The Liquidity Baking Mini-Series – For/Against (Part 3 Of 3) – Roundup

by | Jan 16, 2022 | Latest, Opinion

In this 3-part mini-series (which will be posted together), Allen Walters looks into the topic of ‘Liquidity Baking’, exploring different viewpoints both for and against.

Part 3 concludes with a roundup of Allen Walters’ thoughts.

We’ve seen many so-called “batched” proposals where a proposal includes several upgrades and adjustments on different levels and features.

These combined upgrades are a necessity to evolve fast. So far this hasn’t been much of an issue. But currently, we see people raising an issue against the batched Ithaca proposal. Liquidity Baking (LB) and its current tzBTC pair is the obstacle.

In this opinion piece, I’d like to dive deeper into what the purpose of LB is, the current metrics, and how other tokens do, or do not, fit in.

Quick recap on what LB is: You can view LB basically as a single-pair DEX on protocol level. Liquidity providers for LB are rewarded with XTZ as incentive to add liquidity (current yield is ~ 60%.)

The current token pair that can be traded is tzBTC – XTZ.

Anyone can connect a Tezos wallet and buy or sell tzBTC and XTZ on LB.

You can interact with LB here https://tzkt.io/KT1TxqZ8QtKvLu3V3JH7Gx58n7Co8pgtpQU5/dex?baseCurrency=XTZ&quoteCurrency=tzBTC&tradingTimestamp=daily&tab=Price+%26+Volume and here. https://tezblock.io/swap 

Purpose

With $18.5 million total value locked (TVL), LB has the biggest liquidity pool on the Tezos blockchain and the most healthy trading pair for traders of any level to make trades.

Although the liquidity on LB is obviously healthy and very suitable for the average trader, the primary goal is not necessarily to create a high-volume market. 

LB’s main goal was set to create a market that enables large buyers to buy large quantities of XTZ in one scoop. This is challenging in the current markets.

Even on the larger centralized exchanges the order books can be too thin for large quantity buyers and sellers to trade without influencing the price too much.

That is a problem if you’re trying to buy large quantities, since doing so will drive the price up of the tokens that you try to buy. (Or selling while pushing the price downwards of the tokens that you try to sell.)

For large buyers, a healthy seller’s market is equally important as a healthy buyers’ market. So while considering whether or not to buy large quantities, one will need to assess if it is possible to take a position as much as if it’s possible to exit the market in a safe and healthy manner as part of a risk assessment. 

Long story short: if you want institutions and whales to take an interest in XTZ and consider taking positions, you’ll have to have a market with enough liquidity and depth.

It’s important to realize that there is a big difference in how markets on centralized exchanges (CEX) work compared to how markets on decentralized exchanges (DEX) work. Although volume and deep order books are important on a CEX, volume isn’t important to achieve a healthy market on a DEX.

In a DEX the size of the liquidity pool is what matters. If the liquidity pool on a DEX is large enough, then large trades can be made without slippage or the disadvantages of a thin order book.

So, to achieve one of LBs main goals, a large liquidity pool has to be created. And that is exactly what LB accomplishes. (Metrics follow further down the article.)

Market manipulation

Market manupilation happens through thin order books or clustered stop losses/ buy orders. Clustered orders are the result of the widespread belief in technical analyses (TA’s) which result in clustered entry and exit points around the same values.

This type of predictable behavior is exploited by larger parties to cause pumps or dumps in price.

To get more of an understanding how markets are manipulated this way, this video https://www.youtube.com/watch?v=chE2OEToxOg&t=7s  is a must-watch. 

On a DEX with a large liquidity pool there is no such thing possible due to the absence of an order book and thus the absence of buy and sell orders.

Having a market that is not susceptible to manipulation in the same way as centralized exchanges, could very well work as a buffer to make XTZ less manipulatable.

If prices drop or jump at a centralized exchange, prices on a healthy DEX will remain more stable, which results in arbitrage opportunities that will arise due to the lesser volatile nature of LB.

While taking advantage of the arbitrage by selling or buying in both markets and leveling the prices while doing so, the price jumps will be softened, taking out the amount of control manipulating parties can have on the market. 

So ensuring a healthy XTZ market on LB could counter, or at least soften market manipulation.

Volume and current metrics

Volume isn’t a necessity for the main purpose of LB, but it does contribute to the validation of its existence. A high volume decentralized market is definitely something to pursue. And high volume could also move towards neutralizing the added 0.3% inflation that LB brings.

Half of the collected trading fees in XTZ are burned in the LB protocol. This means that 0.1% of all XTZ trade value is burned. If there is enough trading volume, the amount of XTZ that is burned would be equal (or more) to the amount of XTZ that is minted as LB rewards.

Let’s take a look at the current and past metrics so far.

The primary goal is to create a market that has enough capacity, enough depth, to create an entry and exit point for larger investors and to create an arbitrage tool to counter market manipulation.

To be able to provide such liquidity through a DEX, enough liquidity needs to be provided to the liquidity pool.

We can measure that in the amount of total value locked (TVL), which indicates how much XTZ and tzBTC is locked in the LB liquidity pool.

The TVL has been steadily growing since LB has been deployed. 

Source. https://tzkt.io/KT1TxqZ8QtKvLu3V3JH7Gx58n7Co8pgtpQU5/dex?baseCurrency=XTZ&quoteCurrency=tzBTC&tradingTimestamp=daily&tab=TVL 

Volume so far has been variable. The highest daily volume was on 10 September which reached 83 tzBTC, and according to tzkt.io the average daily volume in January was around 10 tzBTC.

That is around $400,000 daily volume, which would rank LB on the 6th place in daily volume rankings of centralized exchanges.

Source. https://coinmarketcap.com/currencies/tezos/markets/ 

Is it worth continuing LB?

LB data shows TVL levels are still increasing. https://tzkt.io/KT1TxqZ8QtKvLu3V3JH7Gx58n7Co8pgtpQU5/dex?baseCurrency=XTZ&quoteCurrency=tzBTC&tradingTimestamp=daily&tab=TVL And with the current attention for LB, interest is unlikely to diminish.

We see some other incentives enter the ecosystem, such as DeFi platform Youves, https://app.youves.com/ which added LB LP tokens as a collateral option on the platform.

This creates another way to earn extra yield for LB liquidity providers. Everything takes time and it would be premature to quit while LB is obviously still in a growth phase. 

Because of the fact that LB incentivizes people to add liquidity, liquidity pool (PL) holders are rewarded with extra XTZ that is minted by the protocol. This adds extra inflation.

This is about 0.3% yearly extra inflation. In a highly volatile market like crypto that doesn’t blink if there’s a 3% price movement in a single day, one would expect that a yearly 0.3% wouldn’t stir much emotions. It is however the single argument to vote against LB in its current form. (I’ll discuss other tokens that could replace tzBTC in the next paragraph) 

The average daily burn has been 129 tez so far. https://tzkt.io/tz1Ke2h7sDdakHJQh8WX4Z372du1KChsksyU/operations/ Daily emission is 7200 tez. So currently 1.8% of the LB inflation is neutralized through trading volume-related burning. Thank you @imthemule https://twitter.com/imthemule for pointing that out.

This means that if we would aim to neutralize the added inflation by increased trading volume, we still have a long way to go. 

Is it worth it? That conclusion is for every person to draw for him or herself.

But again: about 0.3% yearly extra inflation in a highly volatile market like crypto that doesn’t blink if there’s a 3% price movement in a single day, one would expect that a yearly extra 0.3% (0.0008% daily) wouldn’t be enough of an incentive to make too much of a big deal about.

tzBTC and other tokens

BTC reigns the market. It is the currency of the crypto markets. This results in the fact that all crypto is basically valued in BTC. If BTC drops, the whole market drops simultaneously. If BTC pumps, so does the rest of the market.

If we want to create a market that fulfills the purpose of large amount trades and as decentralized market maker tool, then a BTC pair is the only pair that makes sense. 

Would a pair with a fiat-pegged stablecoin be useful? LB does seem to create healthy liquidity faster than any other DEX currently in the ecosystem. So if we would want to create a market for USD or EUR trades, it would be an option. But not while canceling the BTC pair since that serves a broader purpose than any fiat pair. 

If a fiat pair would be added as a second LB, we would see more inflation added though. 

Pros and cons of the different BTC tokens and USD tokens on the Tezos blockchain are covered in the Tezos Commons interview with Arthur Breitman which you can read here. https://news.tezoscommons.org/liquidity-baking-bridging-deep-liquidity-for-tez-3a3a21ccc3b4 

Future improvements

There are quite a few improvements that can be made to increase the success of LB. More publicity, which seems to be covered during the Ithaca voting round. 

LB could get more integrated in the current Tezos DeFi ecosystem through use-cases like the one Youves has just deployed. Also, the minting process of tzBTC could be improved so more people could enter and exit the market in a more convenient manner. User interface could be improved for a better user experience of LB.

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