Margin Fees And Race To The Bottom.
Updated: Aug 23, 2020
You have heard this before. In order to ensure stability of the network from the onset - we need to ensure that all stake pool operators will not try to grab the market share with the lowest possible fees. Or we face similar centralisation risks as other entities. Direct opposite of what we are trying to achieve today. But is it that bad? Well, not exactly, at least not yet anyways. So bear with me.
We shouldn't be surprised. This ideology has been with crypto world since the early beginning. Especially with Proof of Work where you need to be ahead to win the race or be left behind. Alternatively, Proof of Stake argues for a different approach instead. But how well has it faired so far?
To avoid initial race to the bottom - which would make it impossible for many stake pool operations to participate - a contingency was put in place. This is why current protocol has a minimum fixed fee of 340 ADA per epoch. Operator can set anything above - but at least such amount is required at all times. Most pool operators, not surprisingly, have set this parameter to this lowest possible threshold. Duh.
There also is another fee element to the stake pool operation. And that is margin % fee. Margin fee is more of a success fee of sorts. The better pool performs - the better rewards we all share proportionally. If the pool doesn't perform as well, even operator's rewards don't rise any more than its delegation does. Imagine for a moment - if you were paid at work your fixed salary only. Would you perform better or worse if you had an additional incentive atop of your fix part? Go ahead and I'll let you think about that for a second.
But you can think - they already get a fixed fee - isn't that enough? Apart from added motivation mentioned above - in order to run a serious viable business operation - the answer is - NO. We are building world class code and world class infrastructure. Yes - protocol invites pool operators from all sorts of backgrounds and experiences - but that should not distract us from what our primary role is.
Stake pool operation is not get rich quick scheme - despite many giving it such connotation. Before we ever get any whim of that - we'll spend months, maybe years maintaining and validating network. This is our primary responsibility. So that other smart people can build projects on top of our founding layer of validators. If you think you can do that with a minimum fixed fee long haul - then we all need a reality check of sorts.
In general, there is nothing wrong with optimisation and being able to deliver the most quality product at the lowest possible price. That's what the mantra of capitalism has been all these years. Market will fix everything. However, we barely have any free market anywhere in the world. And we see what exploitation takes place as a side product all along. So to think that market will fix everything in Cardano by default is somewhat naive in an essence. We need to put in the work ourselves.
We have also learned that the price does not mean everything. While there may be appropriate market for every level of price adoption - there is an opportunity cost with every decision you make along the way. My position would be that by choosing minimum margin fees you are doing a dis-service to yourself as an operator. Wearing yourself thin instead of investing into your infrastructure so that we can be better as an ecosystem collectively. We are only as strong as the weakest link within that ecosystem - as everything has a way of coming around. Every failure, regardless of how small, is often aired into the world with the loudest of the voices. Our critics are waiting exactly for such opportunities. I fully respect any decision to do so - but bear with me why that may not be best for you and not a big ask from your delegators to consider either.
So what is the bigger picture on margin fees that everyone forgets about. Little change in % margin fee on operating has minimal impact on rewards to delegators but major impact on operational rewards to the operator.
Number of delegators doesn't mean much in terms of reward computation. Sometimes, this gets used interchangeably in conversations and can give wrong impression. It is important thing to keep in mind though. Naturally, if your pool has more delegators within the same amount of ADA - it will be more stable. That is average lot size of your delegator's stake. If there are only few delegates - who represent large portions of your stake pool delegation - your pool is at greater performance swing risk. If one of these 'whales' leaves your pool all of a sudden. And it will happen. Your goal should not only be to have as much stake as possible but also as diverse as possible to maintain balance and protect interests of everyone in your pool.
Now, little bit of math. YAY!
Let's say that your pool has 1,000,000 ADA delegated. Let's say that your pool produced 1 block of rewards. Let's say that reward was worth 10,000 ADA after all said and done before pool economics are considered (just an example, not a reality).
Your pool fees are as follows: 340 fixed fee and 0% margin fee.
Rewards to be distributed to you as a stakeholder are proportional to your holdings. As mentioned above NOT per number of delegators. So let's assume you have 20,000 ADA out of the total 1,000,000 ADA in that pool. That is you hold 2% of the total delegated ADA and that's the proportionate amount of rewards that you will be entitled at this level of stake delegated.
Following me, still? Don't fall asleep just yet. This is important.
Pool is awarded 10,000 ADA in rewards. Protocol will subtract 340 ADA in fixed fee from 10,000 ADA. Thus, margin eligible rewards are now at 10,000 - 340 = 9,660 ADA.
Next, let's assume the pool charges above mentioned 0% fee on margin. Then 9,660 ADA is now distributed evenly to every staked ADA in that pool. Your skin is 2% - hence 2% from 9,660 ADA is now 193 ADA (and some dust). Congratulations. You've made rewards.
Now let's assume that a stake pool charges 5% margin fee instead of 0%. Okay - let's back track a moment. After we remove fixed fee of 340 ADA - then 5% from 9,660 ADA remaining is 483 ADA. This means distribution available to all the stakeholders now rests at 9,660 - 483 = 9,177 ADA. As you own 2% of the delegated stake - your rewards are now 184 ADA. Congratulations. You've made rewards.
So what is the real difference between the two? 193 ADA at 0% margin rate minus 184 ADA at 5% margin rate = 9 ADA. This is what your additional bang for your ADA comes down to when you choose a pool with no margin instead when opposed to 5%.
Let's flip the coin - the operator made minimum fee of 340 ADA in the first case. In the second case - minimum fee is now accompanied by margin reward and amounts to 823 ADA in total instead. The fact that you made 9ADA less means that your operator made 483 ADA more.
Now, you may think - why is that fair and why should you care. Well - you invested your time and precious ADA into this pool. Do you think skinning stake pool operator will make them MORE or less likely to deliver on their promise consistently over the long term?
This is irrelevant in bigger picture but we can entertain few more thoughts before wrapping up today. In today's currency level - at 0.13 cents - that is just a spare above 100 dollars in 823 operator's reward. Versus the first case where that was worth just about 44 dollars. With the 5% margin fee you just enabled the pool operator to finance upgrades, their time and dedication to keep the stake pool operational.
You have financed the very founding stone of the Cardano network that will only appreciate in value for all of us via every cent in each Lovelace.
Not to mention, once you research many pools - you also find out what they do for the community. Countless pools have already fantastic social programs in place, creating content, driving adoption, and overall making the ecosystem better. That's your margin fees hard at work. Not 0% though.
Regardless of what you may have heard - running a stake pool is not walk in a park. It takes time, it takes ton of effort, and it may as well be often as demanding as a second job. Now, ask yourself again - is above a fair compensation or not? That is up to you to decide. The Cardano philosophy would suggest that we want to enable hundreds or thousand of operators in the future to function and dedicate their time 100% to this network. You can't do that on 0% margin fees. Most definitely not today. 0% margin fees make no sense whatsoever and serve only marketing over any actual substance.
We are all in this for the long haul. By drying out the field - we will all collectively stretch thin and dry out. Leaving only major handful of centralised players - similar to other blockchain solutions out there. If we wanted that - we should have opted for a different proof protocol and not bother. Even more - such concentration of pool staking power can also lead to lower confidence in the network as a whole. Raising concerns over its immutability and long term viability. All potentially contributing to the downward spiral of confidence in Cardano project as a whole.
Good thing is - we are not there yet. Everything still seems sunny. No major clouds by a long shot. We have just started but stakes ahead are high even though there's no sight of them just yet.
If you are an operator - don't be afraid to charge margin fees. If you are a delegator, enable operators to be successful in the long run by embracing these far margin fees where due.
Having said that - vote with your ADA - by choices you make. Vote accordingly for an upward spiral instead!
Rising tide lifts all boats, not just select few. Most importantly, be patient.
Spread the knowledge, not the fud. Edit: Just to be clear - this post is not intended to point fingers at operators that charge 0%. It is to make us think about the ecosystem as a whole. It is a hypothesis only. I have utmost respect for every operator out there regardless of their set up. That's because collectively, we are Cardano.
In the world that we currently are, many small operators feel like that in order to attract delegation they need to go with the 0% fees. Whether temporarily or permanently. Now, that is perfectly viable business decision. And to be honest - that is not surprising and somewhat expected. I am trying to imagine what world would look like where operators didn't feel that huge pressure right from the get go. And how would that ease of pressure enable them create further valuable content by re-investing into ecosystem.
My sentiments, or rather a hypothesis is - wouldn't you want to enable the world where operators regardless of size are able to attract their delegation based on merit and work put it? I wish small operators to succeed because it is incredible important to the network as a whole.
Yes, we need operators of every size - but more small operators - greater chance at stability and close to true decentralisation we are seeking.
It is similar with your delegation - more diverse - more stable it is.
So please, let's not shame/point fingers at operators for charging zero fees. Especially small ones. Often, they feel there is no other way out trying to establish themselves in light of large pools. Frankly, we can't blame them.
Meanwhile, let's think about implications.