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Guide to Cardano

January 26, 2022

Coinbase Cloud supports participation in the Cardano Network, a technological platform with the goal of creating a financial operating system for the underbanked

An introduction to Cardano

Cardano is a proof of stake blockchain based in peer-reviewed research and evidence-based models. Its launch takes place in five phases, with the eventual support for smart contracts, sidechains, governance, and a voted-upon treasury system.

Cardano gains its namesake from the Italian Renaissance mathematician Gerolamo Cardano, and its native currency, ADA, which can be delegated on the network, is named after 19th-century mathematician and early programmer Ada Lovelace.

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Gerolamo Cardano (Source) and Ada Lovelace (Source)

The full launch of Cardano will be executed in five phases: Byron (core of the protocol), Shelley (progressive decentralization — where we are today), Goguen (multi-asset and smart-contract development), Basho (scalability and side-chain enablement), and Voltaire (governance and voting).

While the protocol is currently operating in a limited live mainnet within the Shelley phase, at its full launch its core features will include:

  • Plutus, a purpose-built smart contract development language, which will improve the coherency and usability of the development experience as compared to existing smart contract implementations. This is achieved by use of the functional programming language Haskell, as Haskell allows one codebase to support both on- and off-chain components.

  • Marlow, a high-level domain-specific language for financial contracts built on Plutus, which will allow financial and business experts with no previous technical knowledge to create smart contracts.

  • More than 1,000 Stake Pools for a deep level of engagement and decentralization.

  • Sidechains to greatly expand the throughput, capacity, and capabilities of the network for a variety of diverse use cases.

  • Decentralized governance funded by a treasury of pooled transaction fees and rewards to support development activities, allowing anyone to make a proposal that can be voted on through governance and funded by the community.

Founded with the mission of overseeing and supervising the advancement of Cardano, The Cardano Foundation is focused on core development and ecosystem growth for the protocol. Cardano is backed by Emurgo, a Japanese blockchain technology and venture capital firm, and was launched by IOHK, a blockchain research and development company focused on utilizing peer-to-peer innovations to help increase global access to financial services. IOHK, founded by Charles Hoskinson and Jeremey Wood, will continue to spearhead the development of Cardano through 2020.

Cardano's innovation

Cardano’s primary innovation is its mission to be the first blockchain network developed via evidence-based methods and founded on the pillars of peer-reviewed research. Sometimes referred to as a “professor-coin,” it is regarded as being the most research and theory-focused blockchain in today’s ecosystem.

There are currently 90 white papers supporting the development of Cardano, as compared to the fewer than five developed for the majority of blockchain protocols. A foundation built on scientific methods and research helps to support Cardano’s focus on providing security and sustainability via mathematically proven consensus mechanisms.

How to participate on Cardano

Cardano uses a novel proof of stake consensus mechanism, Ouroboros, which is peer-reviewed and has mathematical backing of its security. Ouroboros is considered secure as long as 51% of the stake is controlled by entities who are not misbehaving, as opposed to the 67% control required by the majority of proof of stake protocols. Block validation within Ouroboros is more akin to that of proof of work blockchains than that of the most common proof of stake protocols. Ouroboros uses probabilistic finality, making reorganization possible due to the blocks being added canonically as opposed to validators finalizing the blocks as they are produced. In its final implementation Ouroboros is expected to enable near-instant finality via an improvement called Hydra.

The state of Cardano will, in its full launch, utilize Extended UTXO (EUTXO) to simplify smart contract use by splitting smart contract execution into multiple transactions. It currently uses the UTXO (unspent transaction output) model, a Bitcoin innovation, to maintain the blockchain’s state. This is unique from other smart contract blockchains, such as Ethereum, which generally tend to utilize account based models.

Cardano’s plan to utilize EUTXO, in addition to those aspects of its block validation which resemble the functionality of proof of work protocols, are two aspects of Cardano that were specifically developed to mirror the simplicity of proof of work protocols while capturing the incentivized participation, scalability, and resource usage benefits of proof of stake models.

The main participants in the Cardano network are core nodes and relay nodes, which together comprise a stake pool. 

  • Core nodes function as protocol validators, connecting only to their relay nodes and holding the certifications needed for block generation. 

  • Relay nodes  act as the interface between validator nodes and the public network, enhancing security for validators. 

The d and k parameters, protocol-defined variables that influence Cardano’s stake pools, are an important aspect of Cardano’s staking dynamics and level of decentralization.

  • The Decentralization Parameter (d) impacts the amount of work (block validation) that stake pools other than the Federation of Nodes are performing within the network 

  • The Saturation Parameter (k) controls the number of stake pools by capping the amount of ADA that can be delegated to an individual stake pool

The d parameter controls the ratio of work completed by the “Federation of Nodes,” or the original three nodes running Cardano in its early phases, to the work completed by other stake pool operators. As the value of the d parameter decreases, the amount of work completed by stake pool operators at large increases, moving the network toward further decentralization. The value was set to decrease by .02/epoch, and in March of 2021, reached 0, bringing Cardano to its fully decentralized launch.

The k parameter controls the number of stake pools in the network by way of adjusting the maximum amount of ADA that can earn rewards when staked to an individual pool (the stake cap). The higher the k parameter, the lower the maximum stake cap per pool. This incentivizes operators and delegators to distribute their tokens across a larger number of stake pools, further increasing decentralization. 

For example, if the k parameter was set to a 100 ADA cap per pool, a stake pool with 100 ADA and a stake pool with 200 ADA would both earn the same rewards. Currently there are upwards of 1100 stake pools participating on the network protocol at any particular time, and a k value of 500. 

There is no active set for proof of stake validation on Cardano. In the long run, the intention is to set the k parameter to optimize the participation of 1000 stake pools. 

ADA holders who want to participate in Cardano without becoming a stake pool operator can delegate. There is no minimum requirement for delegation, outside of having enough ADA to cover the transaction fees—in order to ensure one has enough ADA to cover those fees the protocol does require a user to have at least 10 ADA in their wallet in order to delegate. There is no lock up or unbonding period for delegating within Cardano; delegators can unbond their tokens at any time. Delegators can also change their stake pool at any time, and may divide their ADA delegation between as many stake pools as they would like by creating split wallet addresses within individual wallet UIs. 

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Rewards on Cardano

Stake pools earn fees from delegators for conducting the service of validation. There are two distinct fees, a fixed fee (the Pool Cost) and a variable percentage fee (the Pool Margin). The Pool Cost, a fixed amount of ADA the stake pool retains from rewards each epoch, provides stake pool operators with a regular, stable reward amount, instilling confidence in the value of continuing to operate a stake pool. The Pool Margin, a percentage of rewards post-fixed fee, allows a stake pool operator to scale their earnings with their pool’s success. 

Cardano network’s inflationary rewards process has multiple steps: 

  1. Identify total possible rewards: The maximum possible rewards that can be earned within the network each epoch are identified using a parameter called the Expansion Rate. This rate is applied to the Reserve* to determine how many ADA are used for epoch rewards and funding the treasury.

Currently the Expansion Rate is set to .3%. As such, each epoch .3% of the Reserve is identified as being the potential total possible rewards and the treasury cut for that epoch.

* The Reserve = Maximum Supply of ADA - ADA currently in circulation & treasury

2. Pay into the treasury: A predetermined percentage of the total possible rewards are paid into the treasury. As of November 2020, this number was 20% each epoch out of the .3% of the Reserve identified for total possible rewards; for an epoch at that time roughly 8.3m ADA went into the treasury, leaving 33.1m ADA available for staking rewards.

3. Figure out how much goes to delegators: Inflation is distributed differently in Cardano than in other proof of stake protocols, as the inflation rate is equal to the reward rate. If there are 33.1m ADA in potential rewards for stakers (after the treasury fee is subtracted), the protocol initially assumes this amount will be distributed equally amongst all token holders. However, when it discovers less than 100% of ADA tokens are staked, then tokens that would have been distributed to non-staked tokens are sent back to the Reserve.

For example, using theoretical numbers:

If Protocol A had a 60% staking rate (called active stake) and 10% inflation, the rate of reward for stakers would be 16.67% because they would receive all of those inflationary tokens. If 10% inflation = 1,000 tokens, those tokens are distributed to stakers—the amount of tokens released to circulation does not change.

If Cardano had a 60% staking rate and 10% inflation, the rate of reward for stakers would remain 10%. If 10% inflation = 1,000 tokens, 600 of those tokens will be distributed to the stakers, and 400 will go back into the Reserve.

Then:

  1. Subtract penalties: Rather than deducting a penalty from a token holder’s initial balance, penalties are deducted from the potential rewards earned. Rewards are deducted most commonly for missing block validation and for having a lack of pledged stake in the StakePool.

  2. Align reward rate with pledge amount: If less than 100% of the max ADA on the Stake Pool is composed of Pledged tokens, the reward rate experienced by the pool is decreased.

  3. Subtract pool fixed costs: Each Stake Pool has a fixed declared cost, taken each epoch from the rewards earned by the Stake Pool in that epoch. This fixed cost is paid directly to the Stake Pool operator.

  4. Subtract pool margin: Of the remaining rewards, the Stake Pool operator also takes a fixed margin percentage.

  5. Distribute rewards to delegators: The remainder of the rewards are split proportionally to delegated stake amongst those who delegated to the Stake Pool, including the Stake Pool operators for whom the pledge stake is counted as regular stake.

There is no mandatory self-bond on Cardano, which instead uses a pledging mechanism. Pledging is an optional self-bond that increases the reward rate experienced by the stake pool and, most importantly, functions as a mechanism to prevent Sybil Attacks on the Cardano Network.

Stake pool operators are rewarded for pledging their own ADA to their own stake pool. The higher the pledged amount, the higher the reward rate for the pool. A stake pool that reaches its stake cap with no ADA pledged earns only 77% of the rewards that a stake pool composed completely of pledged ADA earns. The stake pool operator is therefore incentivized to self-bond via pledging and thus prevent the likelihood of a Sybil attack. 

Some uses of economic cost as a Sybil-resistance mechanism are critiqued for creating a barrier to entry for peer-to-peer networks, as only those entities with the capital required to meet that barrier can participate and help to secure the network. Cardano differs in this regard as pledging one’s own Stake Pool is optional, rather than mandatory. As such, smaller Stake Pool operators can begin participating at a lower rate of return with a lower amount of pledged ADA in their pool, and can effectively “scale up” as they earn ADA via rewards by pledging an increasing amount of their ADA to their own Stake Pool.

Pledging is also the key to optimizing rewards on Cardano. The higher the pledged amount, the higher the reward rate experienced by the pool. For operators with low delegation expectations can optimize rewards by pledging the whole stake cap for their stake pools. Operators who expect to draw a significant amount of delegated tokens can determine the best delegation fee to optimize the return for delegates and themselves, thus increasing participation. 

Risks of participation on Cardano

There is no slashing within the Cardano protocol. However, poor behavior can cause a node to miss out on potential rewards. The most common penalties are for: 

  • Missing blocks: the more block production missed by a stake pool, the lower the reward rate that epoch for the stake pool. 

  • Lack of pledged ADA: a stake pool at its stake cap with no pledged ADA earns only 77% of the rewards that a stake pool composed completely of pledged ADA earns.

Governance on Cardano

There is no on-chain governance in the current phase of Cardano (Shelley). The Voltaire phase of Cardano’s launch will focus on proposing, experimenting with, and implementing a decentralized governance model for the protocol to set a voting and treasury system. 

Cardano Improvement Proposals (CIPs) are one of the first implementations of off-chain governance for Cardano. CIPs are led by the Cardano Foundation, which was founded with the mission of overseeing and supervising the advancement of Cardano and is focused on core development and ecosystem growth for the protocol. 

A CIP is a structured design document that is accessible to the Cardano community via a Github repository overseen by the Cardano Foundation. In the current phase, the Cardano Foundation controls and implements Cardano core development. However, CIPs are used to propose new features, collect community input on an issue, and document the design decisions that go into building the protocol. 

The Voltaire phase of development will enable network participants to propose CIPs. Cardano stakeholders will have the ability to vote on their implementation in alignment with the protocol’s staking and delegation process. 

Funding proposals are in-development for off-chain governance of the Cardano treasury. Community members will be able to make proposals aimed at enhancing the Cardano ecosystem, such as developing new integrations or funding platform development. The proposals will be voted on by any ADA holder via a currently unreleased mobile application, with the most successful proposals receiving treasury funding. 

Why run Cardano nodes with Coinbase Cloud?

Earn rewards, without the difficulty of navigating Cardano’s operationally complex infrastructure, by operating your own Stake Pool with Coinbase Cloud.

Operating your own Cardano Stake Pool Cluster enables you to have maximum control over your Cardano staking experience, including:

  • Proven Engineering: while the in-depth and academic nature of Cardano’s economic model is one of its most innovative achievements, operating within the protocol can be difficult to understand and complicated to execute. Working with Coinbase Cloud, a professional infrastructure company with deep engineering and protocol expertise, also gives users the benefit of Coinbase Cloud's high level of engagement with both the Cardano Foundation and IOHK team.

  • Customizable fee structure: those who plan on receiving delegation to their Stake Pool can establish their Pool’s fixed and margin fees to reflect current market conditions, or to encourage increased rates of delegation.

  • Return rate control: by operating your own node, as opposed to delegating to a 3rd party Stake Pool, you can establish the level of pledged ADA and delegation fees to ensure control over your return rate.

  • Flexible investment: there is no lock-up or unbonding period for pledging within the Cardano Protocol. Tokens, including rewards, can be transferred at any time.

  • Active returns: rewards accrue and compound automatically for Stake Pools.