If crypto-economics is all about regulating and promoting economically rational behavior among voluntary contributors, Tezos liquidity baking is a poster child of this concept.  Promoted as one of the key features of the recent Granada network upgrade for Tezos, it is expected to combine the best in Tezos’ existing governance model and a new approach to providing incentives. The goal? To promote the common creation of a public good which is a fancy word for generating as much liquidity for Tezos as possible. A revolutionary experiment or a storm in a teacup?

What Is Tezos Liquidity Baking?

Why liquidity? Well, apart from its general desirability, Tezos aficionados see it as a shortcut to helping their currency achieve “global domination” (their words). So, liquidity baking, in essence, functions as a decentralized liquidity pool for XTZ/tzBTC pair. It involves the creation of a stand-alone single-pair DEX (decentralized exchange) that supports trading with this pair.  Bear in mind that the tzBTC token is backed 1-1 by Bitcoin which should bring some of the much-desired liquidity of Bitcoin to Tezos.

To avoid confusion: despite the reference to the “baking” which usually describes transaction validations on the Tezos network, liquidity baking is not a variance of the same procedure, nor does it include pumping liquidity to Dexter (a decentralized exchange on the Tezos blockchain). It is solely about providing liquidity to the XTZ – tzBTC pair, thus strengthening the overall liquidity of Tezos itself.

How Does It Work?

Liquidity baking is supposed to provide an incentive for the creation of decentralized liquidity involving the XTZ – tzBTC pair. This is done by the minting of a symbolic amount of tez at each block. This amount is deposited to a constant product market maker (CPMM) contract, a concept borrowed from Ethereum. This contract is almost empty at the outset, apart from a small quantity of tez and tzBTC that defines the initial rate. After the contract is deployed on the chain, this amount of tez is credited to it and its default entry point gets to update the stored XTZ pool balance.

This is where it gets interesting, as the amended protocol now increases the pooled tez balance in the CPMM contract by 2.5 tez per block. This is based on the calculation that the minted amount is valued at 1/16^th of the rewards for priority zero block (40 tez per block).

In this manner, it is liquidity providers that get to feed the liquidity pool in exchange for a reward.

They just need to allocate both tokens to the contract and receive redeemable tokens that stand for their contribution to the liquidity pool. This contribution can be reversed by simply returning the redeemable tokens. The catch is that, in this case, they will receive a larger amount of one of the tokens they contributed initially and a smaller amount of the other one if their proportion in the pool has been changed. The same goes for the fees serviced by the trader depending on the proportion of what they have contributed.

In this manner, even the contributors who want to take back their liquidity will ultimately get a larger amount of tez than they initially handed out, since the protocol will reward them with no impact on their stake in the pool.

At the same time, as the protocol increases the tez balance in CPMMs with the creation of new tez per block and drives up the price of tzBTC, more arbitrageurs will trade their tzBTC for tez in the long run.

Finally, an equilibrium is achieved by balancing out the rewards for liquidity providers with those given for regular baking i.e. the amount of 2.5 tez per block will become less attractive as it gets to be shared by too many liquidity providers to stay relevant.

Why Is This Important?

Liquidity baking is a novel concept that still needs to undergo field testing, but it is already getting much attention for its approach to important concepts that go beyond Tezos itself.

For starters, high liquidity in the cryptocurrency market remains a grand prize for many, and those who get to solve this riddle stand to profit much from it. Liquidity is the backbone of every currency and the same applies to cryptos by analogy. Beyond immediate financial benefits, liquidity draws investors, creates the buzz, and builds muscles in a highly competitive world.

In addition, liquidity is essential for cryptocurrency trading. The higher it is, the more both the exchange and the users stand to profit from it. For decentralized exchanges, this could be a game-changer as these operate as intended only if they are supported by sufficiently high liquidity.  The practice has shown that solid liquidity can support trading of smaller value, thus keeping the prices stable. In turn, more stability will allow DeFi to inch towards the mainstream with more confidence and change the perception of blockchain technology in general.

Liquidity baking is a promise of a solution to an age-old problem – how do we make more people add their precious funds to liquidity pools, even if we know that they are aware of their importance in the larger scheme of things. The answer provided by Granada relies on a smart reward-incentive system, based on the solution to the riddle of how to make people do something as a group when no one gets to profit from doing things on their own.

For many, this will also be the evidence of the superiority of Tezos’ approach to governance i.e. its decentralized on-chain component. Whatever may come out of this, liquid baking is still only a part of an experiment – an important one, yes, but still a test. Yet, the fact that it has been agreed upon, launched, monitored and (possibly) stopped if needed, is an important lesson in how we imagine the future of all things blockchain in 2021.

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