Why Financial Institutions Love Tezos
…they just might not know it yet [3 Golden Reasons]
Tezos is uniquely positioned to become the darling crypto-asset investment for financial institutions. Having spoken with dozens of fund owners and portfolio managers across the finance landscape, and researched every new crypto-asset opportunity on the horizon that financial institutions have been eyeing and vetting for when crypto-winter ends, I can say this with full confidence.
I would define 3 main reasons why Tezos stands poised for a rapid embrace by financial institutions: fork-averseness, staking economics, finance-friendly smart-contract technology.
1. Fork-Averseness | Tezos On-Chain Governance
A blockchain fork can potentially divide a crypto-asset’s supporting communities into sectarian factions, and consequently, divide the crypto asset itself into warring rival coins.
For most blockchains, rather than having a system of governance in which the blockchain’s community legislates as a cooperative united bloc, and its amending changes by the demands of the collaborative community consensus, those disagreements end in bitter divisions; forks.
Tezos is fork-verse because of its on-chain governance — is a leading attribute of what makes Tezos unique, and while offering many advantages, financial institutions will appreciate one particular critical consequence of it more than any other: it obsoletes forking.
To put on-chain governance simply, unlike virtually all other blockchain protocols, in which amendments are designed and built off-chain in a backroom, and then brought to the blockchain’s community for a binary (yes or no) vote, Tezos amendments from proposed concept, to writing, deliberation, voting, and implementation are all done within the blockchain.
It’s no secret that off-chain governance blockchains are fork-prone, leading to the division of once united communities who felt disaffected that certain governance decisions did not go their way. In fact, forks and community divergencies are often established in the block that immediately follows a contested vote.
Some may describe the ‘freedom’ to fork a blockchain as actually a highlight of blockchain ecosystems, in that it can be said to ‘help’ accelerate free-market competitive innovation (and that’s not entirely incorrect). Though, for blockchain technology communities, the forking is ultimately another form of secessionism or sectarian separatism. Such forks often lead to massive damage in the short and mid-run for a crypto-asset.
Imagine if other investments classes behaved the same way. It’s not the same as with planned company breakaways like PayPal breaking off from eBay. Financial institutions do not want to commit millions of dollars in a crypto-asset, only to one day wake up and find the community divided (including developer talent, node operations, and other community members) and engaged in an all-out civil war. Such events can and have severely damaged the market value of once unified assets — sometimes permanently.
On-chain governance is more democratic than off-chain methods because it allows all voices to be heard and for proposals to be vetted and changed through a collaborative process. This enables the innovation of the blockchain protocol to reflect the centrist interests of the community and not the loud and/or powerful voices that represent the extremes.
In Tezos, when a proposal is finally accepted or rejected, this process of cooperation and reconciliation can quell even the most upset actors (leaving them feeling that at least they were heard, and perhaps even got at least some of what they wanted). This dramatically reduces the propensity for ongoing dissent, so much so that any attempted fork would fail to garner much interest from developers or node operators (and this has always been the case with Tezos).
To relate a societal example of how a common court of governing action can quell organized dissent, the majority of terrorist groups have disbanded not through military force, but by being absorbed into the political process.
A financial institution investing millions of dollars in Tezos (XTZ) can rest assured that Tezos will always be a united fork-free ecosystem.
2. Staking Economics | A Harmony of Forces
Tezos’ ‘Liquid Proof-of-Stake’ system is the most participatory proof of stake vehicle on the market. Unlike other Proof-of-Stake blockchains which severely limit the number of financially incentivized node operators, Tezos enables anyone with a fair-sized holding of Tez (XTZ) to operate a node.
This has not only led to Tezos having the most amount of distributed nodes around the world of any Proof-of-Stake blockchain, but it has also incentivized a new sector of entrepreneurial development in ‘self-baking technologies’. We will soon see the number of nodes being added to the Tezos network start to snowball.
As a system of economic machinery, a harmonious relationship exists between the Tezos ‘staking ratio’, the ‘staking reward’ rate and the price of Tezos (XTZ).
An inverse relationship exists between the staking ratio and the staking reward; the higher the proportion of XTZ being staked, the lower the staking reward; likewise, the lower the proportion of XTZ being staked, the higher the staking reward. That inverse relationship is set by the blockchain. It makes sense. The goal is to get everyone staking, so the incentive increases as willingness-to-supply decreases, and vice versa until we hit an equilibrium.
Right now, according to tzscan.io, the staking ratio stands at 81%, meaning 81% of activated Tezos circulating out in the world is currently being staked on the grid.
According to StakingRewards, this gives us a current annual staking reward yield of 7.05% (.59% monthly).
Assuming we had full staking of 100% we’d be at the minimum inflation rate of 5.51% annually.
That means if 100% of all Tezos were being staked, staking will return a blockchain reward of 5.51%. While even that number is higher than the bank rate, and thus perhaps a good investment at any time, a lower staking ratio will always earn higher returns.
We would never actually reach a 100% staking ratio though. While technically it’s possible, it would never actually happen because of the ‘natural’ rate of liquidation by crypto traders, as well as by node operators needing to liquidate some XTZ to pay for labor, utilities, and equipment. As long as bitcoin remains the underlying ‘gold’ of the entire crypto-economy, we can expect the staking ratio to take a bit of a hit when bitcoin drops in price as well (since people tend to, at least momentarily, trade some of their altcoins for cheaper bitcoin)
In the described scenario, we will eventually reach a stable equilibrium what I propose we call the Natural Rate of Staking (NRS), in which we’re below a 100% staking ratio, yet nonetheless which for all intents and purposes have achieved ‘full-staking’. (this is similar to the ‘Natural Rate of Unemployment’ rate described in economics)
Here’s the really cool part: When experiencing NRS, or even with the market speculating that we will soon achieve NRS, it means that almost all circulating Tez (XTZ) is being staked, so there is very little liquid XTZ available for trading.
Thus, XTZ will undergo a scarcity of supply, which will drive the market price of XTZ up.
As the price goes up, Tezos stakers will have more incentive to liquidate (and reap the profits), and consequently, the price will go up until the staking ratio goes down. We’ll drop below NRS.
But then as the staking ratio goes down, we know that the staking reward rate goes up, which will incentivize staking to increase again.
These three forces will continue to affect one another until they stabilize and reach an equilibrium after any given macroeconomic event.
You may be thinking, “Hey, this is like the inverse relationship between the Fed-set interest rates and the stock market right?” Unlike the inverse relationship between interest rates and investment in the stock market (controlled by monetarist economic policy and centralized intervention by the Federal Reserve), this harmonious inverse relationship between Tezos staking ratio and its reward rate is programmatically determined by the hands-off mathematics of the blockchain and the free-market economic supply and demand forces themselves.
Financial firms can find confidence in the growth of their XTZ assets for quite some time. Institutional investors can feel confident in Tezos resilience as an asset in its inherent ability to immediately incentivize actions that would rebalance its economic equilibrium. It’s a beautiful thing.
3. Finance-friendly Smart-contracts
Tezos smart-contract technology is built in a manner and for a purpose that financial institutions will not only understand but will also be the first to utilize. Tezos smart-contracts are the absolute best when it comes to issuing blockchain-based financial instruments.
A chief highlight of Tezos — and what is critically conducive to smart-contract-based financial instruments — is excellence in formal verification, greater than any other blockchain. Formal verification is essential for financial smart-contracts. Financial instruments and their pertaining transactions require a level of arithmetic nuance and assurance of mathematical precision in the execution, that far surpasses that of former blockchain protocols. There is no room for surprises in execution when it comes to financial instruments.
Hence, in choosing a blockchain for the creation of financial instruments on smart-contracts, selecting one that is conducive to formal verification is a no-brainer (and a dealbreaker). When it comes to formal verification, nothing can compare to Tezos.
The Tezos blockchain is built on the mathematician’s choice blockchain programming language — OCaml — and its smart-contracts are written in a low-level assembly language called Michelson, which was invented specifically for the creation of Tezos smart-contracts.
Michelson offers many advantages enabling Tezos high-standard of formal verification. Michelson is functional and strongly typed, with clearly-defined semantics. Michelson smart-contracts are very concise and even human-readable. Developers have been finding Michelson fantastic for catching any bugs or errors when their code is compiled, safely long before launch or use in actual transactions.
For added context, while being disruptive and new, Michelson also happens to manifests the best qualities of an older business coding language that for its advantages still dominates financial systems today(including 95% of ATM transactions daily, 80% of point-of-sale transactions daily, and 43% of baking systems). It would be easy to see Tezos and Michelson replacing much of these legacy systems for better precision and security.
For most types of blockchain based dApps (dApps are blockchain-based applications, all built on smart-contracts) Tezos is still developing suitability for those applications; it’s just not there yet. However, if you’re looking to put financial instruments on smart-contracts, Tezos is the most secure and most mathematically precise — accept no substitute!
So let’s recap — financial institutions love Tezos as an investment asset because:
- It’s fork-averse; there is virtually no risk of fragmentation of the asset nor of the community which supports it, in any sense.
- The incentivization economics of the system play marvelously to weathering macro-economic shocks (and can be metered in real-time).
- The application Tezos through its smart-contracts is uniquely conducive to facilitating and issuing the financial instruments of the future — something financial firms can understand and can profitably use.
For further reading on financial institutions entry into Tezos (XTZ) please read my subsequent article:
Decentralizing the ‘Delegation Service’
How Bakepools form and operate