The Heartbeat of Cardano.

Taking a Look at Cardano’s Monetary Policy

Photo by Ilya Pavlov on Unsplash

Money is a commodity that is used as a means of exchanging goods and services. 

Its origin has much to do with the development of barter. The difficulties of trading through barter made the towns look for a faster system of exchange, and that also gave a more precise value to their merchandise. At the end of this article there is a very entertaining video, which briefly summarizes the history of money.

Monetary policy is the economic design that controls monetary factors to ensure economic stability for the development of an economic system.

This monetary policy is aimed at managing a means of exchange for payments, which must be accepted by economic actors, on a daily basis, in transactions of goods and services.

Some consider that money has intrinsic value, but I believe that the value is given by its acceptance as a medium of exchange within an economic system. Take the example of countries with high inflation where fiduciary money issued by governments is not accepted as a means of saving, due to its great loss of value over time. Its intrinsic value does not exist, but rather its value depends on supply and demand, and since citizens do not accept it, it loses more and more value.

Venezuela is the country with the highest currency devaluation, currently registering 472% per year. You can see the data in Inflation Rate – By Country (if you click on the titles you can sort values).

It is necessary to understand that Monetary Theory proposes five essential properties that money should have in order to be considered as such:

  1. Scarce: scarcity in the relationship between supply and demand plays a crucial role in valorization.
  2. Durable: is the permanence of its value over time.
  3. Divisible: monetary units of lesser value to be able to exchange a variety of goods and services of different costs.
  4. Fungible: each monetary unit has the same value for any holder.
  5. Unit of measure: a universal standard that allows the comparison of the values ​​assigned to different goods and services. 

To delve deeper into this topic in the crypto industry, I have written an article about stablecoins (1).

ADA: A Currency with a Non-Inflationary Policy

Cardano has a defined monetary policy, fulfilling the scarcity property, one of the incentives to keep the network stable, based on its PoS (Proof of Stake) consensus protocol.

The total established circulating supply is 45 billion ADAs. It will never change, thus making ADA coins a limited, scarce resource.

You might think that amount of cryptocurrency is a lot compared to the issuance of 21 million bitcoins, roughly 2,143 times more units of ADA, but it’s all relative to demand. I clarify that bitcoin is the cryptocurrency and Bitcoin is the blockchain.

But watch what happens considering divisibility, one of the properties of money. The bitcoin cryptocurrency has the relationship of 1 bitcoin = 100,000,000 satoshis, and 1 ADA = 1,000,000 lovelaces, this means that the division of each unit of bitcoin is 100 times greater than ADA, that is, a total of 2,100,000,000,000,000 satoshis and a total of 45,000,000,000,000,000 lovelaces. Approximately only 21 times more lovelaces than satoshis (you can see how the difference in monetary currency between both economic systems was reduced).

Both Bitcoin and Cardano have monetary systems that do not contemplate the burning of their cryptocurrencies like other blockchains, such as the recent update in Ethereum, which burns part of the fees, trying to revalue the currency, in my opinion artificially, benefiting newcomers and hurting previous holders.

Currently, as of March 5, 2022, the circulating supply of ADAs is approximately 33.99 billion coins, or 75.53% of the total, so the remaining 11.01 billion will be gradually released ( monetary expansion) by the protocol in each epoch (every 5 days), in the following years and until its exhaustion.

From the economic analysis, a monetary policy is inflationary when the currency is greater than the demand for its use in transactions. If there is an abundance of a certain good, and it does not have enough demand to be exhausted, its price tends to fall, that is, it is devalued.

The same thing happens with money, since it is good. If there is a lot of money in circulation greater than its use, over time, more and more of it will be needed to pay for the same goods and services. 

Inflation (increase in general prices) is the product of currency devaluation.

The issuance of ADAs, that is, the monetary expansion, is established at 0.3% of the balance of reserves for each epoch (later I will explain in detail). This means that the balance is getting smaller, therefore, the issue is also smaller. 

Cardano’s monetary policy is non-inflationary considering only its issuance, without taking into account the demand variable, a fact that is also relevant in the market (if there is less demand than issuance, that translates into inflation, and thus into currency devaluation long-term). That is why I said that the monetary policy is non-inflationary, instead of deflationary, since I only consider its programmed emission, without knowing what will happen to its demand.

The Issuance

The issuance of ADAs has three objectives:

  • Means of payment,
  • Rewarding delegators and validators who participate in network consensus, and 
  • Funding the Treasury

The rewards for validators and delegators are made up, in turn, of two sources, monetary issue and transaction fees. It is expected that the issuance, approximately every 4 to 5 years, is reduced, mathematically, by half of the reserves, and therefore reducing the rewards budget. A kind of halving like Bitcoin, but smooth and gradual over time.

After the exhaustion of reserves for the issuance, the only source of rewards will be the transaction fees, which are assumed to be sufficient to sustain the economic incentive, but this is many years away. 

This system is designed to ensure that the portion of rewards drawn from reserves is high at the beginning, when the number of transactions is still relatively low. This incentivizes early adopters to benefit from high initial rewards. 

This mechanism also ensures that the available rewards are predictable and do not vary dramatically, as the fixed percentage, taken from the remaining reserves at each epoch, guarantees a smooth exponential decline.

The treasury is financed with 20% of the network fees and 20% of the monetary issue. At the end I leave the link of an article I wrote about the Cardano Treasury (2).

Each transaction fee for all blocks produced during each epoch goes into a virtual pool τ, plus a fixed percentage of the remaining ADA reserves (the issue), ρ, which is added to that pool. I will explain the values ​​ρ and τ.

Calculating ρ

While the IOHK team searched for the correct ρ value, scientists faced a dilemma: a higher value would mean higher rewards for everyone initially, and the Treasury would fill up faster. But higher values ​​of ρ would also mean that reserves would be depleted faster. Paying high rewards and incentivizing early adopters is a crucial consideration, but so is offering a long-term perspective for all stakeholders. Therefore, the solution to this dilemma required a balance between these two schemes.

Taking an exponential decay approach to avoid Cardano stockpile depletion makes sense in this situation.

The calculation of the “half-life of the reserve”, that is, the time it takes for half of the reserve to be depleted, visualizes the impact of choosing a specific value of ρ over another. Subject of much discussion, finally, the assigned value was 0.3%. 

The reason is that mathematical projections showed that a value of ρ (the fixed percentage of ADA entering the virtual pool each epoch) of 0.3% means a reserve half-life of four to five years. In simple terms, only half of the remaining reserve will be used every four to five years.

Choosing τ

Determining the correct value for τ was equally challenging. There may be a percentage of undistributed issue as a reward on some epochs, which are automatically returned to reserves. After discussions, deliberations and projections, the chosen value was 20%, which means that 20% of the monetary expansion and transaction fees are sent to the Treasury in each epoch.

Source: Cardano monetary policy

My articles mentioned: (1) Stablecoins: A Necessity for the Crypto Industry . (2) Governance in The Voltaire Era and The Cardano Treasury

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