Liquidity Baking: A Decentralized XTZ / TZBTC Pair – Part 2
Note From The Author — Liquidity Baking is a very new concept and the proposal is still in draft status. As the proposal is in draft and is potentially still being amended, any information listed is subject to change.
This is the second article of a 2-part series, for a quick recap on the very basic principles of this topic you can read part 1 here.
This article was co-authored by Allen Walters and Lee Evans.
Before We Start
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.
It should be seen as a stand-alone, single-pair DEX where people can trade XTZ / tzBTC.
As in any liquidity pool, people who want to add liquidity will need to provide both sides of the pair, so both XTZ and tzBTC.
In the ratio of a 1:1 value, for example, $100 in XTZ and $100 in tzBTC.
Liquidity Baking is a decentralized liquidity pool for XTZ / tzBTC. The goal of this concept is to increase the overall liquidity of XTZ on the Tezos blockchain.
Tezos is quite unique in the cryptocurrency space in the sense that an unusually large amount of the network (~80%), participates in the Proof of Stake (PoS) consensus through baking.
This high staking ratio and the fact that many people hold the coin to gain rewards, is thought to have an impact on the liquidity of XTZ. In the case of XTZ value, low liquidity is not necessarily a bad thing.
Low liquidity means higher scarcity, but it can also mean traders are put off from entering in the markets.
When XTZ can be deployed in DeFi applications, better liquidity has its advantages. Liquidity Baking creates the opportunity to make XTZ more liquid in a decentralized fashion.
To get to that point, Liquidity Baking is created. By design, the incentive to add liquidity to the Liquidity Baking pool is extremely high when liquidity is low (Over 2,000% yearly ROI when the amount of XTZ is around 0.1 million), and moves toward ~6% (similar to staking rewards minus inflation) once it reaches ~43.8 million XTZ.
The biggest difference when comparing with pools that we see on Dexter, is the fact that the possibility to delegate your XTZ and earn staking rewards is removed from this particulate liquidity pool.
Instead, “Subsidy” is created, which will incentivize people to provide liquidity to the pool.
The subsidy is created by the protocol in extra XTZ that will be minted (an extra 5 XTZ per block over the 80 XTZ per block that is already created for staking rewards). UPDATE: This 5 XTZ per block is now 2.5 XTZ per block, but also factor in reduced block times from around 1 minute to around 30 seconds with Granada upgrade.
The way this subsidy is distributed over the liquidity providers, will likely result in a very quick increase in liquidity.
So we know that there will be extra inflation of 5 XTZ per block and when the protocol creates extra XTZ, some questions could potentially come to mind.
Will the bakers suffer the costs? Would this be passed on to delegators?
Well, the answer appears to be ingenious as we will find out later, that all stakeholders should benefit and the extra inflation will be significantly outweighed by the benefits that the extra liquidity provides.
First, we’ll take a look at the subsidy distribution, which incentivizes the rapid large growth of liquidity.
There is a fixed amount of XTZ that is being distributed: 5 XTZ per block. If there is one liquidity provider in the pool, he will receive all 5 XTZ per block.
No matter how much XTZ he has added to the pool. If there are two liquidity providers, the 5 XTZ will be divided per ratio added over both providers.
So if Alice provides 40 XTZ and Bob provides 60 XTZ, then the 5 XTZ subsidy is split 40% – 60%, so 2 XTZ for Alice and 3 XTZ for Bob.
In other words, the main factor of how much subsidy you can earn is not just determined by the amount of XTZ you add to the pool, but the total amount that is added to the pool by all participants.
Now let’s do the math. Or, actually, let’s take a look at Andreas, who did the math:
With current tez price the estimated liquidity would be
43,800,000 tez * 2.5 USD/tez = 109,500,000 USD. So the subsidy alone won't get us past Uniswap but will catapult us to the same magnitude.
So, that is just the subsidy, but we must also account for the additional tzBTC being pooled alongside the tez, so this figure would double the liquidity size stated, as any XTZ (subsidy) must be matched with an equivalent amount of tzBTC.
The price of XTZ has increased since this post and now stands at the time of writing at $3.02, this would mean 43,800,000 tez*3.02 USD/Tez = $132,276,000 worth of Tez (subsidy) in the liquidity pool, once it is full.
But as we add the equivalent tzBTC to this total amount in the liquidity pool, it would come out as (including both pairs) $264,552,000.
Here, below we can see a list of the top pools on Uniswap by amount of liquidity:
So for as long as the total amount that is added to Liquidity Baking does not surpass 43.8 million XTZ, providers will make more in subsidy if they provide liquidity, compared to when they delegate their XTZ.
Let’s picture the current reward status. At this point of writing (subject to change), https://better-call.dev/mainnet/KT1DrJV8vhkdLEj76h1H9Q4irZDqAkMPo1Qf/ operations there is just close to 120,000 XTZ in the Dexter liquidity pool.
If all that XTZ would be moved to the Liquidity Baking contract, and you would add 1,200 XTZ and add 0.08 tzBTC to match the 1:1 value ratio (at the current rate), you would receive 1% of the subsidy.
That is 0.05 XTZ per block. One block per minute, that comes down to 3 XTZ per hour. And 72 XTZ per day. That is 2,190 % on a yearly basis. I think we can conclude that liquidity will surpass Dexter levels quite fast.
A lot of people are likely to jump on the opportunity. This will likely result in a quick increase in liquidity.
Once liquidity goes up, trading is quite likely to see more volume.
Low transaction costs and high liquidity is an attractive mix. Adding to that, trading fees will be set as low as 0.1% (Dexter is presently 0.3%).
Consequences For Bakers
All the XTZ that will be provided in Liquidity Baking, will be taken out of the Baking – delegation process (remember: providers won’t be able to delegate their XTZ.)
This means that some Bakers might lose some portion of their delegators because these delegators will move their XTZ to the Liquidity Baker pool.
But at the same time, because this XTZ is taken out of the total baking process, the total staking rewards will be distributed over a slightly smaller group.
This means that Bakers and delegators will receive a bigger cut of the total staking rewards. So what Bakers will lose in fees, they will make up in extra rewards.
We’re not talking huge numbers here. About 0.375%, but this depends on scale.
A trading pair with healthy liquidity will increase opportunities on Tezos. First of all, the Liquidity Baking pool will be the cheapest trading opportunity to trade XTZ – BTC.
Transaction fees on Tezos are already one of the lowest out there (On average 3,000 times cheaper than on Ethereum), but the trading fees for trading in the Liquidity Baking pool will also be one of the lowest out there: 0.1% (!).
So for trading XTZ – BTC, the Liquidity Baking pool would be the most attractive place to trade.
Arbitrage will be a second interesting opportunity.
“The purpose of arbitrage is to take advantage of the difference in prices available for the same financial instrument being offered on different exchanges.”
Since liquidity on Dexter will be lower for XTZ/tzBTC, the price differences between Dexter and the Liquidity Baking pool could be worth some trades between both XTZ / tzBTC pools.
Not only is there price arbitrage to consider, but there is also ‘liquidity arbitrage’. This will enable some interesting arbitrage and hedging opportunities on the different exchange pools such as those on Liquidity Baker and Dexter/Quipuswap.
Another side-effect, is the fact that all this commotion will attract new people to Tezos and these people will experience the ease of use when it comes to wallets such as Kukai and the cheap and fast transactions that the Tezos blockchain can provide.
Liquid Baking Is Currently In Draft Proposal stage
The CPMM Liquidity Baking pool is a fork of a part of Dexter’s code. The advantage of that decision is the fact that this means that the codebase of which the CPMM is forked from has been audited and its functional specification is formally verified.
This advantage taken into account, but it is stressed that even further reviews would be desirable:
“a new round of review and testing would be worthwhile.”
The draft proposal would require an amendment upgrade for the subsidy to be introduced. As the proposal is not too complicated and has already been implemented it is likely the Liquidity Baking upgrade will feature in the 009 amendment and be put into place around May 2021.
The CPMM itself doesn’t have to sit at protocol level in the initial stages.
While at a later stage, it could be implemented on protocol level to potentially improve performance and potentially future composability.
If it was moved to the Tezos protocol level it would be an act of ‘Nationalization’, where crucial smart contracts are adopted to the core protocol, similar to the addition of the Tickets feature to this layer (which is expected to be finalized in Febuary 2021).
The simplicity of this process is one of Tezos’ distinct advantages over other blockchains, which don’t have the option to do this easily and efficiently.
The needed protocol changes for Liquidity Baking are ready to be proposed and we could see this in the next proposal in mid February.
tzBTC is wrapped BTC on the Tezos blockchain: it is a BTC – based token which is 1 : 1 backed by BTC. This makes it possible to trade BTC value on the Tezos blockchain.
Advantages are simple: faster transactions (Tezos blocktime is 10 x faster) and cheaper transactions.
Fun fact: Liquidity Baking is built while using “Tickets”, which is a solution that will be implemented on Tezos’ mainnet when Edo goes live mid February.
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