Hey Tezzies,
Disclaimer: I think half of you are going to hate this idea. That’s fine, this is more of a test balloon than a fleshed-out proposal. I’d appreciate it if you could fully describe the issues you see.
Liquidity baking is usually described as a way to encourage liquidity, but you can also see it as a money game which encourages tez-holders to remove tez from circulation, potentially improving the spot price. Indeed, LB is very similar to yield farming in traditional DeFi which typically has the same two components:
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A means of encouraging liquidity of the token in question, and
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A means of removing the token from circulation, which tends to increase spot prices. E.g. though an incentivized AMM or a farming pool / pond / etc.
Taken together, 1) and 2) can create a kind of financial perpetual motion machine, where it’s always locally optimal to hodl the token and reap the yields. You can also think of it as a game of Prisoner’s Dilemma, where the high yield means the cost of defecting (selling) is especially high, so everyone tends to cooperate (hodl).
I propose that Tezos take another idea from the DeFi world - incentivized lockups. Like liquidity baking, incentivized lockups can be seen through multiple lenses. On the one hand, they are a naked money game designed to increase the spot price. On the other hand, they are a means of rewarding and encouraging a project’s most loyal members.
Definition
By “incentivized lockup”, I mean a mechanism by which a user freezes / locks their tokens for a certain period, and in return earns an additional reward from the protocol. For Tezos, this could be implemented as increasing rewards for bakers the longer they bake, or perhaps as a timelock contract users could put their tez into which would be paid into by the protocol (LB-style).
Viewed as a money game
Incentivized lockups tend to reduce circulating supply, which tends to increase spot prices. This shouldn’t be true if everyone in the system is a perfectly rational agent constantly computing risk-adjusted returns. The reason it works is that people choose the greedy heuristic of selecting the option which has the highest APR right now, which will be to lock up their tokens.
Viewed as the moral choice
Incentivized lockups provide the protocol with a way of rewarding their most loyal members. Members who are in it for the long-haul and will prove it by locking their tokens are more valuable to Tezos than people who will come and go. Thus, it is only fair that such members get higher rewards.
Notes on implementation
First, please note incentivized lockups could be implemented without having any effect on overall inflation. Basically, we’d replace the ~5% inflation with a tiered system, with some tiers paying below 5% (e.g. no lockup) and some paying above (e.g. lockup for a year).
There are many ways incentivized lockups could be implemented on Tezos. But, I suggest implementing them at the level of baking. E.g. bakers and those delegating to them would get higher rewards the longer they keep their tez locked. Here’s why:
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Baking is designed to be profit-neutral, and there’s some anecdotal evidence that might be a bit too harsh - consider the recent baker exits, especially those that have left to pursue higher yields in DeFi. An additional baking incentive could help.
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Flip side of the coin: If implemented at another level (say in an LB-style contract) it would tend to pull even more bakers away from baking.
Please let me know what you think, especially how the idea could be improved!
