Today we are going to talk about what Bancor (BNT) is and how does it work. Bancor is a protocol of the DeFi -Decentralized Finance- ecosystem that allows exchanging cryptoassets in an autonomous, censorship-resistant, and “trustless” way.
What is Bancor (BNT)?
Basically, it works as a fully on-chain Automated Market Maker -AMM- type decentralized exchange -meaning it executes all transactions on the Ethereum blockchain. AMMs take care of algorithmically determining the price of tokens – that is, without the need for any market maker to place orders and quotes – and exchanging them automatically thanks to the use of smart contracts.
What differentiates Bancor from most centralized and decentralized exchanges that opt for a model based on order books is that liquidity is provided by thousands of unaffiliated users who deposit their tokens in liquidity pools, and not by professional market makers. Users who choose to act as liquidity providers for the various Bancor markets will receive in exchange a portion of the commissions generated by the transactions processed by the network.
AMM-based DEXs like Bancor are ideal liquidity vehicles for tokens that do not enjoy as high a trading volume as Bitcoin and Ethereum – assets of enormous importance and popularity, which will always find willing buyers and sellers to trade them. The low liquidity of the thousands of native tokens that act as engines for much more modest blockchain projects – often referred to as long tail tokens – makes it extremely difficult to trade them in order-book based models.
In decentralized order-book based trading platforms, counterparties that accept the purchase or sale of an asset are necessary for the exchange to take place. If the order book is not very liquid -something common in certain DEXs or token pairs-, the user interested in executing a trade at a given price may be forced to wait many hours -or even days- for the trade to be completed.
The fact that Bancor uses a collection of formulas and algorithms to calculate conversion prices, as well as a pooled liquidity model controlled by smart contracts, eliminates the need to find a counterparty for swaps – and, therefore, unnecessary waiting. The downside of DEXs based on an AMM model is that they are not very capital efficient-unless the inventory of a particular liquidity pool is large, trades will incur significant slippage.
In traditional financial markets, large financial institutions leverage their large capital reserves to generate returns as liquidity providers. By positioning different price brackets for buyers and sellers in the order books, these market makers earn a difference – known as a spread.
The problem is that in the crypto sector, the vast majority of tokens – 90% of the total – account for only 5% of total market capitalization and 1% of the trading volume. These types of tokens are not profitable for professional market makers, who are used to executing sophisticated liquidity provision strategies through the order books of centralized and decentralized exchanges. AMM-type DEXs, on the other hand, are ideal for launching or boosting the liquidity of these long tail tokens – and in the case of Bancor, we are not referring exclusively to assets confined to the DeFi ecosystem, as its technology has been used to launch community currencies in developing countries, as in the case of the Sarafu Network in Kenya.
History of Bancor Network
Bancor Protocol would be founded in August 2016 by Eyal Hertzog, Galia Benartzi, Guy Benartzi, and Yudi Levi. Although it would establish its headquarters in Zug (Switzerland), it would also have a development center in Ramat Gan, in the Tel Aviv metropolitan area (Israel). In June 2017, at the height of ICO fever, Bancor would launch its BNT token on the market and manage to raise a whopping $153 million – the highest amount to date. Among the funds that would invest in Bancor, Draper Associates and Blockchain Capital stand out.
Bancor would take its name from an international trade balancing currency, proposed in 1944 by E.F. Schumacher and John Maynard Keynes at the Bretton Woods Conference. The team behind the initiative is headed by Bernard Lietaer who serves as chairman of the foundation, while Eyal Hertzog, Guy Benartzi and GuidoSchmit-Krummacher are the other members of the foundation’s board.
Following its successful ICO, Bancor would launch at the end of 2017 version 1.0 of its protocol, accessible through a web app – which would mean the integration of the first tokens eligible for exchange into the platform. A few months later, in the first quarter of 2018, a mobile-friendly wallet would be launched; and shortly after, a fiat gateway would be implemented.
In September 2018, Bancor would expand beyond Ethereum – the original blockchain on which the protocol would be deployed – also allowing the exchange of EOS and POA tokens.
In 2019, Bancor would announce a series of updates to increase liquidity, attract a larger number of developers and introduce governance processes. To achieve the first objective, an airdrop – a distribution – of the protocol’s ETH pool would be made to all BNT holders, who would see their token converted into an inflationary currency – with an initial issuance rate of 0%, but adaptable to the needs of the community. To incentivize the attraction of developers, a grant program would be launched – the first recipients would be PEG Network and CoTrader.
These upgrades would pave the way for version 2.0 of the protocol, scheduled for summer 2020. Bancor v2 plans to integrate a new AMM model integrated with Chainlink – a decentralized oracle system. The goal is to achieve greater efficiency of liquidity pools from a capital standpoint and to eliminate the risk of impermanent loss – a problem that plagues most AMMs – by introducing a system that allows liquidity providers to make deposits with only one type of token – and not two in a 50/50 ratio, as is common in most DEXs of this type.
How Bancor (BNT) works?
Bancor has two main types of users:
- Those who wish to perform decentralized token exchanges, through the multiple interfaces and applications that integrate the protocol as a liquidity provider.
- Those who wish to obtain a return on their idle assets, depositing them in any of the numerous liquidity pools of the protocol, in exchange for commissions.
Users who want to swap one token for another can go to the official Bancor front-end or to any of the DeFi-type applications that integrate it -such as 1inch or Dex.Ag-, and then select both the token they want to sell and the one they want to acquire. Since Bancor works as an AMM, the interface connected to the protocol will not offer an order book with the different bids and asks offered, but will automatically -through an algorithm- calculate the price and the number of tokens the user will receive depending on the size of the position he/she sells.
The second option is in fact one of the features that distinguishes Bancor – and other AMM-type DEXs such as Uniswap – from the vast majority of traditional liquidity protocols. Instead of relying on a few professional market makers who place their orders -bids and asks- in different quote legs on either side of an order book, Bancor employs liquidity pools in which any user can act as a liquidity provider -of the base pair in question- in exchange for commissions.
The liquidity pools are simply smart contracts that autonomously execute trades between users and the contract, based on an algorithm that calculates the price. Each trade processed by a liquidity pool will generate a commission, which will be distributed pro rata among those users who have acted as liquidity providers.
When a user becomes a liquidity provider for a particular pool, he receives a pool token – an ERC20-compliant token – that will represent his pro rata share of the assets deposited in the pool, as well as the fees generated by the pool. Adding liquidity to a Bancor pool is an unpermitted activity – that is, no centralized authority can block or control the process – and very fast to execute, thanks to interfaces such as 1inch that facilitate the operation.
Bancor’s liquidity pools take as their name the market pair they represent – for example DAI/BNT. In general, BNT – the native token of the Bancor protocol – will tend to be the base pair of most liquidity pools; although in some cases, that function will be performed by USDB – a stablecoin backed by BNT. Thus, a user wishing to act as a DAI/BNT pool liquidity provider will need to deposit both tokens in a 50/50 ratio – as we will see, this is something that will change with version 2.0 of the protocol. Once the assets are deposited, the user will receive the DAIBNT token as a representation of his participation -such token will be redeemable for the originally deposited tokens + the fees generated during the deposit time.
It should be noted, however, that the pool tokens of any AMM type DEX, such as Bancor and Uniswap, are subject to a phenomenon called impermanent loss. When depositing tokens in a liquidity pool, the user must respect a 50/50 ratio, which will not be maintained at the time of withdrawal – market movements tend to cause the user to end up receiving a little less of one asset and a little more of the other. If the asset that has shrunk on the balance sheet has appreciated enormously relative to the one that has grown, the investor may have incurred a particular type of loss – as the fees generated may not be sufficient to offset the gain that has not been realized because of the mismatch. This is one of the problems that the forthcoming version 2.0 of the protocol seeks to address.
As we have explained above, there are multiple interfaces that allow adding and withdrawing liquidity, identifying the Bancor pools that offer the best returns, as well as monitoring the commissions generated by the user – apart from the aforementioned 1inch, we can highlight Zerion, Paraswap or Katana Pools.
An interesting aspect of Bancor Network that distinguishes it from other alternatives also based on AMMs, such as Uniswap, is like having a native token acts as a connector mechanism for exchanges between different blockchains, known as cross-chain swaps. Currently, the protocol allows swaps between tokens based on the Ethereum blockchain and tokens based on the EOS blockchain. In a cross-chain swap, the user actually generates two consecutive transactions, which act as follows:
- A first transaction that swaps the original token for BNT, which in turn moves the latter asset from the source blockchain to the destination blockchain.
- A second transaction that exchanges BNT for the target token.
Both transactions must be signed and executed by the user, from the wallet from which he/she is operating in Bancor.
The fact of having a native token -BNT- that must be deposited as the base pair of most liquidity pools, is a smart mechanism that not only enables the execution of cross-chain swaps, but by increasing the demand for the asset and removing it from circulation, increases its price and therefore the liquidity of the markets -generating a kind of virtuous circle.
Bancor (BNT) applications
The second version of the Bancor protocol, scheduled for summer 2020, is a general upgrade to the system, which will include both new functionalities and the evolution of existing ones. This, in turn, will open up a whole new range of applications that will undoubtedly benefit the DeFi ecosystem as a whole.
First, Bancor v2 implements a new Automated Market Maker liquidity pool class, which integrates Chainlink’s oracle pricing system. The use of an oracle allows to anchor the liquidity of the reserves -that is, to keep their relative value constant-, in order to avoid the impermanent loss problem we mentioned before, which affects most AMM type DEXs -such as Uniswap, for example. In theory, this improvement should encourage more liquidity providers to deposit their tokens in the Bancor markets – by allowing them to generate a return by capturing commissions, without fear of losing part of the potential appreciation of one of the assets they deposit.
There are other AMM-type DEXs with anchored reserves that have proven to be successful, such as Curve. The problem is that in most of them, the elimination of impermanent loss is achieved by using mirror assets -tokens that, like stablecoins, maintain a constant price ratio. The Bancor V2 approach is novel because it allows this system to be applied to any type of asset – and not just stablecoins.
Another advantage of the protocol update will be the possibility of providing liquidity with 100% exposure to a single token. As we have explained above, traditional AMMs oblige liquidity providers to deposit the two tokens that make up each market pair -liquidity pool- in a 50/50 ratio. Removing this requirement will undoubtedly further incentivize the provision of liquidity – which can be a great advantage for modest projects that want to get their pools up and running or even launch their tokens into the market.
AMM-type DEXs have often been criticized for being capital-inefficient – they require a large amount of liquidity in order to compete with order book-based exchanges. Bancor V2 integrates a customizable bonding curve – the mathematical curve that defines the relationship between the price and the number of tokens entering or exiting – which allows amplifying the capital efficiency of the markets – liquidity pools. By concentrating liquidity within a given conversion price range, this new curve greatly reduces slippage – the difference between the expected price and the execution price – thus facilitating better conditions for traders.
This greater efficiency in terms of capital is enhanced by the possibility of integrating lending protocols – cryptocurrency loans – into Bancor’s AMM-type liquidity pools. In this way, Bancor’s liquidity providers see their opportunity cost reduced: in addition to capturing the commissions generated by the liquidity pool in which they have deposited their capital, they can obtain an extra return based on the APR that the lending protocols pay to cryptocurrency lenders.
As previewed in the 2019 roadmap, the protocol plans to convert BNT into an inflationary token – with a default issuance rate of 0% per year, but adaptable based on the needs of the community. Inflation will not be a generalized mechanism, but will be specifically targeted to incentivize the provision of liquidity in certain markets/liquidity pools that initially generate little traction – the liquidity providers therein will add to the fees they already capture an inflationary reward in the form of BNT.
To determine the annual issuance rate and how it is employed within the Bancor network – the percentage that goes to each liquidity pool, for example – BNT holders will have the ability to vote through a special platform called BancorDAO – a DAO is a decentralized autonomous organization designed to vehicle governance processes on a blockchain.
The implementation of an inflationary program as a revulsive to generate traction has been successfully tested in Synthetix – a DeFi ecosystem protocol focused on the decentralized issuance and exchange of synthetic derivatives. The idea is that inflation acts as an economic incentive for owners of NBT tokens to become active participants in the network – as liquidity providers – rather than passive holders – who simply wait for their assets to appreciate in value.
Users who are not willing to deposit their BNT in any of the liquidity pools of the network -acting as stakers-, will see the relative weight of their capital diluted with respect to the total money supply -because it will increase due to the effect of inflation. On the contrary, users who do contribute liquidity to the system will gradually increase the relative value of their capital with respect to the total money supply -thanks to the inflationary rewards they will receive. Importantly, the reward distribution model is being carefully designed to prevent inflation from being concentrated in a small number of pools – and thus to achieve a relatively even distribution of gains.
As for the adoption of DAOs, there are numerous examples of DeFi protocols that seem to be pivoting towards such a governance model: MakerDAO, Kyber Network or Aave, to name just a few. Ultimately, transferring the entire decision-making process to a DAO increases the decentralization of the platform, makes it more resistant to censorship and removes the developer company from any legal responsibility for the autonomous operation of the protocol.
Taking into account all the original features of version 1.0 of the protocol, and the new features soon to be introduced by version 2.0, we can list a number of use cases made possible by the Bancor network that are more than obvious:
- First, a liquidity protocol designed as an ideal AMM for new tokens or tokens with modest market capitalizations/trading volumes -long tail tokens. Improvements to the bonding curve and integration with Chainlink in version 2.0 will increase capital efficiency – resulting in reduced slippage.
- Bancor can be integrated as a liquidity provider for decentralized DeFi-like applications, or even for exchanging services – tokenized, i.e. represented in the form of tokens – without the need to rely on external intermediaries.
- Katana Pools is a portal that makes it possible to use the Bancor protocol to create liquidity pools composed of multiple tokens with different relative weights – instead of the traditional model of two tokens and a 50/50 ratio. This system has also been adopted by Balancer Labs and is ideal for designing pools that function as decentralized exchange-traded funds (ETFs).
- Finally, we have mentioned the case of Sarafu Network in Kenya, as an example of the application of the Bancor protocol for the creation of community currencies – as an economic incentive mechanism for people to participate in their local communities, prioritize access to limited resources, and many others.