Continuing the discussion from Cryptsy LP Issues:
Increasing compensation for a low side (possibly together with lowering compensation for the other side) creates a strong incentive for T1 liquidity providers
- to trade funds (from a crowded side) with a higher level (e.g. T3) to receive funds that can be put on the low side or
- to move funds from exchanges which have plenty of funds on that side or
- to use additional funds from their own pocket and put them on T1
Some of the problems we experience with sides (buy, sell) that run dry (or close to is) might be mitigated if compensation for providing liquidity wouldn’t be static.
At the moment there’s mostly a fixed rate compensation (up to x USD volume within the spread are compensated by y%; funds in excess of x USD value compete for the reward).
Fixed cost (pay y USD per side, let LPs compete for it by adding up to x USD volume (NBT, BTC) at a side) is in experimental state and will soonTM be available once the NuBot/ALP integration is complete.
With fixed cost scheme - but with fixed reward scheme - the T1 situation could be improved by adjusting the compensation based on the size of the side.
If the compensation is set to y USD (per minute, day, whatever) supposing that’s enough to have x funds on the side, an adjustment of y could improve the liquidity situation.
Let me take some numbers for x and y to make it more visible.
Say an ALP operates at an exchange.
x = 10,000 USD value on buy side and sell side shall be achieved.
The monthly compensation per side is y = 720 USD (or 24 USD per day; 1 USD per hour or 1/60 USD per minute).
With fixed rate this results in a daily rate of 0.24% per side - until the 10,000 USD value are reached; above 10,000 USD value LPs compete for compensation.
With fixed compensation a daily compensation of 24 USD is paid - no matter how much liquidity is provided; LPs compete for compensation from the first Dollar value.
The fixed compensation scheme provides (hopefully) a stronger incentive to put funds in low walls than the fixed reward scheme does. That’s one of the reasons why some favour this compensation scheme.
Time will tell whether it really works like intended.
But both the fixed rate and the fixed compensation scheme could adjust incentives if the compensation wouldn’t be static.
Say the target for each side is 10,000 USD value.
What would be a reasonable adjustment of compensation if one side is at 15,000 while the other is at 5,000?
Reduce compensation for the crowded side and increase the compensation for the low side! The total compensation might stay the same.
If one side is at 10,000 while the other is at 5,000 it’s not easily possible to increase compensation for the low side by taking compensation from the other side. For situations like that a buffer in the ALP funds needs to be available.
The idea to adjust compensation in a kind of feedback loop from the fill level of the side is possible with fixed rate and fixed compensation as well.
Increasing compensation for a low side creates a strong incentive to trade funds from the other side with a higher level (e.g. T3) to receive funds that can be put on the low side.
If the LP considers the compensation of the “not so low side” as sufficient (and assuming that the LP has more funds which are just not used for liquidity providing), increasing the compensation of the low side creates an incentive to put funds on it without trading with higher tiers.
It also creates an incentive to balance between exchanges, which obviously will only be effective, if the overall T1 situation is balanced, but some exchanges have much more funds on one side, while others have the opposite situation.
In a situation in which the overall T1 is unbalanced, balancing from higher tiers is incentivized.
The conditions under which compensation can/should be adjusted require some discussion.