The Problem With Token Markets

Today, token launches are problematic and lead to significantly disadvantageous market conditions for investors. The issue mainly originates from the practice of predetermining the supply and distribution of a token prior to launching its market, which often leads to inflated market capitalizations that lack the necessary liquidity to sustain them.

Liquidity serves a crucial role in a market, moderating the capital flow volume without drastically impacting the price. A market with high liquidity allows participants to swiftly and cost-effectively move in and out, creating efficient markets that attract attention, stimulate trading, and foster long-term participation.

However, if a market's liquidity is sparse compared to its total capitalization, it can result in high volatility and less-than-optimal trading conditions. This effect is reflexive; the unpredictability discourages many potential investors from participating in the market, giving market makers fewer reasons to offer their liquidity services to the market—further exacerbating liquidity issues.

To address this issue, projects today often engage market-making firms to provide liquidity in their token markets. However, this approach doesn’t always result in favorable or robust market structures for investors—these firms are third-party entities that operate for their own benefit. They decide when and how to provide liquidity for a token based on their profitability, rather than for the benefit of the holders. This can potentially lead to market conditions that are not necessarily beneficial for the long-term success of the project.

Evolution of Protocol-Owned Liquidity

Blockchain systems have introduced the possibility for entirely new market structures to exist. Due to the programmable nature of on-chain markets, liquidity can be programmed as a core primitive of the token itself: a protocol can effectively make its own market. This paradigm shift dramatically expands the landscape for what is possible in financial markets, and introduces novel mechanisms that can mitigate many of the risks and drawbacks present in traditional markets.

When considering carefully, market makers based on code are more reliable than ones based on humans; algorithms are consistent and unbiased, whereas humans are fickle and self-interested. In a protocol, the rules for liquidity provisioning can be written with the benefit of the holders in mind. If one were to identify a sustainable strategy to do so, it could operate a market with consistently deep liquidity and thin spreads, with zero operational overhead and permanent uptime.

Olympus was one of the first projects to experiment with this idea, pioneering the concept of “protocol-owned liquidity” (POL). In POL, the majority of a token’s liquidity is custodied by the code itself, rather than by external third parties. This gives assurance to token holders that the liquidity conditions of the token cannot be changed arbitrarily, protecting them against "rug pulls” or other scams where the liquidity vanishes.

Olympus was indeed successful at consistently providing deep liquidity for its token, but didn’t factor in token emissions when considering its overall liquidity strategy. Because the liquidity was deployed in a simple Sushiswap xyk pool, the protocol was essentially buying back its tokens at highly inflated prices, incurring deep losses in liquidity over time. Eventually, Olympus could not support its market, leading to its collapse.

Some time later, The White Lotus came along. The White Lotus was a protocol that also owned its own liquidity, but deployed it in a Trader Joe liquidity book with concentrated liquidity bins. Unlike Olympus, the White Lotus was able to provision liquidity at specific prices and depth, creating more the opportunity for more nuanced liquidity strategies. In White Lotus, the protocol would structure its bid-size liquidity by deploying it at two prices: the active trading price to support the current market conditions, and a “floor” price—a calculated price where the protocol could guarantee the ability to buy back its entire circulating supply of tokens. In this aspect, the protocol successfully identified a sustainable bid-side liquidity strategy: throughout its history, the White Lotus was able to buy back every token sold without experiencing insolvency or changing its terms.

Despite successfully identifying a sustainable bid-side strategy, however, the White Lotus only solved half the market-making equation. While it identified a sustainable method to buy tokens algorithmically, it didn't have a strategy to sell them. Unlike the bid-size liquidity, the White Lotus never modified its ask-side liquidity structure as the market developed. Rather, the tokens were deployed a single time upon launch at incrementally higher prices. Once those tokens were purchased at those prices, they were never replenished. This led to a continuously growing bid-ask spread on the market over time, increasing volatility and deteriorating transaction costs.

To address this issue, Jimbo’s Protocol was developed. Jimbo hoped to solve the unaddressed problems in White Lotus by using a liquidity strategy that continuously recycled and redeployed tokens sold back to the Trader Joe pool. By actively redeploying its token liquidity, Jimbo could ensure consistently thin spreads, allowing the market to remain efficient over time.

Unfortunately, soon after launch, this mechanism was exploited, and a significant amount of funds were compromised. Regardless of the hack, however, there were early signs that the strategy to recycle liquidity was not optimal. The Jimbo token was excessively liquid on the upside, requiring significant amounts of capital to move the token's price upwards and obstructing effective price discovery. Although Jimbo correctly identified an unsolved problem in protocol-owned liquidity systems, it failed to provide an adequate solution to fix it.

The Vision of Baseline

After further research and development, Baseline intends formalize the learnings from previous iterations into a generalized system for managing protocol-owned liquidity strategies. In its end state, Baseline will be a smart-contract market maker that algorithmically deploys liquidity across various DEXs for tokens: a permissionless, general-purpose service for algorithmic liquidity management.

If successful, Baseline could revolutionize the way tokens markets are launched and operated.

By integrating token economics directly with liquidity provisioning, Baseline protocol helps projects circumvent the need to pre-determine token distributions and initial market parameters. This means they no longer need to think about token supply, vesting dates, or emissions schedules; nor do they need to deal with market makers, liquidity providers, or their associated incentive structures.

In addition, Baseline offers a native credit facility integrated into its markets, allowing token holders to directly borrow against the protocol’s liquidity reserves by collateralizing their staked tokens. This gives each token in Baseline immediate utility, out-of-the box.

Baseline assures traders that liquidity is deployed by a verifiable, deterministic set of rules—not by people making arbitrary decisions. This improves overall market predictability and helps its participants make more informed decisions when buying and selling the token. In essence, Baseline greatly streamlines the process of launching a token while also creating safer markets for investors and traders.

Mechanisms

Baseline's system is composed of four mechanisms that define the features it provides to market participants. These mechanisms augment incentives and tradeoffs with market actions, helping define clearer expectations around costs and benefits associated with participating in Baseline’s markets. The four mechanisms are:

1. Liquidity Provisioning

2. Staking Rewards

3. Collateralized Liquidity Loans

4. Dynamic Tax Rates

1. Liquidity Provisioning

The first mechanism, liquidity provisioning, is the core mechanism that determines the underlying market structure for the token. The goal is to create a permissionlessly operated market that ensures affordable market transactions, efficient prices, clear risk expectations, and general price stability.

The bid-side strategy of Baseline resembles that of its predecessors, focusing the majority of its liquidity into a single "floor price." The price is calculated as the total available liquidity divided by the total number of tokens in circulation, ensuring that the protocol has enough liquidity to repurchase every circulating token at this price. This establishes a cap for downside market exposure, helping traders evaluate their risk profile and time their entries when engaging with the market.

Any surplus inflows from trading, borrowing, or other market actions that benefit the token are directed towards supporting the market’s bid-side liquidity. For example, protocol income generated from trading and borrowing go to support this liquidity, which means the floor price should only incrementally increase over time, giving holders additional confidence in the market.

Baseline’s ask-side liquidity is directly minted into the liquidity book based percentage of the bid-side's depth; the amount is dynamically adjusted as tokens are bought and sold from the liquidity pool. This ensures the availability of enough liquidity for sellers, allowing a more efficient and fair price discovery process. Importantly, this approach avoids the pitfalls of previous protocols like Jimbo's, which often suffered from excessive liquidity by codifying logic that guarantees that sure the amount of capital required to move a market should increase relative to the the total size of their own POL.

2. Staking Rewards

Staking rewards functions as a mechanism to distinguish between active traders and long-term token holders in Baseline. Staking incentives are an integral part of Baseline's design, offering an additional layer of rewards for long-term participants.

The staking vault aims to offer market participants an alternative means of gaining upside exposure by earning rewards based on market activity rather than price appreciation. In traditional markets, traders can only realize upside in their positions by selling tokens during periods of high market activity. However, in Baseline, a portion of each transaction fee taken by the protocol from every buy and sell order is distributed to the staking vault. This gives stakers upside exposure to market volatility rather than price.

The staking vault's presence also helps discern the intentions of market participants; remaining in the staking vault generally signifies a lack of interest in active token trading. This offers a clearer picture of how the overall market is positioned, providing traders with greater insight into how the market can be expected to behave under certain circumstances.

However, it's important to note that staking is not a permanent action; stakers can withdraw their tokens at any time if they decide to trade them. To deter people from frequently entering and exiting the staking vault, an unstaking fee is applied each time someone leaves the vault. This encourages more long-term staking as frequent entry and exit can quickly become costly and complicates the manipulation of staking interest.

In general, the staking mechanism helps sustain a speculative premium in the token price by reducing sell pressure during periods of high demand. When tokens trade above their floor price in Baseline markets, Baseline yields higher liquidity inflows from its market-making strategy, making the staking vault a vital component of the entire system.

3. Collateralized Liquidity Loans

Apart from earning rewards fees from market activity, staked tokens can also be used as collateral to borrow their floor value directly from the liquidity pool in Baseline markets. This not only provides native utility to the tokens from inception but also results in highly capital-efficient markets: token holders can always realize the minimum underlying value of their token without the risk of liquidation.

Collateralized liquidity loans also eliminate many of the opportunity costs typically associated with trading. Traditionally, traders must choose between accepting the market's current liquidity (selling) or maintaining upside price exposure (holding). In Baseline, however, traders can do both—by borrowing.

Unlike most loans, Baseline does not charge interest on collateralized liquidity loans. Instead, borrowers pay an upfront fee as a percentage of the total loan at origination. This fee contributes to the protocol's liquidity inflows and contributes to the floor price appreciation in the market: more liquidity is added to the market as borrowing volume increases.

Since the value of the collateral cannot decrease and the protocol does not charge interest, borrowers could in theory keep their "borrowed" liquidity indefinitely. To ensure there is an inherent repayment incentive, however, Baseline only allows one loan to be taken at a time, and a loan cannot be rolled or folded.

This compels borrowers to repay their loans before re-borrowing any surplus gains from staking rewards or floor price appreciation from the start of the loan. During times of heavy trading activity, borrowing inflows can be substantial if participants frequently renew their loans. Conversely, when the market is completely inactive, borrowing enables the token to function at minimum as its underlying liquidity.

The borrowing mechanic, when combined with staking, helps create powerful incentives to retain market interest, particularly during periods of low trading activity. This can contribute to the token’s overall longevity and capitalization, fostering its legitimacy and encouraging more third-party integrations over time.

4. Dynamic Tax Rates

The last component of Baseline's system is its dynamic tax rates. Taxes are an important part of the Baseline system; they help moderate market dynamics based on the token’s trading premium, measured by the difference between the token’s active trading price and the floor price guaranteed by the protocol. They also augment the protocol’s liquidity strategy, allowing it to bid tokens at increasingly higher prices. Additionally, taxes are the primary incentive mechanism to reward developers or teams who make early contributions to the token project.

In Baseline, taxes are applied when tokens are bought, sold, borrowed, and unstaked. Rather than a flat fee, however, rates change based on general market outlook. The concept behind using dynamic tax rates is to add an additional lever to moderate market dynamics based on the token’s trading premium, measured by the difference between the token’s active trading price and the floor price guaranteed by the protocol. Essentially, the tax functions as an elastic dampener for market incentives based on current token performance.

During periods of low market premium, Baseline increases buy taxes while decreasing sell, unstaking, and lending taxes. Buy taxes are higher because the risk to enter the market at this point is low; new market entrants in these conditions can always exit with most of their initial cost-basis, assuming the system is functioning as intended.

On the other hand, sell taxes and unstaking taxes are lower during these times because these are when exiting the market creates the least amount of price impact, allowing those who want out of the market to leave peacefully and frictionlessly. This also relates to why lending taxes are lower; borrowing needs to remain as an attractive alternative to selling, so the token can retain its capitalization and market size.

The same principles apply for periods of high premium, but inverse: buy taxes are reduced, while selling, unstaking, and lending taxes are increased. Buy taxes are lower because there is already an inherent risk to buy the token, so adding additional friction would be counterproductive to market interests.

Sell and unstaking taxes are high in order to impose a cost on traders profiting from a market surplus of liquidity. Lending rates also increase during this time, as staking rewards and floor price appreciation are more likely to accumulate swiftly, allowing markets to grow by capitalizing on borrowing demand.

Taxes collected by the protocol are divided into three parts. A portion is channeled back into the market, fueling the growth of the floor price and reinforcing the overall liquidity of the token. This mechanism allows the protocol to continually bolster its own liquidity and stability, creating a more sustainable trading environment for long-term participants.

Another segment of the tax revenue is directed to the staking pool, where it's distributed among the protocol's stakers. This helps establish the alternative incentives mentioned previously in the staking section, allowing long-term holders of a token to capitalize on its trading volume in exchange for price exposure. Staking rewards are ultimately funded by a portion of Baseline taxes.

The final share of the collected taxes is allocated to the Baseline team and associated parties. As there is no initial premine or external incentives for the team, this share of taxes serves as a reward for the initial contributors who invested their time and effort to develop the project. This is a departure from the traditional model of pre-issuing tokens to team members, but ultimately more effective in aligning their long incentives with the long-term success of their projects, as they now are rewarded based on the overall trading activity of their token, rather than being allotted a predetermined amount of equity up front.

Conclusion

With these four main mechanisms, Baseline protocol offers a unique token economy that combines carefully designed mechanisms to create a more balanced and stable market environment. The mechanisms around liquidity provisioning, token staking, collateralized liquidity loans, and dynamic tax rates work in tandem to create an overarching system that promotes the growth of the token in a sustainable way, encourages long-term participation in the ecosystem, and improves its underlying market conditions.

While unconventional and highly experimental, Baseline has the potential to change how tokens are launched, how markets are structured, and ultimately how finance evolves. If successful, we believe Baseline can ignite a new wave of innovation in DeFi, and will be a cornerstone project in crypto over long term.