This is part-2 of our series exploring the new Bancor protocol. You can find part-1 here, where we discussed how the Bancor protocol allows for the proliferation of user-generated tokens while providing the tokens liquidity at the same time through a decentralized exchange on Ethereum via the use of smart contracts (so no counterparty risk like in an exchange).
Here, we discuss how the Bancor protocol can be used for the decentralized token exchange economy not just for newer community-type tokens, but for well-established crypto-tokens on Ethereum as well. We’ll also talk about how this ties into the token asset management space that other projects like Melon and working on.
First, let’s talk about creating a decentralized exchange via the Bancor Protocol.
Decentralized Exchange via Profit Arbitrage
There have been several attempts at creating decentralized exchanges. Many of them rely on external gateways that transfer the assets on the blockchain into ‘real world’ currencies. However, these still have a counterparty risk involved. These include examples like Waves or Bitshares that have a “DEX” (Decentralized Exchange) built into their products, but with the use of external gateways.
However, what Bancor is building is something different. It has the elements of price discovery outside of the decentralized exchange, which then drive the price discovery on the blockchain. The actual exchange mechanism itself is completely decentralized, and doesn’t rely on any external third-party ‘guaranteeing’ assets on the blockchain to be a certain value.
The way this works is through simple price arbitrage. There’s a smart contract that triggers the exchange of one crypto-asset into another. If the relative prices go out of whack by a lot, then arbitrageurs enter the market, and buy the relatively undervalued asset while selling the relatively overvalued asset, while offsetting their positions with the external exchange. This is the key to how the Bancor protocol enables decentralized asset exchange. The smart contract itself has no concept of a price. Instead, the assumption is that the price is determined not by price feeds but by arbitrageurs who have an economic incentive to get the prices in balance, otherwise they can make a riskless profit.
In terms of the actual implementation, like with Token Issuance, there is a certain amount of crypto-assets in reserve. However, these are full reserve as opposed to fractional reserve, and there are two crypto-assets instead of one. Now you’ve created a trading pair. No need of any external exchange.
I believe another important characteristic of the Bancor Protocol is that it enables the creation of new asset pairs that is market determined as opposed to exchange determined. Today, say if you want to use Augur as your base trading pair, you’ll be hard pressed to find an exchange offering you Augur trading pairs. However, with Bancor, you can easily create one by keeping Augur and another crypto-asset fully backed in the smart contract. This way you’ve created an Augur trading pair.
Asset Management and Crypto-ETFs
Another less appreciated aspect of the Bancor protocol is that it enables the creation of crypto-ETF like assets, without any centralized trust component, i.e. only via smart contracts. This will become increasingly important as crypto-assets become a genuine asset class on to themselves. The way Bancor envisions ETFs is the creation of multiple reserve assets in the smart contract, with a 100% backing instead of fractional reserve.
These smart tokens will become an essential part of the portfolio from an investment point of view. Already, companies like Iconomi are working on creating crypto-index funds. However, the ICNX that is created by Iconomi is completely centralized. With the Bancor protocol you can do the same (although for now only with Ethereum-based tokens) in a decentralized manner and just hold units of account in the smart contract that contains the tokens in reserve.
I predict that ‘theme-based’ investing in crypto will become common too. For example, think prediction markets will be the next big thing? There will be a crypto-ETF with Augur’s REP and Gnosis’ GNO tokens. As the scope of projects keeps expanding, this will become more important for investors that don’t want to take chances on individual companies but instead on the market potential.
Photo Credit: normanack