Liquidity Baking: A Decentralized XTZ / TZBTC Pair – Part 1

Liquidity Baking Is Introduced 

On the 7th of January the draft proposal for Liquidity Baking was published and a request for comments was made on Tezos Agora.

Creators of this proposal include Sophia Gold, Arthur Breitman, and Gabriel Alfour. This draft proposal, despite its significance, was delivered in typical Tezos unhyped and understated fashion.

To add clarity on what Liquidity Baking is from the start: this is not a form of baking, and this is not adding liquidity to Dexter, Quipuswap, or any other (future) decentralized exchange. 

Liquidity Baking is a stand-alone, single-pair DEX where people can trade XTZ / tzBTC. Purpose: increasing the overall liquidity of XTZ. 

Liquidity Baking will be a single-pair, semi-protocol-level, decentralized exchange. A unique concept.

There will be a lot of eagerness to provide liquidity for Liquidity Baking (LB). LB provides a Subsidy for liquidity providers that makes it very much worthwhile to add liquidity to the XTZ – tzBTC pair. Especially when liquidity is low, the subsidy rewards will be a lot higher than the staking rewards people can earn baking, or delegating.

In other words, the financial incentive to provide liquidity for the XTZ / tzBTC pair on LB will be at such a level, that liquidity is almost guaranteed to rise substantively immediately after Liquidity Baking goes live on mainnet.

It is expected millions in value will be added in the weeks after the implementation of this feature due to these incentives. The following concepts will be important to understand before we get into the details of Liquidity Baking.

Baking And Delegating

 Tezos is a Proof of Stake (PoS) blockchain. In PoS, the validators (nodes) of the network that secure and decentralize the network, need to prove they have a “stake” in the network.

 Having “skin in the game” and fixing 10% of their stake as a bond to guarantee honest behavior. The bond enables the protocol to punish malicious behavior. This way it is part of the security model that helps to secure the immutability of the blockchain. In return, validators earn a percentage of what they have at stake (staking rewards).

If we compare to Proof of Work (PoW) chains, we see that validators in PoW, earn their rewards (mining rewards) by proving they do the work in the form of heavy (energy-consuming) calculations on specialized hardware.

One of the huge advantages of PoS is the fact that it requires a lot less energy.

Tezos uses a variation called Liquid Proof of Stake (LPoS) where any holder can delegate their XTZ to validators and in that way, receive staking rewards without the need to set up a node. Delegating can be done with a few clicks and does not require you to fix your XTZ for any period of time: you can start and stop at any time.

The Tezos protocol has been running a smooth and high-value mainnet for close to three years and can be labeled as a secure and battle-proven protocol. Running a Tezos node as a validator is called “Baking”. Earning staking rewards by delegating to a Baker is simply called “Delegating”. 

Providing Liquidity In Liquidity Pools

For a (decentralized) exchange to function, people must ultimately be able to buy and sell at all times. Since there are not always buyers and sellers, there are several solutions to solve this issue.

One of these solutions is to enable people to provide liquidity. This means that they add tokens to a pool. This pool is then used by an automated market maker (AMM) to function. An AMM is a smart contract that enables the trades automatically.

Let’s take a look at an XTZ – tzBTC trading pair for example. To be able to trade smoothly, a pool of tokens is created. An x amount of XTZ and an x amount of tzBTC. The AMM can tap into that pool for liquidity, so it can provide the tokens that buyers want to buy. Alice can now buy a certain amount of XTZ or tzBTC.

If she wants to buy XTZ, the AMM will provide her with the XTZ in exchange for the amount of inputted tzBTC at a price determined by the AMM. There is no immediate need for a counterparty.

The pool provides the XTZ. Later, there will always be a buyer that sets the balance straight. He buys tzBTC and gives XTZ in return.

On average, over a stretched period of time, the balance will be settled. However, since there is always a difference between buyers and sellers of XTZ or tzBTC, supply and demand will change the price.

There are certain factors that make pools more efficient.

One important factor is the size of the pool, so the amount of coins that are added by liquidity providers to the pool.

The bigger the amount of coins in the pool, the better the liquidity.

Before you consider providing liquidity, make sure you fully understand what it entails, what the possible risks are, and for example: what impermanent loss is.

There are risks, so make sure you do a thorough amount of research, using several sources. You can start reading more on the subject in the FAQ section of the Tezos-based decentralized exchange “DEXter”.

Incentives For Providing Liquidity In Liquidity Pools

Currently, the biggest incentive for people to provide liquidity is the fact that you earn a portion of the fees that traders pay. For example: fees on DEXter are 0.3%. When you provide liquidity in a liquidity pool, you earn a share of those fees.

If you provided 5% of the total pool size in XTZ and tzBTC for a certain period. Then you earn 5% of all fees that traders pay during that period. The more volume, the more fees are paid, the more you earn as a liquidity provider.

But if the volume is low, your fee earnings are not that high. So before providing liquidity, you could wait for volume to go up.

But if few people add to liquidity pools, then liquidity is low, which can be a disadvantage for traders. So traders could wait for liquidity to be added. Possible result: stalemate, a standstill, chicken, or the egg.

One of the biggest challenges for an exchange is to get liquidity on healthy levels.

Announcing Liquidity Baking on Gitlab, Sophia Gold mentioned “the collective action problem” as described in the Tezos position paper in section 4.3:

“The collective action problem arises when multiple parties would benefit from taking an action but none benefit from individually undertaking the action”.

Staking Rewards In Liquidity Pool

Building on Tezos, staking rewards, and liquidity pools can be a combined force. When adding liquidity to pools that utilize XTZ, you can earn staking rewards while also earning on trading fees. This means that you can delegate the XTZ that you add to liquidity pools.

This way you can earn trading fees in the liquidity pool, while simultaneously earning staking rewards by delegating your XTZ. This means that the earned trading fees are an extra profit on top of your staking rewards.

That already lowers the barrier to be one of the first to provide liquidity. The fee earnings would preferably be higher, but any extra earnings is a bonus anyway. But still, the incentive to provide liquidity can be low in the beginning.

Liquidity Baking introduces “Subsidy” which is the ultimate kick-starter for liquidity pools and provides a huge financial incentive for people to add liquidity to the liquidity pool.

Subsidy is different from governance tokens that are distributed in some of the current DeFi applications we have seen so far. Subsidy is paid in XTZ will be provided by the Tezos protocol. In the next part, which you can find here, we fully explain how Liquidity Baking works.

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