Ripple CTO Explains Passive Income Potential with XRP

Ripple CTO David Schwartz recently explained the workings of the upcoming XRPL AMM feature with regard to the potential for XRP holders to earn passive income.

Schwartz revealed this in a recent exchange on X. Notably, Panos Mekras, co-founder of Anodos Finance, initially took to X, drawing an analogy as he aimed to explain the upcoming XRPL AMM (Automated Market Maker). 

He likened the AMM to a self-running market stall, where the prices are determined by supply and demand rather than an individual’s influence.

This mechanism automatically adjusts prices based on the trading activity, ensuring a constant flow without manual intervention.

Responding to Mekras, a community member expressed concerns about the risk of losing one’s XRP with the AMM. Schwartz stepped in to allay these concerns.

He emphasized that, as long as the AMM has no bugs, there would be no broken invariant, ensuring a secure investment.

Ripple CTO Breaks Down AMM Workings

Schwartz explained that when users provide liquidity to the AMM by depositing into its pools, they receive liquidity tokens specific to the AMM they contributed to. Schwartz detailed a rather unconventional method to measure the value of these tokens. 

Unless there's a bug or flaw in the AMM implementation, it is supposed be impossible for a particular invariant to be broken. By the (admittedly weird) standard of that invariant, it is not supposed to be possible to lose.

When you provide liquidity to an AMM depositing into its…

— David "JoelKatz" Schwartz (@JoelKatz) January 24, 2024

It involves calculating the square root of the product of the amount of the first and second assets received upon redeeming tokens, divided by the number of liquidity tokens owned.

The AMM’s goal is to increase this calculated value over time, irrespective of the prices of the underlying asset. This approach aims to transform volatility into a consistent increase in the actual value of the tokens. 

This increase would materialize even if the asset’s ending price is the same as its starting price during the period of volatility.

However, Schwartz cautioned that while this minimizes losses in certain scenarios, it does not guarantee absolute immunity to value decreases.

The advantages of this system include the purported impossibility of losing value by the defined metric, the ability to convert volatility into yield, and the opportunity to earn yield by facilitating trades with a spread. Additionally, users may not incur as much loss if the value of one of the underlying assets drops.

On the flip side, the upcoming XRPL AMM could present challenges. Users may not gain as much during asset price increases compared to holding the assets directly. 

There’s no guaranteed yield, and potential losses exist if prices decline. Moreover, there’s exposure to at least two assets, and counterparty risk remains, even with a stable asset like the dollar. Schwartz also noted that a bug could lead to an unexpected incident.

Potential for Passive Income

Responding to a community member’s request for numerical examples, Schwartz provided a hypothetical scenario. His scenario presented a minimal volatility situation where XRP drops from $0.50 to $0.40 and then rises back to $0.50, with a 0.5% pool spread.

In this case, users who initially put 2 XRP and $1 (amounting to $2) in the pool would end up with liquidity tokens worth $1.79 during the drop to $0.40 and $2.0007 during the rise back to $0.50, resulting in a gain despite XRP closing with the price it started with ($0.50).

Schwartz acknowledged the simplicity of this example and highlighted the potential for more gains in scenarios with frequent, smaller price movements. He emphasized that these calculations assume perfect arbitrage without considering the impact of liquidity takers.

Meanwhile, the XLS-30D amendment, which would implement the AMM feature on the XRP Ledger, is on the verge of attaining validators’ consensus. The Crypto Basic revealed yesterday that consensus has hit 60%, with 21 validators voting Yea. This figure is now 62%, with 22 Years.