Two weeks ago, I reviewed options to trade SWAP.HIVE for HIVE at a discount. If you haven't, you probably want to read that article first to understand that the current discounted bridges are not your usual Liquidity Pool. This follow up focuses on improving the technology, while possibly helping to understand the math behind Liquidity Pools.
Before we start, let us note that the BXT Rewards for balancing the liquidity have been strongly reduced as @gerber concluded there is no way to fix one-sided liquidity. I disagree. I mean, I am fine with the reduction (I have never been a fan of that mechanics). I disagree with his conclusion.
Rock Player in Poker
Ever heard of a poker player being referenced as "rock"? It is a tight player only playing the best starting hands. The story behind the term was described by David Sklansky and is different to what you may have expected.
The game of poker is a fight for forced bets (called antes and/or blinds) that are placed before the cards are dealt. Without the forced bets, there is no incentive for a player to make any bets unless they hold the best possible hand. With the forced bets, players can risk their chips trying to win something. The more forced bets (in relation to bets to be made during the game), the more action (as more hands have a decent enough shot at winning often enough).
Texas Hold'em variant is usually played with two blinds, rotating around the table every hand. During a full rotation, you have to post small blind once and big blind (twice the size of a small blind) in another hand.
Once upon a time, someone had the brilliant idea of asking the winner of the previous pot to post the next big blind. On surface, someone winning a pot should not mind that nuisance too much. After a while, someone else came with the outstanding idea to help the winner (busy stacking chips) post their big blind - they grabbed a scotch and taped a few chips together - just enough of them to make up the big blind.
This gadget was called a rock.
The rock only made sense because it never left the action section of the table. Whenever you won a pot, you would grab the other chips and leave the rock in. In the usual game, your rock would have to wait a few hands until it was your turn to post the blind.
Then it clicked together for the smarter players. The rock was not a part of the pot they contested. All they could compete for at the beginning was the small blind. The Rock Game played very tight because the risk of entering the game was not rewarded well.
Back to Discounted Bridges
Poker is cool but we want to swap some HIVE, right? The BeeSwap bridge, I know. Let us sum up the conclusions of the previous post:
- There is a fair market rate for the SWAP.HIVE/HIVE trading pair.
- The rate is kept within 0.99-1.01 range (move out and arbitrageurs start creating/destroying SWAP.HIVE through Hive-Enigne's 1% fee gateway).
- The 0.25% fee alternative only works within 0.9975-1.0025 range (move out and people empty one side disabling any trading).
Big picture is, we need a price discovery mechanism. Liquidity pools are one but they are not really suited for this particular situation.
How do Liquidity Pools Work?
The quick trick to understanding a Liquidity Pool is picturing two bowls. One holds apples, the other holds oranges. I do not know if I should allow you to take an apple if you leave your orange in (because there is no way I can tell without - you know - comparing apples to oranges).
What I can do is to invite the whole town over showing them two large heaps of fruit, telling every one I want the heap of apples to be worth exactly the same as the heap of oranges. That sets the current conversion rate and anyone thinking the current state is offerring a good deal can put in the fruit they want less and take out a corresponding amount of the other fruit.
Why Current SWAP.HIVE to HIVE Bridges are not Liquidity Pools
Right now, people seem to prefer regular HIVE (probably out of the excitement for the upcoming snapshot for 3Speak and Ragnarok airdrops). A heap of 100k SWAP.HIVE and a heap of 100 HIVE can hardly meet the expectation of two equally valued entities. HIVE disappeared because it is currently more valuable but it is not not worth 1k SWAP.HIVE.
We could have reset the pool at 50k each but what if someone wants to convert a thousand? The resulting pool with 51k at one side and 49k at the other sets the conversion rate at 0.96 and even that is way out of the rational borders for the price. You do not raise 100k HIVE capital to allow only trading peanuts.
The Rock Liquidity
What if we crowdfunded 20M Hive for the bridge? Seed the bridge with 10M at each side at watch people run at the currently preferred side. After spending 50k SWAP.HIVE (taking out roughly 50k HIVE), our Liquidity Pool is at 9.95M vs 10.05M which sets the price at 0.99. The run cools down and people start using the default gateway instead as our price is no longer competitive.
Or they do not and instead of being rational, they stubbornly keep firing SWAP.HIVE at us. Well, all we need to do is smile broadly when acepting the order and paying out HIVE. We then run to Hive Engine ourselves to burn the excess SWAP.HIVE at better price and return the resulting HIVE in our pool (pocketing a profit for the shareholders).
Our Liquidity Pool is never going to be more unbalanced than 9.95M-10.05M.
Remember the Rock? If we tape 9.95M fake SWAP.HIVE and 9.95M fake HIVE together, we have a Rock that helps us set the SWAP.HIVE/HIVE conversion rate. It never leaves the table so the money does not have to exist. We do not even have to pretend to have it, we just show the real liquidity and calculate the rate behind the scenes by applying regular Liquidity Pool math to Rock-adjusted numbers. All we need is the 100k to be poured back and forth over the sea level while our imaginary iceberg does the pricing.
Any time the liquidity is removed/added, we just adjust the Rock to be 199-times the actual liquidity. There is a bit more math left beyond the scope of this article (charging a fee means the price stops to be attractive even before reaching the feeless-computed boundary so we can afford even bigger leverage) but yeah - I know this is brilliant.
There is no need to be grumpy about losing 1 % on Hive Engine deposits and withdrawals. If Liquidity Providers are confident in running a 0.25 % fee service, Rock Liquidity Pool is the way to go. All you need to do is drop the 1-1 mindset and treat them as two separately valued tokens.