Over the past two years, I’ve had the pleasure of knowing and working with the core team behind Bancor. They’re not only very talented people with integrity, but in case you’re wondering, also a pleasure to work with. Lately, I’ve had the privilege to work intensively on content related to the Bancor Protocol, largely in preparation for their [update: historic, world record setting $152M] token allocation event.
Those qualifications aside, it should be perfectly clear that I’m here representing only myself and my own understanding of Bancor, and it should not be construed that I represent Bancor in any official capacity. I would also like to thank Bernard Lietaer, Arie Ben David, Stephen DeMeulenaere, and Matthew Slater for their help in creating some of the content below.
I hope that what follows will help the community understand the core functionality a bit better, as it can be a bit confusing! As it happens, you really don’t need a computer science degree or finance degree in order to understand what’s happening with Bancor. First, we’ll go through what a Smart Token is in terms of its components. Then, use cases. Finally, some comments on what all this might mean for us moving forward.
Smart Tokens — The Basics
The Bancor Protocol establishes a new class of digital assets, called “Smart Tokens”. These Smart Tokens are “smart” because the smart contracts governing them requires one or more pre-existing token(s) be maintained in a reserve. By holding an easily exchangeable token in reserve, anyone may easily buy into or cash out of a Smart Token at any time. As a function of this capability, Smart Tokens do not need to be traded in an exchange in order to become liquid, nor do they require counterparties with their risks.
Smart Tokens maintain a constant ratio of value between that held in their reserve and the active supply of Smart Tokens in the market through a smart contract and a “Constant Reserve Ratio” (CRR). The smart contract constantly measures the value in reserve against the supply of Smart Tokens in circulation, and establishes a price for exchanging between the two based on the CRR. When a Smart Token is purchased, its price rises; when liquidated, its price falls. In this way, the ratio of value between reserve and supply is maintained over time as value travels into and out of a Smart Token.
The smart contract does more than establish the price, however, by acting as an automated issuer and redeemer of its Smart Token. When a Smart Token is purchased, the value in reserve expands and triggers the smart contract to create and issue new Smart Tokens to the party who made the deposit into the reserve. Conversely, when a Smart Token is liquidated, the smart contract destroys Smart Tokens and credits the party with a corresponding amount of reserve tokens. Again, the ratio of value between reserve and supply is maintained over time as value travels into and out of the Smart Token.
An Illustrated Anatomy of a Smart Token
Smart Tokens can be difficult to grasp as a whole before understanding their components. This guide will help readers develop an understanding of the different elements that compose Smart Tokens and provide some relevant considerations for each. I’ve attempted to map these in a chronological order beginning with a Smart Token’s initialization.
1. Community / Market Purpose
The first essential element is the end user a Smart Token is intended to serve. Without a clear sense of purpose or community, a value instrument exists devoid of any real meaning or functional value.
What problem is being solved?
2. Issuing Authority
Each Smart Token is maintained by the individual, venture, or organization that created it, as well as the smart contract that governs issuance, redemption, and pricing of the Smart Token via its Reserve.
Who makes key decisions?
As every Smart Token must maintain a Reserve, its creators and/or community must capitalize that reserve through a crowdsale of the Smart Token or some other method. The creators must specify what portion of proceeds will capitalize the Reserve.
How is this gaining real buy in from users?
4. The Reserve
A Reserve may be composed of any number of different tokens as its creators wish. Conceptually, anything considered valuable by a community of users could serve as a Reserve; the only practical requirement is that such value must be accounted for as ERC20 tokenized assets.
Example reserves are: tokenized fiat currencies, such as Euro or Dollars; commodities like gold or land; crypto-currencies like Bitcoin or Ether; and/or other Smart Tokens.
What types of tokens best suit this Smart Token’s purpose?
5. Smart Token Supply
Smart Tokens are issued during / after a crowdsale. They may act as currency units for circulation, shares of equity ownership in a company or fund, or may be intended for use as reserves for other Smart Tokens, among a host of other potential uses. See below for use cases in more detail.
What does this token represent as users own & use it?
6. Constant Reserve Ratio (CRR)
The CRR is set upon creation of the Smart Token. 100% CRR is required for certain types of Smart Tokens; others may only require a small percentage of total supply be maintained in reserve for the purposes of maintaining a pool of liquidity for buying in and cashing out. See below for use cases.
What is appropriate for the context & purpose of this token?
Flow of Value & Pricing Basics
This is a step by step walkthrough of what happens when value enters, or leaves, a Smart Token via its reserve tokens where a CRR of 1:2 (or 50%) is in effect. Though no particular unit of account is denoted, it should be understood that the unit measuring value remains constant.
Purchasing Smart Token via Reserve Token
When a user is purchasing a Smart Token:
- They send reserve token to the smart contract; which
- stores this value in the reserve;
- The smart contract calculates the price based on the CRR; and
- issues new Smart Token to the user. In this example, one reserve token yields two Smart Token.
- The Smart Token’s price rises.
Liquidating Smart Token for Reserve Token
When a user is liquidating their Smart Token:
- They send them to the smart contract; which
- destroys Smart Token; and
- in accordance with the price calculated on the basis of the CRR
- credits them with a corresponding number of Reserve Token. In the example, two Smart Token are liquidated into one reserve token.
- The Smart Token’s price falls.
Smart Token Use Cases
A Token Share is what may be seen in the vast majority of ICOs taking place today, where a digital asset is issued in the form of a token in exchange for contributions of capital into a collected pool, venture, etc. These digital assets may convey equity ownership, a claim to profits, or otherwise as defined by the issuer.
The field of social and complementary currencies predates blockchain technology by decades — if not centuries — and offers many exemplary models such as: social currencies that support volunteerism and mutual aid; green incentives offered for reducing carbon footprints and combating climate change; and business oriented loyalty credit schemes which encourage consumers to shop locally rather than with globalized distributors.
A Token Changer holds 2 or more digital assets in its reserve at 100% CRR. By holding ready amounts of these assets, a Token Changer provides a mechanism for exchanging between any two of them; in other words, an automated micro-utility for asset exchange or currency conversion. The Smart Token’s value is determined by the total value of the assets held in its reserve, and grows through fees it might collect from users as they utilize it for conversions.
Advantage 1 — The Bancor Protocol’s price calculation formula ensures that when reserve token A is converted to reserve token B — the price of A decreases and the price of B increases. As on contemporary exchanges, larger transactions will move the price more sharply, causing volatility. Token Changers may remedy this volatility by maintaining sizable reserves.
Advantage 2 — Any standard ERC20 token can be used as a reserve-token, even if it is already traded in other exchanges. In such a scenario, the calculated price of a reserve token and its price in an outside exchange may present a discrepancy. This situation creates an arbitrage opportunity which incentivizes arbitrageurs to restore economic equilibrium, and thus to keep the token changer reserve token prices in sync with their prices on other exchanges.
Advantage 3 — Popular exchanges (such as MtGox and Bitfinex) have been hacked, and hundreds of millions of dollars worth of assets have been stolen from their accounts. Converting one token to another using a token changer does not require depositing funds in an exchange and thus removes the counterparty risk from the process on top of reducing the costs of performing conversions.
Advantage 4 — As is the case with other instant trading solutions, an important additional benefit is that no transaction limits need to be applied due to the decentralized nature of the token changer. While decentralized exchanges offer this benefit as well, Smart Tokens do not rely on trade volume to provide liquidity.
A Token Basket also holds 2 or more digital assets in its reserve with a total CRR of 100%. However, instead of acting in an exchange capacity, it functions similarly to an exchange-traded fund (ETF) or index fund, where the Smart Token represents shares in the portfolio of underlying assets held in its reserve.
Advantage 1 — As prices of any of the reserve tokens rise or fall, so does the value of the Smart Token. Similar to the incentives provided by token changers, arbitrageurs are incentivized to realign the conversion rates with market prices and ensure the proper ratios are kept between the reserves according to their real-time market value. These Smart Tokens enable users to directly hold asset baskets without a financial services provider as an intermediary.
A Network Token is a Smart Token that supplies liquidity to a number of other Smart Tokens. It does this by simultaneously being held as a reserve for other Smart Tokens, and holding those Smart Tokens in its own reserve. By positioning itself between multiple tokens, it acts as an ultimate token changer across its network and becomes a common representation of value present in the network.
Advantage 1 — Network tokens can be useful for those who wish to create multiple and related Smart Tokens for different purposes (e.g. regional network of community currencies, a video game studio with multiple game credits, a group of independent businesses issuing a joint loyalty program). Network tokens make it easy to convert value from one network to another.
Advantage 2 — An additional network token use-case is to interlink a set of token changers, each holding a reserve in the network token and a second reserve in another, standard token. This structure would enable exchanging any token in the network to another, while increasing the demand for the network token whenever a new token changer is created or appreciates.
Advantage 3 — Increased demand for any Smart Tokens in a network increases the demand for their network token, as it is required for purchases of these tokens. Similarly, a rise in the price of a network token benefits the entire network in turn since this price increase is reflected in each Smart Tokens’ reserves.
Summary Advantages of Smart Tokens
- Costs — The only mandatory fees applied by Smart Tokens are the blockchain fees (gas).
- Continuous Liquidity with Lower Risk — A Smart Token may be purchased or liquidated through its smart contract at any time; regardless of its trading volume, and without the need for a counterparty (e.g. an online exchange) with its risks (e.g. hacking/theft).
- Algorithmic Pricing — The smart contract automatically maintains the exchange price between a Smart Token and its reserve token(s), meaning there is a single, real time price for both buying and selling a Smart Token rather than the traditional bid/ask spread.
- Predictable Price Slippage — As a function of the pricing formula, Smart Tokens allow pre-calculation of price slippage for a transaction of a given volume prior to its execution.
- Native Market Depth — While typical crypto-exchanges maintain a market depth of well below 1%, a Smart Token with a reserve of 10% can be compared to an exchange with 10% of the entire supply of a token in its order-book at all times, forming substantial market depth.
Summary Advantages of the Bancor Ecosystem
- Easy Token Creation — Bancor makes creating digital tokens easier, unlocking the long tail of user-generated tokens. These tokens also provide very cheap access to many services that have been prohibitively expensive and/or otherwise inaccessible in the past.
- Modular Toolkit — The Bancor Protocol establishes a single standard that enables multiple use case scenarios for digital tokens. As Smart Tokens are able to hold other Smart Tokens in reserve, they can be used as building blocks for new integrative financial, banking, and monetary solutions that deliver value to themselves and to the ecosystem as a whole.
- Nested Valuation — By holding pre-existing tokens in reserve, Smart Tokens exist in relation to assets with pre-established valuations. Smart Tokens are thus established in terms of the tokens they are connected to, both directly and indirectly in a greater context. The long term evolution of the ecosystem remains open, but with Bancor, networks may design their preference for stability over speculative activity and volatility.
- Connective Framework — Smart Tokens enable very small entities and networks to unite as a collaborative network of networks by helping them share and exchange resources easily without sacrificing individual uniquity.
The Bancor Protocol is establishing not only a new class of digital asset, it is creating the potential for unprecedented creativity and innovation in the realms of money, banking, finance, and trade. While there are certainly many problems that remain in markets and economics, with the Bancor protocol the world is presented with a toolkit for engineering new financial systems which might function in accordance with the values our existing systems seem to have very little regard for. One could say it is as if we have returned to the Bretton Woods Conference, and may now choose freely which proposals we wish to see enacted. We are free to design new global systems which support life, support the earth, and empower people to realize their full potential.