The under-estimated importance of DEFI vs CEFI for the decentralization of Cardano

Staking & Delegation Stake Delegation
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Hello

I have already expressed some concerns when I cannot convince people to stake on pools instead of moving their funds to big exchanges like Binance because they offer better staking rewards (7 to 20% vs 5% for a pool), increasing the centralisation of the network.

Today, there are no financial incentives to stake with a pool. You get a better return by trusting a central exchange to hold your funds. And I am not optimistic about the long term consequences of this.

A network running on the pools of a few corporations gathering all the votes is not very appealing to me. It sounds very much like today’s central banking system, and I am not sure the average holder of the future global network will value the price of de-centralization as much as the community does today.

Exchanges can offer a better rewards because they have many financial tools to increase the ROI from your funds (staking, unclaimed rewards, loans, exchange fee, insurances etc…), and at the end of the day, they have room to give you a better return than a simple staking pool, and still be profitable.

I do not see a lot of solutions. I know a lot of energy goes into the fine tuning of the protocol parameters, but I am really not sure it will be enough to counter CEFI.

Another solution I can think about is to build a strong DEFI competition to this CEFI problem. A DEFI app cannot run a node and it could also add some randomness in the stake delegation, which would help small pools and the decentralization of block production.

If we get a kick-ass DEFI app or ecosystem, able to combine different financial tools in order to provide a return as good as a central exchange, then maybe there is hope for decentralization.

I am not at all a financial nor DEFI specialist. I cannot really develop much further than this post, but I feel that the actual trend and its long term consequences are under-estimated.

If what I say makes sense, maybe we should already put more energy into DEFI research, before CEFI gets too much power.

And if it is as fundamental as I think it is, maybe it could be tackled directly at IOG level to show the way and get at least one DEFI app able to compete with the CEFI offer.

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This is an issue at the protocol level IMHO, which is currently designed to eventually cluster all stake around k saturated pools. k may in future get increased from 500 → 1000 → … but surely not larger than there are blocks / epoch (i.e. 21600), there is also a0 which will give pledge more weight, but none of those parameter tweaks can fix the issue with pools run by exchanges, which as you say vastly outperform any other pool.

The problem is with an entity assuming multiple identities in the staking process (i.e. one entity running multiple pools) either openly or covertly. Unfortunately, I don’t know enough about this at the research level, but my gut-feeling is that it is a tricky question, which ultimately would require some sort of KYC.

I totally trust that the network will find ways to protect itself eventually. k saturated pools, all of which belonging to a handful of exchanges is just not going to happen because it would delegitimize the network’s existence.

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How the staking is ‘organised’ was not really my point.
The point is that the exchanges are getting a much better return from your funds than just staking because they use people’s funds to run various financial products in addition to the standard staking reward offered by the delegation to pools.
So they will always be able to offer you a better roi than a pool delegation and it only make sense to go with them. This is the same reason why it doesn’t make sense to keep your banknotes under your pillow when a bank can give you a 3% return because they manage behind to scene to get a 6% out of it.

The point is still partially valid if the exchange does not stake themselves but decide to delegates to a fair network of spos. In that (unlikely) scenario they would not run the network, which is a little bit better, but they would still get the ownership of people’s stake. And it doesn’t matter the k, a0, pledge…

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A question of curiosity. On binance they offer EST. XX%, where I assume it stands for estimated == not guaranteed. Have you tried or know someone who did and how much they actually got.

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In that case, we are talking about cross-financing, which I would say is totally fine and a legitimate way to run a business (i.e. they earn x with something else and distribute the profit to y). If we stick to Cardano staking alone, it is also easy to see how exchanges can outperform any other pool even without doing x. Because they are the custodian of ADA that are not being staked by their respective owners (i.e. ADA on the various order books (ADA/USDT, ADA/BNB, ADA/EUR, ADA/ETH, …), plus ADA that is idly sitting in wallets and not being traded/withdrawn), they can stake that ADA themselves and distribute the rewards among the few that take part in their staking program.

Binance is currently running 64 pools holding 12,3% of the total stake. Whether we agree with this or not doesn’t really matter, the Cardano incentive model does - it promotes clustering of stake to pools with lower cost by giving higher rewards and does not enforce a single identity policy. We would not be talking about Binance, if they were only running a single saturated pool - regardless of how much they pump into that pool via cross-financing.

Perhaps the a0 tweak can be an effective counter measure, because the exchanges would be forced to pledge a significant portion of ADA that they either own or are the custodian of. This pledge would have to be deducted from their liquidity and would make trading ADA on Binance more risky. Likely that they internally have minimum liquidity requirements which prevents them from locking large amounts in pool pledges.

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Yes, its real - I know folks who do this. They say its hard to get into those 90 day programs, but once you’re in you get the advertised ROA.

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Of course it is legitimate, this is how centralize finance has been working for centuries.
But this defeat the initial purpose of crypto and decentralization. Being fine with it with will rebuild the central system on top of an extra layer of cryptography which ,at the end, is likely to become pointless anyway.

And I think we should talk about Binance and other exchanges even if they were running no pool at all, as long as they are increasing their ownership of the stake, which is kind of the ownership of the governance.

Cardano has the ambition to be the backbone of entire economies, countries, billions of people. But is it ok to propose a country to migrate, let say its election system, to Cardano when its governance is likely to be more and more centralized in the hands of large exchanges under foreign juridiction or sometimes under no juridiction ?

I like your analysis of the a0 tweak though. I don’t think it would be enough, but I think it could be an improvement.

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I just got pinged on a PM on this so I might as well answer with a public response, although I think the responses above have already covered most of the ground.

I’m glad some later comments clarified the statement (which might otherwise mislead less experienced or speedy readers) that the BNP pools were “outperforming” other pools… to say that they are not doing so on the staking network itself. That obnoxious pool farm gets around an average of 4% rewards (since they don’t have to assure 100% reliability to make money, which comes from more conventional financing of exchange “staked” deposits) while a 100% performant stake pool will get, depending on a0 / pledge factor, 5.7% or more (see some of the top choices in Adafolio: High Performance).

So yes, many people are anxious for Cardano to support the same kind of “cross-financing” that will allow DeFi apps and DAOs to keep the collateralised ada in their operating smart contracts in addresses which themselves are delegated to stake pools. That way the PoS network will survive as planned while providing long term ada holders with the same vastly greater rewards of the currently well known longer-term DeFi Ethereum contract based deposit schemes.

So just tell everyone to hang in there because a few projects like we’ve seen on Catalyst & elsewhere will bring DeFi, liquidity, stablecoins and lending (pools and P2P) to Cardano, and with the smart contract launch reannounced for August I’d like to think we’ll see some of them going live in Q3 2021 :heart_eyes:

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If the identity issue is not addressed, it can be expected that all stake will eventually be owned by those entities that manage to run most profitable for the delegator using “collateralised ada in their operating smart contracts” (i.e. k pools, all owned by a few organisations). That would mean the end of the single pool operator model. Likely also, that you don’t mean that at all and I only misread what you said.

Could you perhaps elaborate a little?

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I understand that a smart contract would indeed take the custody of collateralized Ada, and decide of the delegation strategie. It could be a delegation to k predefined pools, or maybe a random delegation changing every epoch, or it could dynamically follow some delegation rules based on each pools performances…
In the end it will be up to the contract developer and the possibility offered by the language, but it would be immutable and the rules would be public.
At least, that is my understanding, but I am far from being a smart contract expert…

Ps: I suppose that if a smart contract has a great performance, but ‘unfair’ delegation, it would be easy to fork it into one with same performances, and ‘fair’ delegation.

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Maybe the last response from @togowaf confirms what you were hoping I was saying? i.e. that the delegations for smart contracts don’t have to conform to multiple pools with a single identity. Those delegations could (and should) instead be dispersed through the staking network, either by coming from a lot of little contract addresses for lots of little projects (perhaps each delegating to their own pool) or from institutions delegating to a portfolio of smaller pools.

Why would they choose the smaller pools? Generally they will do better with the smaller performant pools than the big ones (as confirmed the link above). The long arranged strategy of IOG to kill all but the K largest pools has not given those large favoured pools much incentive to keep delegator rewards competitive, since the UI wallets still rank pools almost exclusively by descending size.

The return of ratio staking to the Cardano protocol will facilitate breaking up large-value delegation amounts into multiple pools even when the amount of that delegation exceeds the saturation limit for a single pool. So even if a DAO or DeFi project is enormous it will be free to follow the rewards rather than the pool size… and if they are truly doing so then they will end up delegating to both small and large pools.

So the saturation limit might remain the same, but a dispersion of delegation in favour of real rewards, rather than assumptions about rewards based on size (“non-myopic rewards”), would lessen the steep drop-off in stake between the K biggest pools and those that are currently shut out by the size-ranking wallets. As we discussed in a CIP editors’ meeting not long ago, decentralisation of stake by including rewards in the ranking algorithm would be one way to smooth out that steep drop-off, as suggested in this proposal which has apparently and unfortunately been abandoned:

Therefore: since we can’t rely on IOG to retract its commitment to a so-called “Nash Equilibrium” that kills off the pools beyond the set size of K, the same goal can be accomplished through rewards-based delegation choices from the smart contracts directly, to offset the herd behaviour of wallet users. In the upcoming era of Cardano smart contracts it will be up to the DAO and DeFi architects to choose profitable delegations, not just large-pool delegations… and therefore decentralisation will be supported by the incentive to offset those systems’ operating costs, or increase their income, with delegation rewards from those contract addresses.

The resulting dispersion of delegation between small & large pools will maintain the profitability of smaller pools and therefore promote the resilience of the staking network by supporting a larger number of unaffiliated pools.

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This is funny … so in the end we all agree on the same thing? :wink:

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I guess a few rants:

  • Charles originally said that exchanges wouldn’t be able to run stake pools…obviously that hasn’t happened.
  • The model used to test network parameters and the Nash equilibrium that was predicted implicitly assumes that there is only a single operator per pool…obviously this is not the case.
  • There is no way to truly enforce either one or both of the previous cases without an identity solution, something like Prism. Until then, there’s really nothing that we, as a decentralized network, can do. I.e. that pandora’s box is open and there’s no putting it back in the near future.

To play devil’s advocate:

  • As you mention, CEFI is going to offer better returns than staking because of what they can do with your funds. There’s nothing wrong with this, they see a business opportunity and take it. If CEFI can provide more utility for ADA, so be it.
  • Does it hurt the network to have exchanges run pools? Would anyone be talking about centralization if they were private (even if they’re ‘accepting delegation’ through a back door)?
  • Speaking of private, what about IOG and their pools? They used the system that they built (rigged for high pledge) to their advantage for months, and still do, to get roughly a 6.75% return where most anyone else would get a 5.25% return. Why do people complain about exchanges centralizing the ecosystem, but not IOG/Emurgo/CF, when they control just as large of a portion of ADA?

To attempt to answer your questions/remarks:

  • You’re always going to have an unequal distribution of delegation (Pareto principle - Wikipedia). It’s somewhat subjective, but IMO, the current distribution isn’t all that bad (https://adapools.org/groups). That being said, this doesn’t mean that things can’t or won’t centralize more in the future. For some aspects, there’s nothing we can do to prevent this, for other’s there’s nothing we can do yet (ex: we need an identity solution that works). I think that DEFI is definitely a good tool to have, but it doesn’t necessarily mean that DEFI will lead to more decentralization (depending on how you define decentralization). Keep in mind, any ADA that’s locked up in DEFI contracts isn’t being staked, meanwhile CEFI exchanges can stake the lot of their ADA since everything is done in their internal books.
  • In general, for as much as I’ve talked about staking rewards, network parameters, and the like, I’m not nearly as concerned with equitable returns as I am with equitable governance, but that’s a whole other issue.

In the meantime, we need to figure out, as a community, what decentralization means to us. Decentralization can be good, that doesn’t mean that more decentralization is always better. To me, I see it like averaging out error…initially, it’s very important to get more samples to reduce your error, but the more samples you have the less effective each new sample is at reducing the error. Eventually, you have to weigh how much benefit you get by adding more to how much it costs to do so.

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A lot of good thoughts, but I but there are 2 points where I have remarks:

  • True that IOG/Emurgo/CF hold a lot of Adas, but it is truly their Adas and it is not going to get worse because they do not try to increase that amount by convincing people to send funds to them by offering better rewards than the network. That makes a big difference imo. I don’t have a anything against wealth inequality and the fundamental principles of POS, but getting other people’s voting power by giving them financial incentives, like exchanges do, sounds like bribery to me. Especially when you don’t say what you will do with that power.
    I suppose that smart contracts on the other hand, will exactly tell you what they will do with your voting power.

  • You say that “any ADA that’s locked up in DEFI contracts isn’t being staked”: I do not agree. I am not into the smart contract projects, but I do not see why not. Maybe someone into the incoming DEFI can confirm, but the locked ADA should be delegated for staking somehow by the contract. This is where DEFI can help the pool decentralization, by implementing fair delegation of the locked ADAs.

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Yes, ADA locked in a contract can be staked. I imagine that such will become the standard practice for contracts that hold a significant amount.

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@bwbush is right, you currently cannot make a (plutus) smart contract the recipient of pool rewards nor can it receive delegator rewards. Lars was saying that this is an import point, that eventually will have to change.

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@tomdx, Thanks for clarifying this. I was wondering if there was a way for a script to sign a delegation certificate. So it looks like the situation right now is as follows, but eventually everything may be stakeable:

Payment Portion of Address Stake Portion of Address Stakeable?
0 key / script / contract (none) no
1 key key yes
2 script / contract key yes
3 key script / contract no
4 script / contract script / contract no

Case #1 is the common situation. I’ve been testing case #2 on testnet with a simple script.