Network effect, liquid and smart tokens… or how does the Bancor protocol work?

By contributor Laszlo Fazekas

Network effect, liquid and smart tokens… or how does the Bancor protocol work?

Bancor is one of the most successful community funded campaigns, which means that they collected more than $ 150 million in ETH. This is a huge amount of money. But the most interesting thing about it: Bancor is completely open source. Anyone can copy, upgrade, or use it in any way. How were developers able to collect $ 150 million for a project which is virtually public?

Well, in the world of blockchains you will see a lot of project like this. In addition to many other projects, Ethereum, or Bitcoin, is open source as well, and the price of a single unit today even higher than $ 5,000. Like Bancor, Bitcoin can be copied by anyone and can launch their own Bitcoin network, which is technologically identical to the original version. In fact, there is no need for even more programming skills.

Even so no one is trying to copy Bitcoin since it would be completely meaningless. Some set of data on one network is a huge amount of money, but on a second/different network is just a worthless. Bitcoin has a value against our own clone network: it is accepted by a lot of places as a currency and can be exchanged for a traditional money. But how did Bitcoin get here so far? How are you now willing to give $ 5,000 for a single database entry that was just as worthless as our clone network for a few years?

Network effect

The solution is the network effect. This is the business model of any open source blockchain project, including the Bancor, mentioned in the title. It’s simply that if someone has used it as a payment tool, then it will have a value and others will use it rather than any other alternative. I accept your payment because I know that others will accept it too if I want to pay with it. As the scope of acceptance is growing larger, the whole network will be more secure, and it will produce larger willingness to join others too. The process becomes self-generating after a while, and exponentially increases the number of accepting locations, which means – in the case of a limited number of existing coins (such as most cryptocurrencies, including Bitcoin) – that the value will also grow as well, until the market is saturated or users are diving into a better alternative, which will be more difficult as the network grows.

Willingness to accept

The first steps are the hardest of course. For example, Bitcoin does not have a high value for a while (everyone knows the tale of the 10,000 BTC pizza), but as the willingness to accept has begun, the price has started to grow slightly and we still cannot see the end. Anyone who is trying to create a cryptocurrency nowadays will face a difficult task because there are plenty of alternatives, but if you have a good project, it’s much easier to get started with an ICO. In case of an ICO, the project sells a certain number of tokens to the potential buyer at a low price. Because ICO tokens are typically having a special role in the project, there will be at least one accepting location: the issuing project itself.

The value of the token

For example, in our ENVIENTA project, in the first phase, an educational center is built and the issued tokens can be spent here for accommodation, education and other services. This gives a real value the tokens.

But I would also like to mention Ethereum, where we can run smart contracts in exchange for ETH. Additionally, who has given money to tokens, will also want to use that service with a good chance. Thus, an ICO means not only to gather the required amount of money which is needed to develop the project but also builds a community around the project. It helps to reach the critical mass from where the exponential growth could start.


After this general description, let’s talk about the Bancor protocol. One of the biggest problems of starting coins and ICO tokens is liquidity. Liquidity is basically the currency’s solvency. Traditional money (and even Bitcoin itself) has high liquidity as they are accepted as a currency in many places. However, the liquidity of an ICO token is typically small after launch. This does not mean that it would be worthless, but the value of development depends very much on the relationship between demand and supply: if demand is high on the token, its price can rise, but if it is stagnating, the value can be easily dropped or the token cannot be sold at all. It’s almost as if we do not have anything. In general, demand and supply are not always met in space and time, which causes the lack of liquidity.

Liquid funds

Bancor’s solution to the problem is that they are putting some liquid funds to that token. Since the token can be freely exchanged over and back, it will remain liquid and its exchange rate can be fixed to the value. Of course, the thing is not that simple. Coverage may be less than or equal to the total value of the tokens issued. More if we want to achieve more liquidity than collateral, but typically the collateral is less than the total value. This typically moves around 10-20% but may be smaller or larger.

In practice, all this seems to be that, if we issue 1000 tokens with a value of 1 ETH per piece, then we have to deposit 100 ETHs as a 10% coverage. This covers our 1000 ETH total token release. By this, the value of our token was fixed to 1 ETH. At first sight, it might seem a little bit magical as if we were doing 1000 ETHs from 100 ETH. It looks that we made 1000% profit or we made tenfold of our money. Of course, this is not the case.

In fact, in the financial world, it is not uncommon for such things: the gold-cover of the currencies (where it exists) is much less for example than the amount of money issued. But who would not know, banks are operating in a similar way. When we take credit from a bank, the bank will “create/print/issue” as much money as we needed. So a bank has the right to issue money from nothing. The only thing is that some percent of the money which have been issued by the bunk must be covered somewhere.

But we do not have to move so far away from the world of cryptocurrencies. For example, the volume of Bitcoin on the market is limited to very small amounts. If at one time everyone wanted to exchange their Bitcoin to dollars, we would have a great trouble. It happened more than once in the case of traditional money. It’s called hyperinflation. Fortunately, people do not want to return their BTC massively, so there is no such problem.

Smart Token

But what about Bancor? What if suddenly someone wants to exchange a number of tokens which equals with the collateral? Then comes the magical “price discovery”, which is why Bancor tokens have also received the clever “smart token” flag. The repurchase value is growing in parallel with the increase of buying tokens and decreasing with the sale of tokens. So as people sell the tokens, the buyback value goes down, which will result that the cover never runs out.

The thing behind is really a very simple formula. If someone is interested in this please read the white paper. In addition, if the token is on the stock exchange and can be used otherwise, the operating mechanism is opposite than the regular exchange robots (buy at a low price, sold at a high price) which nearly fixes the token output and the price according to the market. Bancor’s “smart token” (the Smart Token term is also the trademark of the project itself) thus secures liquidity of the token with an automatic rate-determining system.

However, it is important to note that the value will not be given by the collater but also what it can be used for! The collateral is only to cushion the exchange rate fluctuations and help set a stable exchange rate. By enabling the token to be converted, we really want to make sure nobody wants to exchange it. If we assume that we give 1 ETH for the token, it is not necessary to exchange it, it will worth 1 ETH in itself. This is true only if the token can be spent, so there are places where it gets accepted and there is a market of the right size. If the tokens are useless (or some of them unusable), the owner can do only one thing by returning it to the cover tokens, but then the Bancor formula will be activated and the exchange rate will fall.

We’ve also talked about network effects and smart tokens, but we still did not tell you that how $ 150 million came up for this and what the Bancor tokens (BNTs) were all about. Why do you call the project a Bancor protocol or even more a Bancor network?

Well, the Bancor token is the very first smart token. It has 10% ETH coverage. When someone creates a smart token, the default is to have a cover in BNT. Since BNT is initially fixed to the ETH, it is not better, but not worse than if ETH was the cover. However, since tokens can be swapped back and forth with the cover tokens, therefore, if a token uses BNT as collateral, it also increases the liquidity of BNT. The thing goes back and forth.

It is easy to see this, but let’s look at an example: let’s have a token A and a token B covered by BNT. This means that the token A can be exchanged to BNT and token B token also. This increases the liquidity of tokens, but also increases the liquidity of BNT, since if there is a BNT, it can also be exchanged to token A and/or B. So where they accept token A or B as a currency, there will be the BNT also accepted. This is how we came back to the network effect mentioned at the beginning of the article.

The Bancor network

Since more smart tokens using BNT, it will be more accepted currency, and since BNT is more accepted currency, it will be used more as collateral. BNT connects these tokens, this is the Bancor network. So this is the business model. This is what made it possible to sell $ 150 million of Bancor token and made Bancor one of the most successful crowdfunding campaigns while all the components of the project are open source and free to use.

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