Potential Impacts of Cardano’s Treasury Mechanism

Explore how the Chang era impacts the Cardano Treasury Mechanism

Tokenomics in the Chang Era

As Cardano moves into the Chang Era with community-managed treasury systems, members of the broader Cardano ecosystem must understand the possible implications of an unexpected increase in ada supply.

While never certain, the relationship between supply, demand, and price is studied in the field of tokenomics—which studies the interplay of supply and demand with incentives and decentralized decisions in a distributed system. In Cardano, ada supply was historically driven primarily by validation rewards and following a well-tested parametric system. Adding decentralized governance with the ability to release unspecified ada from the Cardano Treasury introduces new uncertainty. This needs to be carefully understood, and we hope this series of blog posts will contribute to that understanding.

Inflationary pressures in proof of stake

One of the fundamental assumptions in both Bitcoin and Cardano is that a reduction in the rate of new tokens entering circulation has a beneficial effect on the valuation of the token by reducing inflationary pressures. In proof-of-stake systems, such as Cardano, the network's operational costs are relatively low compared to proof-of-work systems such as Bitcoin, where energy consumption adds substantial overhead. One key difference is that in Cardano’s proof-of-stake model, all stakers benefit from inflation, not just miners as in proof-of-work. This means rewards are more evenly distributed across network participants.

Additionally, staking with Cardano is remarkably easy as it doesn’t require specialized or particularly energy-intensive hardware. Anyone holding ada can participate by delegating their stake to a pool and start earning rewards. This lowers the barrier to entry and encourages broader participation in securing the network.

Instead of a mechanism like Bitcoin’s, which halves miner rewards at a set rate, Cardano has a gradual reduction in the rate at which new ada enters circulation, happening every five days (equals one so-called epoch), with an approximate 0.3% reduction of the ada amount added to circulation per epoch. This creates a steady and predictable rate of inflation, enabling stable economic planning within the ecosystem.

Treasury withdrawals as a new factor

With the Chang upgrade, Cardano is introducing a new factor affecting supply: community treasury withdrawals. Unlike staking rewards, which are a regular flow that is often held by validators and delegators to increase their stake, such treasury withdrawals are not easily predictable. Furthermore, it is reasonable to assume they will be sold more frequently and quickly on the market because they are needed to cover operational costs in fiat currency.
In these dimensions, community treasury withdrawals appear most similar to treasury withdrawals for Project Catalyst (the Cardano community grant program). Project Catalyst provides some historical data to observe how these withdrawals might affect market dynamics. However, further investigation is needed to determine exactly how the withdrawn ada are utilized, how much is being converted to fiat, and at which speed. We would welcome any insights the community has on these data points via the Cardano Forum.

Current key finding

We have conducted preliminary research on how treasury withdrawals and changes in circulating supply affect ada’s price dynamics. Using multiple forms of statistical analysis, we’ve found that more than 60% of ada’s price movements are independent of the crypto cycle, which accounts for around 50% of the total price variations and can be explained by supply factors, such as circulating supply and treasury dynamics.

Our analysis shows that regular increases in circulating supply, including those associated with the release of reserves to increase the treasury and pay the staking rewards, have a very limited effect on the price. However, treasury withdrawals that are not parameterized and reduce the treasury have an outsized impact compared to staking rewards.

Burn or use?

The challenge of how to best utilize an on-chain treasury is not unique. Other blockchain ecosystems have been engaged in a debate on whether to burn unused treasury funds or use them as quickly as possible to grow the ecosystem. This debate has now become very relevant to Cardano, as similar discussions about whether to focus on reducing supply or aggressively funding new projects have already begun. Our research highlights that treasury withdrawals if not carefully managed, can increase sell pressure. We believe that it is critical that Cardano governance participants ensure that Cardano retains the ability to fund future development and innovation.

What does this all mean?

Although the broader crypto market heavily influences price dynamics for Cardano, treasury withdrawals can introduce significant price pressure due to their size and unpredictability. This suggests that as the ecosystem moves forward with community-led governance, we need to be mindful of both the size and frequency of these withdrawals and how their release onto the market is managed.

Here are some recommendations from our research that can help mitigate described effects:

• •Keep withdrawals limited or in line with historical patterns, making them more predictable for the market. Unpredictable, large-scale withdrawals tend to create more inflationary pressure.
• •Introduce vesting or loan design mechanisms that force recipients to hold ada longer, reducing immediate sell pressure.
• •Improve the selling practices of grant recipients to ensure that ada is not dumped in bulk on the market. Encouraging recipients to sell in smaller chunks over time can reduce price volatility.

Further research and discussion

While we consider these initial findings, it’s important to acknowledge that this research is ongoing. There are many factors at play both within the Cardano ecosystem and in the larger cryptocurrency market that can influence market dynamics. While our work indicates clear patterns, more investigation is required to fully understand the effect of different factors on market growth and stability. We encourage open dialogue and further discussion on these matters and are committed to transparency. We plan to publish more of our findings to allow for community review and input.

The Cardano on-chain treasury system is a powerful tool for funding development and ensuring the network’s long-term sustainability, but like all powerful tools, it comes with significant responsibilities. The Cardano community must balance the need for funding with maintaining stability to ensure that the Cardano ecosystem can continue to grow in a healthy and sustainable way.