Tezos is an open-source protocol that represents one of the first “second generation” blockchains focused on building a smart contract platform to facilitate the creation/development of new tokens and decentralized applications. Notably, Tezos is not an EVM compatible blockchain. The protocol is reliant on a “liquid proof-of-stake” (LPoS) consensus mechanism and differentiates itself from other alternative layer 1s in that it is “self-amending,” meaning protocol upgrades are managed through on-chain governance (as opposed to hard forks). While the project remained largely under-the-radar during the early stages of its development and subsequent upgrades from 2018 to 2020, the protocol experienced a surge in usage and notoriety beginning in 2021 as NFTs entered mainstream consciousness. Tezos quickly became a prominent destination for both artists and collectors to issue and trade NFTs in a faster and cheaper environment, relative to Ethereum.
The Tezos white paper was released in 2014 by Kathleen and Arthur Breitman, co-founders who sought to build a protocol that could solve several perceived drawbacks of bitcoin at the time, including network congestion, limited composability for new features and a rigid governance model. Despite its ICO in July 2017, the Tezos mainnet did not go live until September 2018 because of challenges stemming from legal disputes amongst the founders. Since then, the protocol has implemented 10 upgrades to the network via its on-chain governance model, each of which was proposed, voted on, and implemented by the community of XTZ holders (detailed in table 1 below).
This model for protocol upgrades differentiates Tezos from other blockchains in that it inherently avoids hard forks and the potential community fragmentation that can result from hard forks. Instead, the Tezos community achieves consensus for upgrades in a democratic manner, requiring a super-majority quorum of at least 80% of voters (not including the voting power held by the Tezos Foundation). This structure allows the protocol and its community to be unified in their strategic initiatives, while remaining highly adaptable and flexible relative to other blockchains.
Table 1. Historical Tezos protocol upgrades
Name of upgrade
Date of upgrade
Increased the gas limit and lowered the “roll size” from 10,000 XTZ to 8,000 XTZ (min. amount of XTZ required to be a "baker")
Implemented a more robust consensus algorithm (“Emmy+”); simplified smart contract development; refined the delegation process
Increased the gas limit for each block and operation by 30%, allowing developers to run more complex applications; improved the accuracy and security of calculating baking rewards; disincentivized selfish-mining attacks from non-cooperative bakers
Decreased gas costs by adjusting the gas model and reduced storage costs by 4 times
Introduced an “adoption” period into the governance model to allow all stakeholders in the ecosystem a reasonable period of time to prepare for any changes that future proposals might include; introduced key privacy and authentication improvements
Doubled the maximum operation size; introduced more intuitive smart contract writing processes; further refined gas economics
Introduced new incentives for liquidity providers; reduced gas consumption costs; introduced an improved consensus algorithm (“Emmy*”), which reduced block times by 50%
Introduced new features like time-lock encryption, views, caching, and a global table of constants
Introduced an update to the consensus algorithm known as “Tenderbake,” which reduced the minimum number of XTZ required to be selected as a validator from 8,000 XTZ to 6,000 XTZ, facilitating faster finality (only requiring two blocks) and smoother running applications
Introduction of Transaction Optimistic Rollups (TORUs), an experimental implementation of optimistic rollups to enable higher throughput of transactions
Tezos’ token XTZ is primarily used to (1) pay gas fees associated with transactions or smart contract execution and (2) stake validator nodes to secure the network and receive rewards in the form of newly issued XTZ tokens in proportion to the number of tokens staked. Further, XTZ is also awarded to members of the community that propose protocol upgrades that are successfully implemented. Uniquely, Tezos’ on-chain governance system allows stakers of any size to participate in the development of the protocol via pro-rata shares of voting rights. Holders of XTZ can also elect to delegate their voting rights to other “bakers” (i.e. validators or stakers) if they do not have the capacity to directly stake themselves. Currently, a minimum of 6,000 XTZ (or ~US$11,500 at today’s prices) is required to be a validator.
It is important to note that the supply of XTZ is unlimited and there are currently over 904M tokens outstanding. New XTZ is issued as inflationary rewards for stakers and has historically grown in the range of ~4-5% per annum. Therefore, assuming that the entirety of XTZ is not staked at any given time (currently ~74% of all XTZ is staked), stakers and their corresponding delegators can expect their annualized rewards to outpace the issuance of new XTZ (current average APY of 6.12%). That said, holders of XTZ that opt not to stake or delegate their tokens are being diluted by new issuance over time. The market cap of XTZ relative to ETH has steadily declined over the past 18 months, as the outstanding supply of XTZ has risen by roughly ~18% over the same period (compared to the outstanding supply of ETH growing by ~8% over the same period).
Chart 1. Breakdown of the initial XTZ token supply
Usage growth / carving out an NFT-based niche
As previously mentioned, the Tezos ecosystem experienced a meaningful surge in usage in mid 2021 as artists and collectors flocked to the platform to issue and trade NFTs. Driven primarily by the network congestion and resultant exorbitant gas prices on Ethereum, Tezos emerged as an alternative for NFT market participants that offered relatively fast and cheap transactions. The NFT ecosystem relies on a number of different contract calls including minting, listing, delisting, buying and selling – all of which became rather costly on Ethereum in 2H21.
For new and emerging artists (who were unlikely to sell their work for more than the cost to mint the NFTs), it became uneconomical to mint and sell their work on Ethereum at that time. This prompted an influx of organic traction within the Tezos ecosystem – popularizing community-led and art-focused marketplace dApps such as Objkt, Hic Et Nunc (now TEIA), FXHASH and Versum – as creators could more profitably share their artwork and collectors could purchase a higher quantity of NFTs at lower price points. Despite the market cap of XTZ representing less than 1% of the market cap of Ethereum, the number of daily transfers (of positive value) on Tezos represented ~8% of the total on Ethereum at the end of April, up from less than 1% at the beginning of 2021.
Chart 2. Market cap and daily transfers (XTZ as % ETH)
Towards the end of 2021, the groundswell of support for the Tezos NFT ecosystem began blossoming into mainstream notoriety. Several established, well-know generative NFT artists who had previously released their artwork on Art Blocks (the preeminent generative art platform on Ethereum), began minting subsequent artwork on Tezos, specifically the generative art platform called FXHASH. Prominent artists in this subgenre of NFTs such as William Mapan, Casey Reas, and Piter Pasma, among others, decided to migrate their activities to Tezos despite having immense success on Ethereum.
This recognition by the broader artist community was driven in part by the relative efficiency of the Tezos blockchain, but also the tenor/ethos of the Tezos community itself which is largely art-focused and less interested in the realm of hype-driven profile pictures (PFPs) which had become an outsized segment of the Ethereum NFT ecosystem. As a result, the artwork from Tezos-based artists has increasingly been showcased at large-scale digital art exhibitions.
Despite the recent resurgence of the ecosystem, in large part driven by NFTs, the Tezos network and its native token XTZ are not without their own set of challenges. At a high level, the amendable nature of the blockchain could be considered a double-edged sword. On one hand, the adaptable architecture of the protocol allows it to more readily integrate new cryptographic technologies in a cohesive manner that is less likely to fragment the community. Conversely, this structure suggests that the protocol (as well as the monetary policy of XTZ) are unlikely to ossify over time. Therefore, absent a protocol upgrade that limits the ultimate supply of XTZ, it is difficult to gain long-term conviction with regard to the potential value accrual of the token. Considering the rewards for stakers only marginally outpace the rate of annual issuance, it's possible that the primary form of usage of XTZ will be as a medium of exchange as opposed to a store of value.
Another issue is that while the super-majority quorum (at least 80%) required to make protocol changes ensures a unified strategic direction for the network, it also perpetuates a difficult threshold for successful implementation of upgrades. This can at times slow the pace of development. This was arguably the case in the early stages of development from 2018 through 2020, wherein only four total protocol upgrades were implemented. This slower pace of development, while deliberate and conservative, may have contributed to the lack of DeFi activity on Tezos during the 2020 “summer of DeFi.” To date, there remains a minuscule amount of total value locked across Tezos-based DeFi protocols (~US$33M currently, down from ~US$198M at its peak in October 2021). Over the past 18 months, however, this pace has accelerated meaningfully as six total protocol upgrades have taken place.
Further, it is worth noting that although ~74% of all outstanding XTZ is currently staked (or delegated), the number of full bakers crafting new blocks of transactions is only ~400. For context, that means Tezos has roughly 1,000x fewer validators than Ethereum boasts today. That said, the Tezos protocol incentivizes bakers to stake the entirety of their holdings in one address/node, as opposed to splitting their interest across several validator nodes (which is commonplace on Ethereum). Likely a more representative estimate of Ethereum validator operators is the number of unique, synced beacon chain nodes, which currently totals ~4.5k (or 10x the amount of Tezos bakers). Therefore, Tezos developers would argue that while the number of validators is lower in absolute terms relative to Ethereum, their count is perhaps a more concrete representation of discrete individuals working to secure the network.
The conservative ethos of the Tezos development community has historically been focused on moving deliberately, avoiding fragmentation, and allowing the protocol to organically attract new users via usability as opposed to hype-driven financialization. In the eyes of the co-founders, the popularization of various DeFi applications replicated across competing layer 1 blockchains, particularly yield farming protocols, was likely an unsustainable mechanism for onboarding new users. In that sense, the lack of DeFi activity on Tezos could be considered a blessing in disguise, as it allowed the protocol to grow more organically pursuant to its inherent utility in the realm of NFTs.
Faster and cheaper transactions, combined with an ever-growing community of enthusiastic NFT artists and collectors, have allowed Tezos to carve out an important niche in the landscape of competing layer 1 blockchains. That said, while it is likely that stakers will remain economically incentivized to secure the network, simply holding the XTZ token is a dilutive proposition in the context of the token’s unlimited supply. Therefore, it is difficult to handicap the value accrual to the token over the long-term. Nevertheless, the Tezos ecosystem represents a truly differentiated breeding ground for cryptographic technologies and is quickly becoming a more specialized L1 for NFT artists and collectors.