This article aims to provide a more in-depth introduction to the design of the Bancor protocol and how it has continued to evolve over the years.
Original title: “In-depth analysis of Bancor, is BNT underestimated? 》
Written by: The Way of Defi
In 1944, the proposal of economist John Maynard Keynes ultimately failed to pass at the Bretton Woods Conference, which laid the foundation for the US-centric international monetary system as we know it today. Bancor is a supranational currency created based on the French banque (bank gold”) prototype, and it will be given its initial conceptual form.
In other words, we finally realized Keynes’ idea in 2017. To pay tribute to Keynes’ philosophy, Keynes proposed a universal and neutral accounting unit to settle all international trade and maintain global trade balance. The idea of ​​the Bancor protocol is to use the Bancor Network Token (BNT) as the inheritor of a certain Keynesian philosophy. Here, BNT will serve as the basic trading pair for each token trading pair listed on the Decentralized Exchange (DEX) platform.
This article aims to provide a more in-depth introduction to the design of the Bancor protocol and how it has continued to evolve over the years. One area of ​​special attention is the innovation introduced by the latest Bancor V2.1 released in October 2020 to solve the existing pain points faced by decentralized exchange liquidity providers. In other words, these are the gratuitous losses caused by the difference in the price of the token portfolio, and the losses caused by the forced two-way liquidity staking. Bancor’s solution to these problems has produced a compelling proposal (USP) that market participants have begun to take notice and have promoted the adoption of the agreement in recent months.
1. Automated Market Maker (AMM)
Bancor is the pioneer of the Ethereum Automated Market Maker (AMM) model. Before the advent of AMM, decentralized exchanges had to rely on traditional order-style quotation matching to execute transactions. However, Bancor chose to completely abandon this traditional method and instead use a network of on-chain liquidity pools to pair token pools with each other. Then, users can trade according to the token pairs in these pools, and the transaction price is set algorithmically based on the user’s transaction volume and the depth of the corresponding token pool.
This new market-making method has proven to be a paradigm shift in the field of decentralized exchanges. Now, traders guarantee liquidity on the chain without the need for counterparties through transparent pre-pricing. Token owners can also provide liquidity to the pools of these decentralized exchanges, convert existing assets into productive assets, and earn a return from the protocol swap fees charged for transactions conducted through the platform.
2. BNT
The Bancor token model of the same name is unique among existing decentralized exchanges.
BNT is deeply integrated in the protocol as the basic asset for pairing with ETH and each ERC-20 token (token) listed on Bancor. By using the pair of tokens A/BNT and token B/BNT, any transaction between tokens A and B will pass through BNT as a “connector”: token A -> BNT -> token B, vice versa.
However, this proved to be Bancor’s Achilles’ heel. Those token holders who want to provide liquidity on the platform must obtain a matching amount of BNT before they can enter any token pool. This leads to those holders who cannot directly combine two existing assets to pay capital expenses in advance or redistribute assets. Without the option of unilateral liquidity clauses, market participants have no incentive to use Bancor’s ecosystem by purchasing BNT tokens.
In response to this problem, in November 2018, a competitor named Uniswap quickly appeared. This new AMM decentralized exchange completely eliminates the user’s need for native tokens and allows anyone to establish a liquidity pool between any token and ETH. This reduces user friction and quickly attracts more and more liquidity providers (LP) and traders, thus forming a positive feedback loop. Since then, Uniswap has become the master of the decentralized exchange field, and it has always occupied the largest share of trading volume.
3. A dark horse
Although Uniswap has achieved great success and similar competitors such as SushiSwap are on the rise, the Bancor team still insists on iterating their original products. With the release of Bancor v2.1 in October 2020, the combination of unilateral liquidity supply and gratuitous loss insurance seems to be the proposed USP required to make a breakthrough in the fiercely competitive decentralized exchange field. This is clearly reflected in some indicators, such as the total lock-up volume (TVL) and the increase in transaction volume since the agreement was updated.
Total lock-up amount of the pool
Bancor monthly trading volume
4. In-depth understanding of the code
Bancor’s new model is driven by a new flexible BNT supply mechanism. Flexible supply refers to the agreement’s ability to mint and destroy BNT when needed. Due to the pairing with BNT in all liquidity pools, this situation will only be triggered under certain circumstances.
One-sided liquidity supply
The elastic supply model helps liquidity providers by providing one-sided supply of any ERC-20 token, which is currently not possible with other decentralized exchanges. When choosing to provide one-sided liquidity for a particular token, the agreement will inject matching tokens into the token/BNT pool to provide liquidity for the other party. The newly generated BNT is still in the pool and will be destroyed after the token liquidity provider recharges.
However, before the destruction occurs, it is now possible for other participants to unilaterally provide BNT.
Any BNT balance stipulated in the agreement in the liquidity pool can be replaced by BNT from an external source to meet the demand for unilateral liquidity supply from both the token and BNT. This replacement is achieved through the agreement to destroy the corresponding amount of BNT when the user staking BNT is received.
Using protocol-based BNT for initial liquidity matching is a powerful feature that overcomes the “chicken or egg” problem without diluting the circulating supply of BNT. Any eventual destruction of BNT (whether it is withdrawing from tokens or replacing BNT) will also include the exchange fee share accumulated by the agreement from the pool. As long as the transaction takes place between the coin minting and the destruction event, because the amount of BNT destroyed will be greater than the amount of BNT initially minted, this will lead to a greater shortage of BNT. Therefore, the agreement automatically makes joint investments in itself (up to a certain limit determined by community governance), and returns the profits obtained to BNT to increase its value.
5. Uncertain loss insurance
Most importantly, the flexible supply of BNT creates the possibility of agreement free loss insurance. By using BNT to compensate for any gratuitous losses experienced in the pool, coverage is achieved when liquidity is recovered. Similar to unilateral liquidity provision, competitors such as Uniswap or SushiSwap cannot provide this feature. The BNT used for this purpose first comes from the swap fee earned by the agreement (from the BNT of the co-investment), and will only be used as a guarantee measure when the fee reserve is insufficient.
This is especially important for the long-term viability of an LP, because the return on investment sometimes exceeds the profit of the swap fee. Take Chainlink’s token as an example. Its price has increased by 700% from April 2019 to 2020, resulting in a relative loss of value for the liquidity provider on the LINK/ETH pair compared to holding the two assets separately. More than 50%.
In addition, Bancor’s implementation has been carefully designed to avoid excessive inflation caused by the payment of impermanent losses. As mentioned earlier, impermanent loss insurance will be “realized” only when liquidity is recovered and there is no claimable expenditure in the middle. Since insurance claims are supported by minted BNT, the cost of providing such insurance is theoretically borne by all BNT holders through dilution. But in practice, this cost has so far been completely covered by the return on the swap fee income of the negotiated investment in BNT.
Judging from the agreement activities from November 2020 to January 2021, for every dollar earned by the agreement, there is only $0.07 in free loss compensation. Please note that this sums up all the free loss insurance costs and the income of the swap fee in the agreement, effectively dispersing the risk of impermanent loss in all liquidity pools. This led to the agreement to provide sustainable and impermanent loss insurance for all LPs participating in the Bancor ecosystem.
6. Impermanence loss
The Bancor team modeled the worst-case scenario for impermanent loss insurance claims, assuming that all LLPs withdraw all liquidity at the same time, with a coverage rate of 100%. It can be clearly seen from the figure below that the inflation caused by all the impermanent loss coverage provided in the implementation agreement only accounts for a small part of the total supply of BNT. It is estimated that if all the liquidity is recovered today, Bancor only needs to achieve complete impermanent loss coverage at about 4.2% of the current BNT supply. Any redemption of BNT will be locked up for 24 hours to prevent LP from making rash decisions.
The system also encourages liquidity providers to make long-term commitments because impermanent loss insurance is granted in a gradual manner. The funds of the liquidity provider will only be guaranteed at a rate of 1% increase per day, that is, the liquidity provider must provide 100 days of liquidity to obtain 100% protection when withdrawing funds. There is a period of at least 30 days before the impermanent loss insurance starts to take effect, so if the liquidity is withdrawn early, no insurance will be provided.
Currently, no other index on the market provides a similar solution for mitigating impermanent losses.
The distribution of SushiSwap native tokens to liquidity providers can be used as an indirect method to offset impermanence losses, but this is not a targeted solution, and the distribution rate is not affected by impermanence losses in any way. THORChain chose to use Bancor design, but the impermanent loss coverage is covered by the limited agreement reserve. Purchasing token options used to provide liquidity is another viable strategy, but it is not friendly to beginners and depends on the liquid option market available for the tokens involved.
In view of the increasing price volatility of various encrypted assets, impermanent loss insurance will help alleviate the main concerns that prevent more users from becoming liquidity providers. With the impermanent loss coverage guaranteed by the agreement in place, with the acquisition of swap fees, the positions of all liquidity providers will only face potential upside risks over time.
7. Liquidity Black Hole
It is worth reiterating that impermanent loss insurance and one-sided liquidity also apply to BNT’s liquidity supply. This has a good synergy with Bancor’s ongoing liquidity mining incentive mechanism, because BNT rewards can be directly invested in the liquidity pool. The incentive of compound interest rewards for BNT stakeholders will help strengthen the depth of the agreement’s liquidity pool, while doubling as a supply pool, minimizing the phenomenon of “mine collapsed”. As of March 2021, 78% of BNT’s rewards to liquidity providers have been re-staking.
Due to the co-investment restrictions of the BNT agreement, this also helps to ultimately increase the overall size of the pool.
Since the new univariate BNT is provided to the pool, which further replaces the BNT that has been generated in the agreement, there is more room for the liquidity of the token. The symbiosis here is obvious, and token holders are rewarded for their contribution to the overall functional strength of the platform.
In addition, Bancor’s liquidity is highly concentrated, because each token has only one pool on the platform-token/BNT. The token/token pair introduced by Uniswap V2 often leads to the dispersion of available token liquidity into shallower pools (such as token/ETH, token/USDT, token/USDC, etc.). Greater liquidity results in an increase in transaction volume due to lower slippage, which in turn charges higher fees to investors holding BNT, ultimately making BNT more attractive for purchases and re-staking of agreements.
8.Banco Vortex
Bancor’s latest product, Bancor Vortex, raises the utility and capital efficiency of BNT to a new level. It unlocks a whole new range of possible use cases for vBNT tokens. vBNT is Bancor’s governance token, minted by a unilateral supply of BNT liquid assets, and the tokens obtained by liquidity providers representing% ownership of the pool are doubled. Through Vortex, a BNT/vBNT liquidity pool was created, which allows BNT participants to exchange their vBNT for more BNT. This is actually a no-interest and no-liquidation leverage, with an upper limit of 1 time. The extra BNT obtained by the user can be exchanged with any supported token or deposited into the agreement as a form of leveraged mining.
In the end, users only need to buy back the initial number of vBNT positions (plus accumulated fees) through the same Vortex pool to unlock them. It should be noted here that any debt that uses Vortex as incremental leverage is denominated in BNT. If the value of BNT increases, the value of outstanding debt will increase accordingly (in U.S. dollars).
In the near future, the agreement will implement additional swap fees and use these fees for the purchase and destruction of vBNT. This provides continued upward price pressure to offset the impact of vBNT holders exchanging tokens for BNT.
Now let’s take a moment to consider the impact of this design on the circulating supply of BNT. In its current form, the additional utility obtained by BNT liquidity providers can help encourage more participants to use BNT for staking. Once the vBNT repurchase agreement is implemented, it essentially acts as a one-way bridge, depositing BNT into Vortex, and gradually absorbing more BNT over time.
When predicting the long-term impact of this continued repurchase activity, things become even more interesting. The total supply of existing vBNT is less than the BNT that produced it, leading to the hypothetical situation that 1 vBNT> 1 BNT. This creates an arbitrage opportunity where anyone can buy BNT, deposit it in any liquidity pool to make BNT at a 1:1 ratio, and sell it to Vortex to obtain more BNT than originally purchased. With the principal and profit in hand, the arbitrageur will have no incentive to return to the agreement to redeem the deposit of BNT and will leave it in the pool forever. This is another way for Vortex to introduce externally circulating BNT into the agreement and enhance its liquidity reserves.
In the short term, this effect may not be realized because vBNT holders will be encouraged to exchange their vBNT for BNT when the Vortex price anchor tends to 1:1. The closer the exchange rate is to parity, the less risk the user has to take in creating a leveraged Vortex position. In any case, 1 vBNT> and 1 BNT will also cause the agreement to effectively “pay” existing vBNT holders to assume leverage. In any case, the positions obtained using BNT help create “sticky” liquidity and attract more BNT into the Bancor system.
9. Potential disadvantages
We also need to discuss the potential limitations of the Bancor model. The core functions in v2.1 are ultimately subject to the governance whitelisting process, and only approved tokens can benefit from unilateral liquidity supply and free loss insurance, which limits potential growth. Any liquidity mining rewards in the liquidity pool must also obtain the same governance approval and must be renewed after 12 weeks.
New startup projects that have not yet been established are unlikely to be approved on the whitelist. Therefore, considering the inconvenience caused by the acquisition of BNT, these projects have no incentive to increase Bancor’s liquidity.
The stablecoin pool was also found to have contributed significantly to Bancor’s unpaid loss insurance costs. The stronger the market trend in any one direction, the higher the price deviation of any stablecoin/BNT pair.
10. Future Outlook
After establishing the foundation of a full range of automated market makers, Bancor is very optimistic about the future. In the face of fierce competition for market dominance, the Bancor team continues to boldly enter the uncharted territory of decentralized exchange design, differentiate the products they provide, and seek ways to add value to the industry. Market leaders Uniswap and SushiSwap may make a fortune for Bancor’s upcoming series of products:
Original pool: Bancor’s alternative to the SushiSwap Onsen plan, by stimulating the listing of new projects on Bancor, and providing unilateral free loss protection.
Shadow coin stable coin pool: Bancor’s own stable coin exchange pool, which attracts TVL and Curve as a decentralized exchange for the exchange of main stable coins
Layer 2 expansion: Bancor may be the first decentralized exchange to be launched on the Arbitrum mainnet, and the Arbitrum mainnet is scheduled to be released in the second quarter of 2021
Cross-chain expansion: Polkadot Bridge is under construction. This is the first step towards multi-chain in the future, using BNT to route cross-chain exchanges
Further improvements in on-chain governance (no gas voting) and user interface (UI) reforms are a complete transformation since Bancor v2.
Just as Keynes’ vision of Bancor aims to revitalize traditional finance and rebuild the world economy, perhaps we will see Bancor completely reform decentralized finance-establishing itself as the central clearing house for the growing DeFi ecosystem.
