Understanding the Bancor Protocol (and Its Similarties to Bitshares)

I recently came across the Bancor protocol and their whitepaper, and I must admit, it gave me some pause - something I haven't felt since the release of the original Bitshares whitepaper. I don't want to compare the two too much, because the use cases are different. However, just like Bitshares, Bancor works based on an arbitrage mechanism that can be exploited to keep prices stable. I admit that I like such kinds of mechanisms quite a bit, and hence this post.

The Bancor whitepaper does a decent job of explaining the protocol but I'll explain it more simply in this post.

The Core Idea of Bancor

At its core, Bancor is a protocol that provides liquidity to crypto-tokens even without a centralized exchange (or even a decentralized one like Bitshares). Bancor is created on Ethereum, so we'll use that in our explanation. Simply put, the Bancor protocol allows you to buy crypto-tokens for ETH or sell your crypto-tokens for ETH without having any need for an exchange, DEX, counterparties, gateways, etc. It does this by a clever pricing mechanism and a smart contract that holds a reserve of the underlying crypto (for simplicity, we'll just assume that's Ethereum).

The use-case is simple - anyone looking to issue new crypto-tokens. This can be for a very small community - I could issue tokens that sell an hour of my time, for example, to a few of my friends or clients. The advantage of doing this over Bancor instead of issuing my own Ethereum-based ERC20 token, or a Bitshares asset is that there is an inherent price discovery mechanism through the smart contract which makes these tokens instantly liquid irrespective of whether an exchange lists them or not.

We'll discuss the pricing mechanism and how it operates in the next section.

Bancor Pricing Mechanism

The pricing mechanism works in a way that whenever you execute a buy, i.e. convert your ETH into these crypto-tokens, the price increases. You see, there is a fixed price that is determined by the Ethereum smart contract on this conversion ratio, which is set at the onset based on how much the reserves are, what percentage of the total are in reserves, and the total number of tokens.

However, this price isn't static, but dynamic. With each buy or sell, the price floats. If you buy these crypto-tokens by sending some ETH to the smart contract, the price increases. This means the next buy is more expensive for everyone. On the other hand, if you sell some of your crypto-tokens for ETH, you will get it at the stated price. However, the price decreases for everyone, so the next sell would yield fewer ETH. If there are enough buyers and sellers, then an equilibrium is quickly reached and the price stabilizes.

Since this is a beginner guide, I won't cover the math of the price increase and decrease. You can find it on the whitepaper listed above. If there's demand from the community, I can cover that math in another post.

Interaction of Bancor-based Tokens and Exchanges

Things start to get really interesting when these Bancor based crypto-tokens are also listed on an exchange. Now there are two different market prices for the same token - one based on third-party external exchanges and one based on the rate implied by the smart contract. A buyer or seller can use either mechanism to buy or sell these crypto-tokens.

Whenever there are two prices in the market, arbitrageurs come into play. This is similar to how bitUSD or bitBTC maintains its peg even without centralized backing - if there's deviation, arbitrageurs are incentivized to bet in the opposite direction and ultimately the pricing inefficiency goes to zero (or sustains if there are genuine differences between the two mechanisms).

With the Bancor-based tokens, we can also see an interesting mix of play where one of the exchanges is a smart contract and therefore more trustworthy than a centralized exchange. I would expect the price based on the smart contract may be a little higher, just because it is more trustless than an exchange that has counterparty risk. Of course, things get even more interesting (especially if you're an arbitrageur!) if this crypto-token is also listed on Bitshares DEX! Then there is a native smart contract, a decentralized exchange, and several centralized exchanges.

I also believe that due to this inherent arbitrage opportunity, the trading volume for popular Bancor-based tokens will be higher than usual. This may further provide an incentive for newer crypto projects to use the Bancor protocol to issue their tokens instead of just regular ERC20 type tokens.

I think Bancor is providing an interesting play here, and some of the market mechanics are similar to how Bitshares and BitAssets work. I think the Bitshares community would like the project.

Check out their whitepaper and their website to learn more. Let me know if there's demand for a more in-depth look at how the pricing mechanism works, or any other questions you folks may have!