Game theory of Liquidity Baking

I would like to start a discussion on the incentives of Liquidity Baking and the game theory involved so we can optimise the results of this tool.

For starters I want to make clear this is not a proposal to change Granada, but an attempt on having a discussion so we can develop a better understanding of the economics involved and we can take optimal decisions in the future.

The questions I would like to see answered in this thread are the following:

For how long should we give subsidy to liquidity providers?

Is it worth it to give subsidy to several asset pairs?

Which asset pairs will have the most positive impact on the tezos ecosystem?

Which is the optimal size for the subsidy?

My point of view:

The size of the subsidy is the amplitude: bigger subsidy = bigger liquidity and greater onboarding of wrapped assets. BUT the relationship isn’t lineal. e. g: there are just few investors willing to provide liquidity to a tezos pair, no matter how big the subsidy. Meaning there is a sweet spot that achieves the best result, this spot is very difficult to calculate theorically and in my opinion the best option is to start small and increase progressively.

Why progressive increase instead of a static reward?

The logistics involved in buying/wrapping a big quantity of assets can take time and the risk involved on providing liquidity to a contract could mean a big investor would prefer to start small to check the safety of the software. Beside that the information can take time to propagate and reach the interested parties.

Now, what about the duration of the subsidy?

With the current implementation I expect the liquidity to grow strongly in the beginning and progressively reach a plateau. After that point the subsidy loses efficiency, it doesn’t increase the liquidity anymore it just keeps it there.

I believe it is a bad idea to pay a subsidy for keeping the same amount of liquidity, at that point the subsidy is generating unnecessary inflationary pressure. If the Idea is to keep the subsidy forever it might be smart to transition to the LB model I proposed on “a better liquidity baking”

In my opinion the best choice is to cut the subsidy once we reach the plateau, but what will happen when the subsidy ends?

Personally I believe a meaningful fraction of the liquidity will stay in tezos, for the simple reason that the actors providing liquidity already went trough the hassle of KYC-ing and wrapping the BTC. A migration to other contracts with higher fees is expected but the desired outcome has already been achieved: a greater supply of wrapped assets and a greater liquidity.

And that brings me to the next point:

It might be a good idea to do LB on one asset pair for a limited amount of time e.g: 6 months, to jump-start liquidity and then jump to the next asset pair (Lugh, tzGold, USDC and wETH come to mind).

Lastly, which are the best assets to LB?

I believe wrapped assets are the natural choice, at the beginning I thought kUSD, being a native asset, could be a good option, but I am not sure anymore, here is why:

Once the incentive ends kUSD can be burned with no friction at all and the liquidity would drop sharply. On top of that because of the mechanics of collateralised stablecoins, having large ovens of kUSD could have the sad consequence of attracting market manipulators seeking to profit from a large scale oven liquidation event.

On the other hand, unwrapping wrapped assets involve friction and because of that the liquidity is more likely to remain in the network.

Example: If I wanted to provide liquidity to Lugh, I would have to have euros, send these to the coinhouse exchange’s Société Generale bank account with the involved KYC, then send the lugh tokens to the contract.

In stark contrast to kUSD this does not generate a honeypot for market manipulators, and it creates a strong bridge for euro holders that could impact positively tez price

Many people complain about the kyc and I agree that for cryptocurrencies it would be preferable to have some kind of decentralised bridge, in that sense ETH might be an easier target than BTC.

I hope we can have a discussion about this topic and this doesn’t end in the usual crickets for tezosagora posts.


The subsidy should correlate fairly closely with the ultimate size of the liquidity pool. Since, in the current proposal, it is equal to 1/16th baking and endorsing rewards, one can expect the pool to be equal to 1/16th total rolls. The reason is arbitrage with baking. While it’s less than that size, being an LP pays a greater return than baking and when it’s greater it pays a lesser return. Modulo some small deviation to account for delegation fees and trading fees.

With that in mind, it’s hard to say what the optimal subsidy is. I think the current proposal is very tolerable from an inflation standpoint, while the resulting liquidity pool will be large enough to drastically affect the economics of tez compared to other cryptocurrencies, create a media event around the wrapping of a large amount of bitcoin, change the risk profile of holding tez for many institutions, and reduce price pressure from their trades.

While I think it will be necessary to continue the subsidy past the current sunset, I hope it won’t be necessary indefinitely. There needs to be demand for tez for people to provide liquidity, but there needs to be liquidity to have greater demand for tez. I see liquidity baking as bootstrapping this. Eventually one hopes there will be enough demand for tez that it’s not necessary to incentivize liquidity providers.

What liquidity baking is not about is providing liquidity to other assets, e.g. tzBTC. An ideal asset for liquidity baking should have a liquid highly capitalized underlying that is as closely correlated with tez as possible, be technically secure, and able to tolerate a sharp increase in supply. At the moment, I think tzBTC best meets those requirements. If something better appears, we can easily change it in a future upgrade, but I don’t think it makes sense to provide a subsidy to multiple pairs since it’s not about supporting the other asset.


We need that triple MM smart contract.

Well, I only brought it up because I can build it fairly easily :slight_smile:

There’s actually quite a bit involved with computing the mean within a smart contract, but the formula is the easy part of contracts like these since it’s straightforward to verify its correctness.


First of all, thank you for chiming in and taking the time to answer.

I agree with everything you said.

*The amount of time it will take to boostrap liquidity is unknown

*LB is about bringing capital into tezos and increase xtz liquidity, and not other pairs.

I would like to elaborate on the dynamics of bringing liquidity vs keeping the liquidity on chain.

I said it before and I will repeat it, I don’t believe it’s a good Idea to use LB to retain the liquidity on chain. Once the tzBTC enters the network we should aim to provide utility to it so it stays inside for other incentives different from the subsidy.

For example, it could be used as collateral in a stablecoin, or used to mint synthetic assets, it could be used in a lending contract or a farming contract, once it has enough reasons to stay here we could tape the subsidy and rotate it to a different asset pair.

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