Blockchains are distributed ledger systems that store immutable data. Blockchains require a mechanism of establishing trust in a distributed system for which it uses a consensus algorithm. For the security of a blockchain network it is essential that even if some nodes of the network fail the consensus about the state of the ledger in the network is not broken.
The consensus mechanism used in the earlier generation blockchain networks like that of Bitcoin and Ethereum is known as Proof of Work (PoW). With PoW, new transactions are added to the distributed ledger after nodes in the network verifies a set of those transactions by validating the incoming and outgoing digital assets so as to prevent double spending. This process is called mining and is designed to mitigate attacks that can break the consensus mechanism. Each miner node competes in solving a computationally expensive algorithmic problem to ensure the validity of the transaction. The node that wins this challenge appends its block to the shared ledger. As rewards it earns a fee in the native cryptocurrency of that blockchain. PoW however, comes with the downside of high energy usage, expensive hardware requirements, slow transaction speeds and high transaction fees.
A newer consensus mechanism that mitigates the side effects of PoW is called Proof of Stake (PoS). In proof of stake, instead of solving computationally expensive puzzles, the nodes earn the right to create the next block by virtue of the amount of stake held by them. The stake refers to the amount of native cryptocurrency owned by the node. A variant to this simple scheme of PoS is where stakeholders can delegate their stake to a node that participates in the block production. This is also known as Delegated Proof of Stake (DPoS). Cardano uses this type of consensus mechanism which uses the amount of stake (simply put as value of ADA delegated) held in the network to determine consensus. ADA held by anyone on the Cardano network, when delegated to a stake pool or pledged as a stake pool operator, represents their stake in the network, with the size of the stake proportional to the amount of ADA held.
The reward mechanism Cardano uses parameters like saturation parameter, pledge influence factor, pool margin and pool fixed cost for calculating the rewards awarded to a node that creates the block.
The saturation parameter sets the maximum stake cap per pool, after which the pool will receive diminishing rewards. The saturation mechanism intends to promote decentralization by encouraging delegators to delegate to different stake pools, and incentivizing operators to set up alternative pools so that they can continue earning maximum rewards. As of December 2020, the k parameter on Cardano is 500, setting the saturation point (stake cap) for a stake pool at 64 million ADA.
The pledge influence parameter determines the reward of a pool by virtue of the stake pledged by the SPO. It aims to create incentives for pledging more of an SPOs stake to a single pool, rather than splitting it. This parameter intends to secure a healthy level of decentralization as it encourages large operators to control fewer pools with a high pledge. As for the SPO, higher pledge increases the chance of delegates joining the pool because SPO has skin in the game and it increases the rewards earned by the pool as well. Also if the pool owners collectively delegate less than the declared pledge, pool rewards for that epoch will be zero.
The fixed cost is a set fee that is paid to the SPO to compensate for the pool’s operating costs. At this time the minimum fixed cost is 340 ADA per epoch. The pool margin is the percentage of rewards paid to the stake pool operator in addition to the fixed cost but before rewards are distributed to the delegators including the pool owners.
The PoS consensus protocol ‘Ouroboros’ used by Cardano relies on stake pools to create blocks. Blocks are aggregates of several transactions. Stake pools are responsible for processing transactions on the Cardano blockchain. ADA holders can participate in the block production process by delegating their stake to a stake pool run by someone else, or running their own stake pool. The process by which ada holders delegate the stake associated with their ada to a stake pool is called delegation.
The larger the amount of ADA staked in the network towards block production, the better the health and sustainability of the network becomes. As a result staking is incentivised though rewards for block production. Stake pools receive a reward for a successfully minted block. These rewards will be distributed by the protocol amongst all delegators to that pool, including the fees for the stake pool operator.
It is important to note that delegation is completely non custodial. Delegators do not lose control of their funds while staking and they can spend their delegated ADA at any time. Delegation is supported by almost all ADA wallets. In order to delegate you can search for a stake pool by their ticker and sign a delegation transaction. The total ADA in your wallet gets delegated to that pool without leaving your wallet.
When delegating for the first time from a wallet, a stakeholder has to pay a deposit for registering a stake address. Once a stake address is registered, the stakeholder will only pay network transaction fees to delegate to a desired pool or to change existing delegation to another pool.