CHIPs discussion phase: Re-designing the Inflation Formula

Hub Proposals CHIPs
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RE-DESIGNING HUB’S INFLATION

Proposed Reform: Integrating Liquid Staking Ratio

Incorporation of Liquid Staking Ratio:

  • Definition: Liquid staking allows ATOM holders to stake their tokens while maintaining liquidity, enabling them to trade or utilize staked tokens without unbonding them.
  • Integration: The inflation rate formula should incorporate a liquid staking ratio (LSR), which is the proportion of ATOMs staked in liquid form versus traditional staking.
  • Rationale: The liquid staking ratio is able to indirectly measure the economic activity in the interchain (the demand for ATOM as a capital).

Proposed Inflation Formula

The proposed inflation formula can be expressed as follows:

  • bondedRatio: The proportion of tokens that are staked (liquid staking included).
  • GoalBonded: The target level of staking (e.g., 66% of total tokens staked).
  • LsmRatio: The percentage of tokens staked in a liquid form (as a % of total stake).
  • InflationRateChange: The base rate of change for inflation (currently set at 1.00)

Note: the square root can be removed but it introduces some interesting non-linear properties.

Including the Liquid Staking Ratio (LsmRatio) in the formula for adjusting inflation dynamically can be rationalized by drawing parallels with traditional finance concepts, specifically liquidity management and fractional reserve banking.

Traditional Finance Equivalent: Fractional Reserve Banking

  1. Liquidity Risk Management:
  • In traditional banking, liquidity management is crucial to ensure that banks have enough liquid assets to meet withdrawal demands. Similarly, in the context of a blockchain network, the LsmRatio represents the proportion of staked tokens that are still liquid (i.e., can be traded or used without unstaking).
  • Rationale: Just as banks need to manage the balance between deposits that are locked up in long-term loans and those that remain liquid for daily operations, a blockchain network needs to balance between tokens that are staked (which provide security to the network) and those that remain liquid. Higher liquidity (LsmRatio) could indicate a greater ability for the network participants to transact and engage in economic activities, but it might also suggest less security if too much is liquid.
  1. Interest Rate Adjustment Based on Reserve Ratios:
  • In fractional reserve banking, central banks often adjust interest rates based on the reserve ratios of commercial banks. When banks hold a lower percentage of reserves (relative to their deposits), the central bank might increase interest rates to encourage more saving and reduce lending, thus lowering liquidity and ensuring financial stability.
  • Rationale: The LsmRatio in the blockchain context is akin to the reserve ratio in traditional finance. If the LsmRatio is high, indicating that a significant portion of the staked tokens is liquid, it might be perceived as a higher liquidity risk. By amplifying the inflation rate of change when the LsmRatio is high, the system allows for a swift adjustment of the monetary policy. Combined with the liquid staking tax proposed by Blockworks, it also incentivizes participants to convert liquid stakes back to traditional (non-liquid) staking, thereby increasing network security when the ratio is too elevated.
  1. Balancing Security and Economic Activity:
  • In traditional finance, central banks aim to balance economic growth (which requires liquidity) and financial stability (which requires sufficient reserves). Similarly, in the blockchain network, balancing liquidity (LsmRatio) with security (bondedRatio) is crucial.
  • Rationale: Including the LsmRatio in the inflation adjustment formula allows the network to dynamically balance these competing needs. If too much liquidity threatens network security, the system adjusts by increasing inflation and imposing a gradual tax on liquid staking, incentivizing more traditional staking (which boosts security). Conversely, if the liquidity is low and the demand for capital is too hot (high ratio of liquid staking), the inflation adjustment will decrease more swiftly, allowing for more efficient monetary policy response.

Conclusion

Incorporating a proposed LsmRatio parameter into the inflation adjustment formula allows the blockchain network to dynamically respond to changes in liquidity conditions, much like how central banks adjust interest rates based on reserve ratios in traditional finance. This approach ensures a balance between maintaining network security and supporting economic activity, reflecting the dual objectives of liquidity management and financial stability seen in traditional financial systems.

As a Cosmos Hub Improvement Proposal (CHIP), we present this initial post as part of the preliminary “discussion phase” in accordance with the CHIP specification process. We invite community feedback on this proposal and welcome insights from core development team members regarding the potential technical challenges and specifications before progressing to the next “signaling phase.”

Proposed Steps Forward:

We welcome feedback from members with economic expertise or familiarity with existing LSM or inflation-related topics, such as @Noam, @effortcapital, @zaki_iqlusion, @Thyborg, @btruax, @StakeLab, and others, who we hope won’t feel overlooked for not being mentioned. Once there is consensus during this preliminary stage—whether in support of the proposed formula or in deciding to reject it entirely—we would suggest moving to the signaling phase. At that point, we plan to present a comprehensive economic model that allows the broader community to explore and understand the potential practical effects if voted for in the on-chain signaling. Only after this step would the topic proceed to the implementation phase and be voted on for addition to the chain.

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Hey Govmos

I feel like you didn’t explain at all what it does. Could you provide quick scenarios that shows what it does? In which proportion/amplitude?

Don’t get me wrong it does look very interesting but the current post just say “hey I propose to add x” but no explanation on how inflation will change. Not everybody can just look at an equation and visualize what it actually do

Including the Liquid Staking Ratio (LsmRatio) in the formula for adjusting inflation dynamically can be rationalized by drawing parallels with traditional finance concepts, specifically liquidity management and fractional reserve banking.

Ok so it adjust inflation in a dynamic way. Could you go a little bit further ?

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You are absolutely correct, and we will update the original post to clarify our thought process. The purpose of the discussion phase is to gather user feedback. Developing economic models to illustrate the potential effects of this modification requires agreement on the proposed formula first. If the community finds this idea worth exploring, we plan to create a simplified financial model to visualize the potential impact. At this stage, we aim to gather feedback from both informed users who can assess the improvement proposal to the formula, as well as from core development teams, who can identify the potential technical complexities and dependencies that may be affected by such changes.

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Hi @Govmos,

Thanks for the initiating the discussion.

While I don’t claim expertise in traditional finance or central bank interest rate adjustments, I’ve come across an explanation that I do not agree with, and that you present as a fact:

From my understanding, the LsmRatio only indicates the current proportion of staked tokens in liquid form, either as LSM shares or staked via a Liquid Staking provider. This differs from the total proportion of staked tokens that could potentially be traded or used without unstaking.

I believe the 25% Global Liquid Staking Cap introduced by the LSM is a more accurate representation of this potential. Even if my staked tokens are illiquid now, the LSM allows me to make them liquid with a single transaction. Only when we hit the 25% cap do staked ATOMs become truly untradeable / unusable without unstaking.

If we’re concerned about excessive liquidity of staked ATOMs, I suggest adjusting the Global Liquid Staking Cap rather than factoring current liquidity into the inflation formula. Indeed, I fail to see how the inflation adjustment would affect how much of staked ATOM is liquid.

Thank you.

Regards,
arlai

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To clarify further, we will break down two key assumptions that may have been overlooked in the initial post, potentially leading to confusion.

The first point relates to the use of Liquid Staking Modules (LSM). It’s important not to limit the vision to the LSM solely for creating “liquid” forms of staked ATOMs. Theoretically, anyone could deploy a smart contract to stake liquid ATOMs on behalf of users and issue a liquid tradable token that transfers ownership under predefined criteria, or via a simple redemption (burn) mechanism for each minted token. In this way, you can effectively create “liquid” staked ATOM without it being reflected in the LsmRatio we proposed.

Now, you might ask how the LSM differs from this approach. Essentially, the LSM enables the minting of liquid staking derivatives, similar to the process outlined above, but the key difference is that it tokenizes existing staked ATOMs rather than staking liquid ATOMs through a smart contract. This distinction is critical because the LSM allows liquidity to be unlocked from existing stakes without waiting for the 21-day unbonding period.

The second point relates to the financial use case of a parameter like the LsmRatio, which represents the “percentage of tokens staked in a liquid form (as a % of total stake).” Since smart contract use cases cannot be tracked, we suggest focusing on the number of LSM shares that have been liquified and measuring their relative percentage against the total amount of bonded ATOMs. This parameter reflects the demand for liquidity originating from existing stake, as opposed to liquid tokens that are subsequently staked by a smart contract. From a user’s perspective, these two motivations likely differ. Using the LSM typically signals an immediate need for liquidity or short-term money market derivative demand, akin to traditional financial systems.

Hence, our comparison with real-world economics: short-term money market funds or near-instant liquidity savings contracts generally yield returns close to central bank base rates. These rates, set by committees like the FOMC in the U.S. or the ECB in Europe, factor in the inflation rate of both prices and money supply. Reverse-engineering this logic, it makes sense to infer a connection between the inflation rate of the money supply and the demand for short-term liquidity, hence the reason why we initiate this proposal.

We hope these clarifications help your better understand the motivation to reflect on the need to introduce an additional short-term liquidity demand parameter in order to speed up the inflation adjustment rate in the formula. We remind everyone that if, and only if, the community deems this proposition viable, we would then consider a fully comprehensive economic model to highlight the effects this would have compared to the current form without the LsmRatio.

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Thanks for your answer.

However, I would like to ask if you could please clarify further your definition of LsmRatio.

Indeed, in my understanding, it included all ATOM staked by Stride, Drop, Persistence, Quicksilver, and any potential smart contract that would stake ATOMs on behalf of users.
The 3.2% ratio that is currently showing on Moonkitt’s Validators page is what I was thinking of when reading your definition of LsmRatio.

If this is not your definition, do you mean that you only count the number of ATOMs that are currently (at a specific time) under the form of Tokenized Shares (using the LSM)?
For instance, at the time I am writing this message, there are 733 Tokenized Shares (haven’t counted the number of ATOM they represent). If I counted the number of ATOMs these shares represent, and divide by the total number of staked ATOMs, would I reach the LsmRatio as per your definition?

Thank you for clarifying.

Regards,
arlai

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This is precisely the point we intended to convey in the initial proposition. The goal here is to assess the technical requirements for the potential upcoming specification period preceding the next proposal with a “signaling phase”. We specifically requested input from developers to confirm which solution is most suitable in terms of protocol specifications.

Based on what we know so far, integrating lsmshares into the formula appears relatively straightforward to implement between the LSM and the x/mint module. In contrast, including all tokenized liquid forms (such as delegations via smart contracts) would likely introduce significantly more complexity. This is why we initially proposed limiting the scope to LSM shares unless developers suggest an alternative solution that yields similar economic outcomes with better feasibility. It’s important to remember that this CHIP is still in the discussion phase.

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I think limiting the scope to LSM shares is irrelevant, because LSM shares do not represent, by far, the total liquid atoms staked.
For example, when you send LSM shares to Stride, they will not hold them as LSM shares, they will redeem it as native stake and mint stAtom for you.
The LSM module considers any interchain account staking as a LST provider, at the moment this is probably correct.
You can use this metric, it is updated by the LSM module, it needs it to disallow the creation of LSM shares if the LST ratio is > 25% of the total bonded atoms.

If I understand correctly, with this new formula minimum or maximum inflation will be reach all the more so faster as the LSM ratio is big, right ?

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Definitions

To ensure clarity, let’s distinguish the two different terms:

  • Total Liquid Staked: The sum of all ATOMs staked in liquid forms, including LSM shares and stakes managed by smart contracts or other chains via ICA. This metric is subject to the Global Liquid Staking Cap (currently 25% on Cosmos Hub). Current values and ratios are available on Moonkitt’s Status page.
  • Total Tokenized Staked Assets: The sum of ATOMs staked specifically as LSM shares, excluding other forms of liquid staking.

From a development perspective, both metrics are queryable through the SDK. Total Liquid Staked can be retrieved via a simple state query, while Total Tokenized Staked Assets requires iterating over all LSM shares, calculating ratios, and summing ATOM values.

Current state

Presently, LSM shares serve primarily as a transitional mechanism for converting “solid staked” ATOMs into liquid forms (e.g., stATOM, dATOM, stkATOM).
This is reflected in current statistics:

  • Only 735 LSM shares exist (1.3% of 54,520 LSM liquefying actions)
  • Total Tokenized Staked Assets: 6,890 ATOM
  • Total Liquid Staked: 7,821,265 ATOM

Hydro’s Potential Impact

Hydro’s introduction will likely provide the first significant use case for holding LSM shares. This is expected to increase both the number of LSM shares and the Total Tokenized Staked Assets.

Should Hydro’s utilization of LSM shares influence the inflation formula? If so, what would be the rationale, considering that Hydro will lock these shares for 1 month to 1 year, making them even less liquid than traditionally (solid) staked ATOMs?

Thank you.

Regards,
arlai

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Thank you for clarifying and defining the terms. We mistakenly assumed that LSM shares would be the easiest data to collect, but after reviewing your post, it appears the opposite is true. Naturally, using the Total Liquid Staked assets in the formula would provide a much more effective monetary aggregate to account for.

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Thank you. Do you agree though that neither of the two definitions I provided earlier aligns precisely with the concept of can be traded or used without unstaking from the initial post?

To clarify:

  1. The Global Liquid Staking Cap (currently set at 25% and adjustable by governance) most closely represents the concept of “staked ATOM that can be traded or used without unstaking.” This cap limits the total amount of ATOM that can be in liquid staking forms.
  2. The definitions I provided earlier (Total Liquid Staked and Total Tokenized Staked Assets) describe different aspects of liquid staking but don’t directly capture the “tradable without unstaking” characteristic.

If the goal is to incorporate into the inflation formula the amount of ATOM that can be traded or used without unstaking, then I would think the Global Liquid Staking Cap would be more appropriate than the previously discussed definitions.

While it’s challenging to draw direct parallels with traditional finance, we shouldn’t modify the inflation change formula arbitrarily. As it stands, I am not convinced of any benefit of including any of the discussed values in the inflation change formula.

Regards,
arlai

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That definition is accurate. The main distinction between the two lies in how the derivative token is created. One is derived from existing staked capital, converting it into a liquid form without requiring unbonding (LSM shares), while the other is generated from liquid capital and then staked (anything outside of LSM shares, like smart contracts).

As you rightly mention, smart contract forms may not always allow asset trading unless specified in the contract. Some contracts do enable the minting of fully tradable derivative shares, but many are designed solely to transfer ownership of the stake under specific conditions defined in the contract code. Therefore, this second form cannot be classified as short-term money or near-instant liquidity savings contracts in the economic sense, as the contract code exclusively governs ownership transfers.

If the idea is to introduce the proposed LsmRatio in the formula, there’s an important community discussion that needs to take place to define the eligible tokens. At Govmos, we believe that the simplest technical solution should be considered if the gap between alternatives is significant. However, if the gap is minor, we would recommend counting the broader liquidity pool. Based on these two principles, our current stance leans toward your proposed Total Liquid Staked: the sum of all ATOMs staked in liquid forms, including LSM shares and stakes managed by smart contracts or other chains via ICA. That said, we remain open to revising this view if further information or community feedback demonstrates that the alternative solution, which only counts LSM shares, is more effective.

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The LSM shares are derived from existing staked capital, converting it into a liquid form without requiring unbonding: I agree, this is correct.

The other (anything outside of LSM shares, like smart contracts) is generated from liquid capital and then staked: I do not agree, there is no evidence supporting this.
For instance, LSTs like stATOM, dATOM, stkATOM, etc. either originate from liquid capital then staked, OR from existing staked capital, initially converted using the Liquidity Staking Module. Although they are not - at the present time - LSM shares anymore, they may originate from LSM shares - in the past.

Then, I don’t see any feedback to my suggestion of using the 25% Global Liquid Staking cap as the best definition of can be traded or used without unstaking from the initial post?
For instance, I have 100 ATOM staked with Pro Delegators in my account. Thanks to the LSM, I can trade / use them without unstaking, as long as the Global Liquid Staking cap is not reached (and of course Pro Delegators have enough validator-bond to allow for my stake to be liquefied).

So the total amount of ATOM that can be traded or used without unstaking is effectively 25% of the total stake.

Thank you.

Regards,
arlai

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You raise a very interesting point. To ensure we fully understand all the complexities within this topic, we suggest scheduling a call to discuss both the technical aspects and the broader context of this reform. Afterward, we could share our mutual conclusions on this forum so the public can benefit from the insights as well. If you’re open to this, feel free to reach out to us via email at contact@pro-delegators.com, and we’ll be happy to arrange a meeting with you at your earliest convenience.

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