Adaptive inflation

Adaptive issuance.

For the security of its consensus algorithm, Tezos relies on bakers that place security deposits, equal to about 7.6% of the supply of tez, and attract delegations. Those bakers are compensated for the work they are doing and the bond they lock up by receiving block and endorsement rewards.

But how does the protocol know-how just much to pay bakers? The answer is, it doesn’t. In order to deal with this, a reward is paid, about 4.6% of the supply is distributed as a reward to bakers every year. Note that the security deposit used to be about 10% of the supply and the reward 5.5% but the absolute numbers have not been updated to grow with the supply since launch.

A 4.6% reward paid to people putting 7.6% of stake is effectively a 60% a year return on the stake, before node operating costs. This is a high reward. However, because bakers compete to attract delegations that do determine who gets rewards, much of this return ends up being paid to delegators. Assuming bakers pay about 85% of the rewards to the delegators, and with 75% of the network delegating, that’s about 5.2% reward per delegate against 4.6% inflation. Net-net, this is equivalent to about 0.6% deflation.

The way the network determines how much security costs is via this emergent mechanism of payment to delegators. Look at it as a refund for excess inflation.

There are two ways though in which this isn’t exactly equivalent to deflation:

  1. There are nominal effects at play that make people value rewards even if they are inflationary. This is a true free lunch in the sense that it helps with SoV status.
  2. Depending on jurisdiction, the tax treatment can be unfavorable.

The first is an argument in favor of this model, the second against it.

A few more arguments against it are:

  1. It could potentially create a compliance burden to operator bakeries
  2. It means there’s an opportunity cost to not delegating a tez, which becomes an issue for applications where tez is pooled. ctez solves that problem, but it adds a layer of indirection.

Is it possible to design a system where the cost of security is determined directly, without this mechanism? Yes, and it wouldn’t require a huge change to the codebase, although of course it would have huge consequences on the baking ecosystem and on the economics of tez.

The way this could be achieved is as follow:

  1. Decree that tez at risk (i.e. held as a frozen bond by the baker) carries twice as much block creation right as a delegated stake.
  2. Set the global inflation rate to be (2/(100 x))^2 where x is the global fraction of tez staked (at risk). So if bakers altogether place 20% of the whole supply at stake, the global inflation rate would be 0.5% per year. If they only place 10%, it would be 2% per year to incentivize more stake to be placed, if it’s 30% it would be 0.22% because that’s plenty of economic security and there’s no need to inflate all that much to attract stake.

You can pick any curve you want here, the general idea is to find an equilibrium between amount staked and inflation. If we have a rough idea of the target amount staked, this will generally pick the lowest possible inflation to be around that value.

Of course, this means that delegation and payments to delegates would become a much smaller part of the staking experience. Out-of-protocol custodial arrangements to delegate would become more common as opposed to simple delegation.

There are pros and cons to doing this, but I’m writing it so that there’s a concrete proposal out there that can be debated. I’m often asked about the topic and whether inflation could be smaller. If that’s the goal, this is how to do it. There are some benefits:

  • tax efficiency
  • simpler narrative, no need to explain non-dilutionary inflation
  • better composability of tez for defi
  • can simplify baking

There are some costs:

  • loss of reward narrative
  • changes the role and landscape of delegation
  • no transfer from inactive delegators to active delegators

Personally, I lean towards this being positive on the balance and have for a couple years, but this is a big change to the economics of the chain and it’s worth a thorough think about.

In the meantime, it would still be wise to increase the bond requirement back to over 10% or more, and consider whether to increase back the issuance in conjunction or not.

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I like this and all the pros, but also worry that the values ascribed to cryptos by the masses are done so with such utter lack of knowledgeable consideration for economic models. It feels like retail wouldn’t like the loss of a reward narrative while not “having a fixed supply” or an ethereum-like burning mechanism.

But maybe I (we?) should have more faith in people? Or maybe there’s an optimal time to switch to a new model like this? Does this become a harder sell as time passes, or easier because it becomes about survival as others are first to shore up their models into more sustainable and sensible ones?

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You could do this in conjunction with fee burning which is also potentially more tax efficient. I’ve written about some of the downsides of EIP-1559 fee burning in terms of congestion, but they are less of an issue if the network scales.

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This can make more variations of LB possible? With narrative being less-inflation. Rn few people are against the little inflation introduced by LB.

Composability in defi with tez is lucrative, but how much of the existing tooling has to be upgraded?

Reward narrative has been a nice narrative so far. Could reward narrative can be focused around LB then?

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I like this very, an emission curve instead 42m fixed yearly rewards

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I like that I won’t have to explain to everyone outside the community that the inflation is really not 5% - 6% and that it’s currently less than Bitcoin’s.

Tweeting “#Tezos has less inflation than #Bitcoin. Super duper ultra sound money.” will be fun :wink:

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Can a mechanism that allows third party to bond with a node, not be implemented? Many chains allow this.

@Ali, can you share an example for clarity? I’d love to learn more about this.

Thanks for starting this important conversation. I wonder if you could elaborate a bit on the specifics of your proposal?

  1. Decreeing that Tez at risk carries 2x more weight than delegated stake. Why twice as much specifically?

  2. Same for the formula of the inflation rate – can you elaborate on this specific choice? As a side note, I don’t get your results; if 20% of the supply is at stake, the global inflation rate would be (2/(100*0.2))^2 = 1%, no?

Anyway, I think there are 3 worthy goals of a monetary reform:

  • The real return for bakers should increase (to incentivise more bakers)
  • The real return for delegators should decrease (to incentivise more productive uses of Tez)
  • The total amount of Tez locked up either in baking or delegating should decrease (to reduce excessive inflation)

To my understanding your proposal would achieve all three. Here is a possible downside: is there not a risk of the governance process being captured by the bakers? The interests of bakers are not always aligned with the protocol stakeholders more broadly, certainly not on shorter timelines.

In terms of narrative, if we look at the top 100 coins by market cap, it looks to me like the market is still trying to figure itself out. Recent events have made it abundantly clear that while narrative matters, it is no guarantee for long-term success. As the market matures, narratives are bound to change and adoption is the only certain road to long-term sustainability. All that to say that I feel strongly that Tezos should continue to do what’s best for the chain, as it has always done, regardless of narratives. More prosaically, this for me is precisely Tezos’s strongest narrative. It does not care to cultivate hype. It seeks only to create the best possible chain, technically and financially.

Lastly, some thoughts on fee burning. If the goal of issuance is to find an equilibrium between inflation and the amount staked, then fees being distributed to bakers are a kind of unpredictable factor that can distort this equation. The primary purpose of fees in any case is not to enrich bakers, but to have users pay for the computational cost of their actions on the chain. Burning fees benefits holders of Tez that are not delegating or baking and holders of Tez that are baking or delegating equally, and therefore further incentivises productive uses for Tez. To me this is an excellent idea, and without meaning to contradict my previous thoughts on this, the narrative potential is boundless (Tez is deflationary!).

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Arbitrary, it leaves a place for delegation while shifting the whole system much more towards staking.

The 2 should be outside of the square, typo, my bad.

This can’t be done so long as bakers form a competitive economy.

You can use tez productively while delegating.

This proposal would increase the amount of staked tez.

Thanks for your reply.

Well if I am a baker uninterested in attracting delegation, I would be better off under your proposal, right? Since I’m getting a slightly larger piece of the inflation pie than I would currently? (doubling block creation right as you proposed).

Yes, I did not say that you couldn’t, nor did I mean to imply so. But in reality plenty of Tez locked up in staking is not doing anything else.

I expressed myself poorly there, I meant the sum total of baking + delegation.

I am also wondering how this new proposal affects voting. I am guessing tez will still be delegated to bakers as before but with substantially less rewards. Seems this would cause less people to participate in (or even know about) the voting process and therefore change the community ownership dynamic?

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I’m concerned the influx of delegators seeking to arrange custody deals with bakers would significantly increase bakers’ compliance burden and investors’ third-party risk.

Assuming bakers frozen tez double rewards, how much would delegators rewards reduce by? By half (2.6%)? Or are you suggesting completely eliminating the delegation aspect?

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I am not sure if I understand this part here:

So if I am a successful baker/brand that clients like to delegate to basically my whole effort in establish that trust relationship with clients over the last years is for nothing after this?

Maybe but not necessarily. In this model, the opportunity cost of ignoring baking for regular users largely goes away. A lending market may appear to help bakers put up the extra collateral but it need not involve a very large number of participants.

No, there’s still delegation so it’s not for nothing, but it is indeed less relevant. In this scenario, there’s potentially a misalignment between token holders and bakers. This is unfortunate but the idea should be considered based on its worth for the network as a whole. There can be Coasian payments (e.g. tokenholders to bakers) as part of an agreement.

In this model, the opportunity cost of ignoring baking for regular users largely goes away.

While this is good for 25% of tez holders, it will difficult to sell this to the delegators.

A lending market may appear to help bakers put up the extra collateral but it need not involve a very large number of participants.

This would be great, though I was more talking about the compliance burden of setting up contracts with thousands of delegators.

Wouldn’t this proposal give a monopoly of the inflation supply to the bakers and give delegators less reason to hold their tez for the long term?

I suppose it could increase the demand for tez in one way - people wanting to continue to receive the optimal rewards would need to suddenly acquire 6k to become an active baker.

If bakers received twice as much for tez at risk, would that equate to delegators receive half as much ie 5.85%/2 = 2.925% ?

To be honest this is the only way to go: Cut 42m inflation fixed, make it flexible, the more staking percentage, the less supply printed. Get rid of the unnecessary supply printing

Hey,

So basically a third party can lock in their tokens as a collateral for slashing, however, it is not in control by the node operator, but at their mercy

Hello first post after 7 months, I hope I don’t get censored this time.

I like the idea, but wouldn’t be better if we could stop monetary emission completely (what many here call “inflation”)? And just run baker nodes based on transaction fees as the incentive? If NANO chain survives without transaction fees nor block rewards because people run NANO nodes altruistically without any other incentives except the bag they hodl, because they believe in that crypto, why wouldn’t tezos bakers run baker nodes if there still be the transaction fees as an incentive?

My personal opinion is that we are playing to be the FED, changing the monetary policy every once in a while, now we are making it “dynamic”. Too much uncertainty with Tezos, first inflationary subsidies to fund liquidity baking and now dynamic monetary emission based on network staking percentage…

Bitcoin monetary policy doesn’t change and won’t change in hundreds of years, and that is what it gives bitcoin that trust. Here in tezos, humans can change monetary policy every 3-4 months, we are slowly becoming like the FED, we might rebrand tezos as central bank coin of FED coin.

What I want to see in order for tezos to succeed, is to get rid of monetary emission completely (no more “inflation”), and bakers only running baker nodes to receive transaction fees, and that the bakers stop playing to be the FED, or nobody in this world will take this crypto seriously, given the fact that crypto market is full of people that hate the FED and human intervention in economics.

There should be something, a constitution or whatever you want to call it, that forbid bakers to approve any monetary emission of any kind, no block rewards, no subsidies for liquidity baking, nothing, and bakers agreeing that their only income source will be the transaction fees, that’s what I want to see.

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Most can barely afford to run a (fully delegated) baker and will definitely not do it for nothing. Freaking why? I mean we could pump Tez x100 and I assume a lot of people will do it for the next 100years “for free” but seriously why would you make such an effort for not getting anything? (And the x100 case would not count for new bakers which are important). Believing in something does not buy me bread. Inflation itself is not bad - the cantillon effect is in combination with it. The whole inflation narrative is mostly only showing ignorance imo…

If we change monetary policy we have to find a good mechanism to control and incentivise baker participation for the sake of the network security. It is the ultimate goal.
If we want to integrate another factor I would opt for MiCA2 compliance and the minimum regulatory restrictions in order to let the “raspberry pi guy” effectively bake as the deutsche bank.