This is the 2nd version of my interpretation of Jordan Lee’s liquidity model and why it failed. I expanded it so much from the first version that I couldn’t fit it all into one post, so I was forced to create a new thread.
Intro
I’m going to attempt to describe my interpretation of @JordanLee’s liquidity engine model as best as I understand it, however I am not Jordan, so I may be leaving out important things or getting something completely wrong. It is my belief that we’re in the financial situation we’re currently in because we haven’t been listening to Jordan’s guidance on liquidity matters. He did get NuShare buybacks wrong, but I believe most of what he says is correct.
Most of what follows depends on the basic assumption that providing high amounts of liquidity at a tight spread will attract even more liquidity through increased NuBit sales. If Jordan is incorrect about this basic assumption, then the entire article that follows is based on a false assumption. I lack the knowledge necessary to determine whether his assumption is true or false. This is only my attempt at understanding his model based on what he believes and has said in the past.
At different times over the course of this experiment, Jordan has brought up major points with shareholders that give us a glimpse into his vision of the future of Nu. For example, early on he revealed his goal to replace Bitcoin as the intermediary currency for crypto, through providing lots of liquidity. Later on he revealed that Nu is not designed to keep reserves forever, because with a reserve comes counterparty risk that could destroy the system if it ever fell out of our control. Recently though he began speaking of Nu as a “liquidity engine.” I had not heard him use this term until recently, but I believe it ties back into his first point about becoming the intermediary currency for crypto through the provision of deep liquidity.
Jordan’s Quotes on Nu as a Liquidity Engine
Here are all the quotes I could find where Jordan referred to Nu as a liquidity engine…
A Degraded Peg is Not a Peg, but a Tight Peg is Costly
The most important thing to understand is that a degraded peg with a lower buy side is not a peg at all and will cause customers of Nu to lose money when they cash out. This isn’t desirable, so customers would rather avoid NuBits, causing demand to drop like a rock. In Jordan’s words, a degraded peg means we have no peg at all and our liquidity engine is shut off until we return the spread to within normal parameters. A peg is only desirable when it has a tight spread, which offers something useful to the customer without causing loss of money. The counter-argument though is that when the spread is too tight, Nu loses money from our BTC reserve, which is slowly eroded away over time by users who trade NuBits using our buy and sell walls.
So our product is most valuable when it’s provided with lots of liquidity at a tight spread, but it’s also more costly to maintain. If there weren’t enough NuBits burned through transaction fees to cancel out the costs of liquidity provision at a tight spread and Nu couldn’t gain anymore NuBit sales to replenish the reserve with more BTC, the BTC in our reserve would be slowly eaten away until it was gone and the peg would collapse from lack of buy side funds.
How Nu Functions as a Liquidity Engine
This is where the term liquidity engine comes in. Nu starts off by selling NuBits. The BTC proceeds from those sales are placed on the buy wall at a tight spread. The large amount of liquidity provided by this BTC buy wall encourages trading, which over time increases demand for more NuBits, which are then sold on the market. The process repeats with more BTC proceeds being added to the buy wall from NuBit sales. So as NuBits are sold, liquidity increases, which encourages even more demand. This does not go on increasing forever, as Bitcoin’s ups and downs will effect NuBits demand as well. However, after low demand cycles are over, as long as we continue to provide lots of liquidity at a tight spread, NuBits demand will return and it may return stronger than ever before, adding more sales, more BTC and more liquidity to the system. This high liquidity is more powerful than any advertisement we could possibly make for Nu.
This system acts similar to a vehicle engine. @mhps described it well in the quote below…
In other terms, BTC is used to provide liquidity, which acts similar to transmission fluid. Transmission fluid is a slippery liquid that acts as a lubricant for all of the moving parts inside your transmission. In the same way, a high amount of liquidity acts like a lubricant for traders, making it easier for them to trade in and out of NuBits or BTC.
At the same time, the BTC used to lubricate the markets is also used as if it were fuel. It costs money to keep large amounts of liquidity up at tight spreads. BTC is slowly burned up as if it were fuel in order to keep this liquidity engine running at full speed. This can cause the BTC reserve to erode or shrink over time, but the little bit of BTC that is burned in order to provide these tight spreads is more than made up for in the form of increased NuBit demand and sales, which will increase the BTC reserve and liquidity even further. The BTC expenses for maintaining lots of liquidity at a tight spread is a small price to pay for keeping the liquidity engine running, if the end result is the engine picking up even more speed through increased NuBit demand and sales.
At times the engine will slow down due to lower demand because of BTC price swings. We protect ourselves from this by keeping a high tier 4 reserve and through using tier 5 park rates if necessary. If the reserve is high enough, then we won’t need to use parking that much. Tier 6 NSR sales should rarely be used if ever as long as the network is in a healthy condition and has lots of reserves. These upper tiers will continue to be in effect until Bitcoin reverses and NuBit demand picks back up, which causes the liquidity engine to roar back to life.
So in theory, as long as we continue to provide high amounts of liquidity at a tight spread, NuBit demand will continue to increase. It will hit periods of low demand, but when it returns NuBits will become useful to more and more people. Once again, high liquidity and tight spreads cause increased demand and NuBit sales, which adds more BTC to our reserve. A higher reserve means we have more BTC to add as liquidity on our trading pairs. This higher liquidity encourages increased demand and more NuBit sales. The whole thing is cyclical. It’s an engine designed to attract greater and greater amounts of liquidity through the burning of BTC. As liquidity rises, more BTC is gained through increased NuBit sales and is used to continue refueling the engine, which allows it to pick up speed and gain momentum.
Using Liquidity to Scale up the NuBit Money Supply
I believe @JordanLee was describing this process in his post here…
In the quote above, Jordan talks about using liquidity as a tool in order to scale up our network’s money supply through increased NuBit sales. He also says that as the NuBit supply scales upward, Nu’s liquidity costs as a percentage of the total money supply should drop dramatically. In other words, as we use liquidity as a tool to increase demand and sell more NuBits, the amount of liquidity Nu will need to provide as a percentage of the entire NuBit supply will decrease.
In the same quote, he also mentions that the US government and the Federal Reserve don’t pay for liquidity at all, because they have achieved such a large scale in their money supply. It seems as if he is implying here that if the NuBit money supply were to achieve a similar scale, that Nu would no longer need to pay for liquidity as well. I am not quite sure though without a confirmation from Jordan, so I will continue as if Nu will always need to provide at least some liquidity in order to keep the peg.
NuBits as the Intermediary Currency Used in Cryptoasset Trading
At this point, it’s very important to remind you of Jordan’s vision for using the liquidity engine as described above in order to exceed the liquidity offered by Bitcoin and ultimately replace it as the intermediary currency used in the cryptoasset trading market. Here are a bunch of quotes detailing his plan to do this…
As Nu provides liquidity at a tight spread, it will attract more NuBit sales, more BTC and even higher levels of liquidity. This will have the intended result of scaling the NuBit money supply upward. As this process continues and more and more people use NuBits as a trading instrument, the trading volumes for NuBits in terms of dollars will exceed that of Bitcoin’s trading volume. When this happens, NuBits will have surpassed Bitcoin as the intermediary currency used in the cryptoasset trading market.
The Unsustainability of Nu’s Liquidity Engine Without Revenue
While replacing Bitcoin as the intermediary currency used in the cryptoasset trading market would be a significant achievement for Nu, it wouldn’t solve the problem that the liquidity engine model which led to Nu’s rise is ultimately unsustainable in the long-term without some way for Nu to generate actual revenue.
Remember, in order to attract larger amounts of liquidity to Nu through increased NuBit sales, Nu needs to use the BTC it obtains as liquidity at a tight spread. This whole process of generating larger and larger amounts of liquidity in order to scale up Nu’s money supply can be very expensive to maintain in terms of Nu’s BTC reserve. The larger and larger amounts of BTC being brought in through sales is all being slowly burned in order to keep this process of scaling up the money supply going. It’s ultimately unsustainable in the long-term to maintain high amounts of liquidity at a tight spread without finding a way to generate enough revenue to cancel out the cost of liquidity provision. If no model for creating revenue existed, the BTC reserve would eventually burn away until there was none left to support the buy walls. There is also the fact that Nu’s reserve is being kept in a volatile asset, which can do damage to the value of that reserve over time. Now read this quote from Jordan again…
In the quote above, Jordan says that his liquidity engine model is made possible by crypto. I believe he is referring to transaction fees here. As NuBits are voluntarily transacted with on the blockchain by users of the network, transaction fees are required. The fees themselves are burned, which means the supply of NuBits is naturally eroded over time through use of the blockchain. Burning NuBits through transaction fees, thereby lowering the total supply makes final revenue for the network because Nu’s liabilities are reduced as a result.
If there were enough people using the network that the NuBits burned through fees canceled out the cost of liquidity provision at a tight spread, the network would be self-sustainable. However, the major problem is that in the beginning when the network is immature, there are not enough transaction fees to cover the costs of liquidity provision. In fact, most of the trading volume is done off-chain on centralized exchanges, which means fees aren’t charged at all, except for depositing and withdrawing NuBits, which requires actual use of the blockchain.
As far as I understand the model and the problems of low transaction fees in the beginning, there is only one path forward that has a chance of succeeding, and that is to get the liquidity engine running by providing high amounts of liquidity at a tight spread. It needs to be allowed to run at full speed, so that it continues attracting more sales and greater amounts of liquidity. If the engine is purposefully shut off or if shareholders try slowing it down by decreasing liquidity, NuBit sales will stagnate and the entire system will be in danger of collapse. You never want to intentionally stifle the engine and prevent it from doing its job.
As long as we allow it to run at full speed, it will continue to attract greater amounts of liquidity until it reaches a point where NuBits surpasses the volume of Bitcoin. On a scale from an immature network with little transaction fees to reaching the scale of surpassing Bitcoin, transaction fee levels will continue to rise as more people start to use NuBits. Even at the level of surpassing Bitcoin, Nu transaction fees will not be enough to cover the costs of liquidity provision. The primary reason is because at this point, most NuBit transactions will be done on exchanges where no fees can be charged.
If Nu were to reach the scale of becoming the intermediary currency used for cryptoasset trading, then as Jordan says in his quotes above, we will have gained the necessary amount of trust, credibility, liquidity and infrastructure needed to push beyond exchange trading and into the arena of payment processing.
Payment processing would be a gold mine for Nu precisely because on-chain transaction fees will be required for the majority of transactions, as opposed to making no fees by acting as a hedging tool for exchange users. No costly liquidity provision is needed and revenue is generated by people all over the world who use the network for payments. Nu as a payment processor would be even more successful for the mass adoption of cryptocurrency than Bitcoin was because of the price stable nature of NuBits.
Reaching this point may allow the network enough transaction fees to completely cover the costs of liquidity provision at a tight spread on exchanges. Even if it wasn’t enough though, Nu is a business and can create other profit models that don’t rely solely on transaction fees, such as loaning. New and talented people with big ideas to create profit will be attracted to Nu and become shareholders as we start to increase in scale and find more success. Any revenue brought in that exceeds the costs of liquidity provision can be distributed to shareholders as dividends, which will draw even more people to the organization.
While all of this sounds great, the only way to reach this point is if we first prove ourselves in the arena of cryptoasset trading as an intermediary currency. There is no path that allows Nu to skip straight to payment processing. Without proving ourselves first by supplanting Bitcoin as the intermediary currency, we won’t have the levels of trust, credibility, liquidity and infrastructure necessary to push beyond being used as a hedging instrument for traders.
Transitioning Nu to a Zero Reserve Model
Another long-term danger to Nu is keeping a reserve. I will once again refer you to Jordan’s quote, except this time with a different part bolded…
There are numerous problems that come with keeping a reserve. Here are some of them…
- Bitcoin’s price volatility can eat away at the value of Nu’s reserve.
- The reserve needs to be properly guarded by trusted shareholders using multisignature.
- Counterparty Risk - Providing liquidity using Nu’s reserve funds could place the entire system at risk if those funds were stolen through an exchange hack or corruption of the multisig group.
Like Jordan says in his quote above, Nu should only use BTC reserves while the network is immature. A reserve system doesn’t scale well because of the above 3 reasons. That’s why Jordan has advocated for the use of a zero reserve model in order to protect Nu from the drawbacks of keeping a reserve.
A zero reserve model however cannot be sustained without high amounts of transaction fees on the network, which means Nu needs to be mature enough before attempting the transition. In the immature reserve model, NuShareholders use the BTC reserve itself to provide liquidity on exchanges, but in the mature zero reserve model, NuShareholders print NuBits in order to incentivize people around the world to provide liquidity on exchanges using their own funds. The zero reserve model will protect Nu from the drawbacks of holding a reserve, however it can cost more due to the fact that liquidity providers need to be paid enough by Nu in order to make a profit in the face of Bitcoin’s price volatility.
The only way a zero reserve system can be sustainable in the long-term is if the number of NuBits printed to incentivize liquidity operations is equal to the number of NuBits burned through transaction fees from regular users of the network. This zero reserve model can’t be used in an immature state, because there wouldn’t be enough fees destroyed to sustain paying out that many NuBits to liquidity providers. The peg would eventually collapse due to too many liabilities. The amount of NuBits printed for liquidity operations needs to be balanced out by NuBits burned through fees in order for the zero reserve model to function properly, so it would be best to start making the transition after the level of fees generated reaches a high enough point. Whether this can be achieved before reaching payment processor status is unknown. Once fees are enough to support a successful transition, Nu will not only be self-sustainable, it will be free from counterparty risk.
