Did they Pull the 5.51% Out of their Oven? — Understanding Inflation in the Tezos Protocol

Following our series on the economics behind the Tezos protocol, today’s article is about understanding inflation, what its implications are and why Tezos token holders should avoid hodling their coins.

Note: Before reading this article, I strongly recommend taking a look at the previous ones in our economics series:

  1. Understanding Overdelegation and Self-bond Requirements: https://medium.com/cryptium/is-your-favourite-baker-overdelegated-understanding-self-bond-requirements-in-tezos-bb005a05c609
  2. Introduction to Tezos Proof-of-Stake and Understanding Rewards: https://medium.com/cryptium/hello-admin-when-payout-tez-19fc5e460cce

Finally, note that when writing about PoS Protocols and variants, all “PoS protocols” that suffer from the Nothing-at-Stake problem are excluded from the scope.

Lake Lucerne & Pilatus mountain — VideoBlocks

What is Inflation?

Inflation, in the cryptocurrency space, refers to the increase tokens in circulation in a network, normally measured per annum. Inflation rates vary from network to network. It depends on how many tokens are introduced with every newly produced block, commonly in the form of rewards. As determined by the Tezos protocol, bakers or validating nodes (nodes that satisfy the self-bond requirements and are eligible to participate in consensus) receive rewards from two main tasks: baking and endorsements, which is a way of incentivising infrastructure operators.

As the official documentation indicates, the annual inflation rate of XTZ is ~5.51%.

Is the 5.51% Black Magic? Where does the number come from?

Well, kind of. Nevertheless, if we take a closer look, this value comes from the following parameters:

Baking rewards per block = 16 XTZ
Endorsement rewards per unit = 2 XTZ / endorsement (max)
Endorsers per block = 32 (max)

And the following assumptions:

  • While endorsement rewards could be of value 2 XTZ (if baker with highest priority made the endorsement), value 1 XTZ (if baker of second highest priority made the endorsement) or value 0 XTZ (if neither made the endorsement), in this case I will assume the most optimistic scenario where all endorsements earn 2 XTZ
  • Likewise, I will assume that all 32 endorsement slots are successfully fulfilled per block, so the total endorsement rewards add up to 32 * 2 = 64 XTZ

With these assumptions, the total rewards introduced per block are:

New XTZ per Block = Baking Rewards +  Num. of Endorsers * Endorsement Reward
New XTZ per Block = 16 + 32 * 2 = 80 XTZ

In Tezos, time is measured by cycles.

  • Every cycle equals to 4,096 blocks. There is a minimum of 1 minute waiting time between blocks.
  • Assuming the most optimistic scenario, were the time between blocks is always 1 minute, one cycle lasts a maximum of 2 days, 20 hours, and 16 minutes or 4,096 minutes.
  • This means that a year (525,600 minutes) can introduce a total of 42,048,000 XTZ into circulation (525,600 * 80). The initial coin supply was 763,306,929.69 XTZ, which makes the first year’s inflation rate:
First Year's Inflation = 42,048,000/ 763,306,929.69 = 0,0550866216 (~5.51 %)

What Are the Implications of Inflation for a Tezos Token Holder?

Before some months ago, token holders could buy, sell, spend or hodle. In all variants of PoS, such as LPoS (Tezos), token holders are discouraged from hodling. With PoS networks going into production, there are two new actions that token holders can make: become a validator (a baker on Tezos) or delegate their tokens.

The reason why validating or delegating is suggested is due to inflation: hodling will cause the token hodler to not earn any portion of the rewards introduced with every new block. Following the protocol, bakers are the ones receiving the rewards from successful bakings and endorsements. A public baker (that offers delegation services) commits to distribute the rewards that its delegators are entitled of, proportionally to how much each delegation contributes to the total staked pool of the baker — minus a service fee that varies from baker to baker.

Upcoming Topics

With this article, inflation has been throughly explained, together with why token holders are discouraged from hodling. However, these implications will become more tangible with the upcoming articles, which will give examples with real parameters:

  • Expected Rewards from Solo-Baking
  • Expected Rewards from Offering a Baking Service
  • Expected Rewards from Delegating