuration. This brings us to the question;
What are the desirable system configurations?
One of the most economical configurations is having a single party to maintain the processing ledger while allowing other members to join that party. But, many-a-time, minimizing the transaction processing cost is not the sole requirement especially when you need a failure-free system. Single pool leader also implies a single point for system failure. This is exactly distributed ledger or coexistence of different stake pools can avoid. In other words, we get decentralization by distributed ledger making it an ideal system configuration
What is the Reward-sharing scheme in stake pools?
The Rewards are generated at regular intervals and the pool manager retains the pool maintenance cost before distributing the rewards among the pool stakeholders. Pool membership can be tracked using the given staking keys of the members and the agreed reward split is encoded using a meticulously designed smart contract and added to the protocol service. The pool managers are provided a bounty for their entrepreneurship and leadership skills as mentioned in the pool creation certificate. The certificate is embedded on the ledger and also boasts the profit margin ( the additional fixed cost of the pool reward). So, all the cost – operation fee, and the profit margin are declared and deducted before distributing the rewards among the stakeholders.
How the Reward scheme is different than Bitcoin Reward scheme?
Unlike PoS, in PoW protocol, the pool rewards are in proportion to the mining hash power. The pool generated reward is split according to the quantity of pool stake. Say, for instance, if a mining pool has 30% of the total hashing power, the pool can only reap 30% of the total rewards. In simple words, the pool rewards are directly based on the number of blocks created by the pool and the number of blocks created by the pool is proportional to the pool’s mining power. Now, the question arises
Will the Bitcoin-like-mechanism lead to a centralized system?
As the pool rewards are based on the number of pool members, what happens when they centralize to one pool? There are times when different mining pools come together can even exceed the 50% threshold required to maintain the integrity and resilience of the ledger.
Say, initially there are people wealthy enough to create their own stake pools by renting and setting servers to increase their share of rewards. The stakeholders join this pool so as to contribute to the ledger. But, they check for the pool with minimal cost and profit margin for maximizing their rewards. There could even be pools with zero profit margin. Such pools will attract all the stakeholders as they could earn the most. Similarly, other pools managers will realize that joining such pool will be better than maintaining their own as they could receive more for their stake because of higher pool size. Eventually, this would result in a single dictatorial or centralized pool which we don’t want. This is where the 51% attack or Sybil attack can also come in.
It is clear by now, that a trade-off should be maintained between the rewards and the size for achieving decentralization. In short, the linearity between the reward and size should be tapered at a certain stage. For this, a two-stage system is implemented in Cardano. The growth stage where linearity is respected and the stabilization stage (when the pool size increases to a level beyond the threshold) where the linearity is tapered. This threshold is called the saturation point. So, after the saturation point, the rewards are constant and does not increase for the increase in the pool size.
Suppose, there are two pools with the same profit margins, one by Alice and another by Bob. But, the operational costs are different, 25 coins in Alice and 30 coins in Bob. Now say, there is a total reward of 1000 coins to be distributed among the members. The Alice pool has 20% of the stake while Bob sits at 19%. The saturation point of the reward-sharing scheme sits at 20%. Now, Charlie with 1% stake wants to join a pool but is confused. If he joins Alice’s pool, the total stake will increase to 21% but as the saturation point is set at 20%, the pool will only get 20% of the total reward (200 coins). Deducting the operational cost of 25 coins, a total of 175 coins is to be distributed. Now, Charlie’s stake is (1/21) of the 175 coins. After deducting profit margin, he would get 8 coins as the reward.
Now, if he joins Bob’s pool, the total stake of his pool will increase to 20%. The reward will be the same as 200 coins. Deducting 30 coins as operation cost, a total of 170 coins is to be distributed. Here, the charlie stake is (1/20) of the 170 coins. After subtracting the profit margin, it turns out that Charlie will receive 2% more if he joins Bob’s pool. So, for maximizing the rewards, Charlie should go for Bob’s pool in this situation.
Another situation is that Alice’s pool is already at 20% of the total stake and Bob’s pool sits at 3%. Now, at same profit margin and saturation point, Charlie would significantly earn less if he joins Bob’s pool. This is because Bob has a very small pool. So, the rewards will be just 4% (3% earlier and 1% of Charlie’s) of the total reward. If you calculate, that would be 70% less than what he would have got if he joined Alice’s pool.
In the above example, the rational decision would be to go for Alice’s pool even if his membership will exceed the total stake beyond saturation point.
The key is to be far-sighted
What Charlie needs to do is to contemplate his profit carefully by taking into account the initial pool stake, his stake, the saturation point, profit margin, and operation cost.
This better reward-scheme would converge to a desirable decentralized configuration as stakeholders will never join a pool when the total stake exceed the saturation points so much that it would significantly reduce their reward.
Kiayias, A. (2018, October 23). Stake pools in Cardano. Retrieved from https://iohk.io/blog/stake-pools-in-cardano/
What does staking your ADA mean in Cardano? [Video file]. (2018, September 28). Retrieved from https://www.youtube.com/watch?v=4WeYfgHpNtg