Bancor is an open-source protocol that allows users to convert between any two tokens on the Bancor Network using a formula which balances buys and sells in order to maintain a constant ratio known as a “Constant Reserve Ratio” (CRR). This CRR is set by the smart contract which uses a “connector” token to balance buys and sells.
Bancor attempts to solve the problem of lack of liquidity by creating a market-making mechanism that works regardless of trade volume so that users are not subject to transaction costs when converting between any two currencies on its network. Bancor also has plans for future features including price-stable cryptocurrencies, decentralized margin lending, and prediction markets.
A market is said to be perfectly liquid when each unit of currency buys every other unit at an identical price. In other words, if you want to buy or sell two different items (currency pairs) at the exact same moment in time there will always be a buyer and seller for both. For liquid assets, there are no transaction costs.
Now let’s define smart contracts. Smart contracts are computer protocols that facilitate, verify, or enforce the negotiation or performance of a contract, or that make a contractual clause unnecessary. Smart contracts usually also have a user interface and often emulate the logic of contractual clauses.
Bancor uses smart contracts to automatically create liquidity through market making without requiring any matching bid/ask orders from users (merely called traders in this context). This enables Bancor tokens to achieve 24hr trading volume on Ethereum despite having zero traders/investors!
To convert between any two tokens on Bancor Network , you begin by depositing one token into the “Smart Token” contract and receiving a Smart Token in return which holds a balance of another token. The contract has a default CRR (Constant Reserve Ratio) which means that when you withdraw your tokens, they are exchanged for the desired amount of the other token and then burned so there is no change either way.
The connector token must always have an initial balance equal to its total supply . For example, if the smart token is holding 1 million ETH and has 100 million supply , then it receives 100 ETH from the connector when it’s created and their ratio becomes 1:100.
Now let’s define market-making. Market-making is defined as any device or mechanism used by an exchange to create extra tradeable units in a financial instrument in order to enhance liquidity. A market maker is a person or program that quotes both a buy and sell price in a financial instrument or commodity , with the intention of making a profit on each trade regardless of the direction of the asset’s price movement.
Bancor uses smart contracts to automatically create liquidity through market making without requiring any matching bid/ask orders from users (merely called traders in this context). In fact, it does not even have a user interface, so the only way to buy or sell is through other people. Users can thus earn money from Bancor by being market-makers when they offer their tokens to the “Smart Token” contract .
A market maker, also called a liquidity provider, is a person or firm that stands ready to buy or sell a particular security, commodity, or derivative at a publicly quoted price when there are other buyers or sellers in the market. A liquidity provider holds assets in its inventory to meet additional buying and selling demand for this stock from customers
If the market maker is unable to agree on a price for the security with a counterparty, it is said to be “unable to find a contra party.” Market makers must possess certain characteristics such as:
* low cost and ready availability of assets,
* an ability to rapidly obtain or generate large quantities of financial instruments,
* extensive knowledge of prices and trades in the market(s) in which they operate, and
* a deep understanding of the forces that move markets ( supply and demand )
The Bancor Protocol utilizes smart contracts to create an incentive for market makers to provide continuous liquidity at or near real-time prices. To put it another way, the protocol allows traders to buy and sell tokens without the inconvenience of having to find someone else who wants to trade, or wait for other traders before making a trade.
Market makers are incentivized by earning profits from providing liquidity, while market takers benefit from gaining access to instant liquidity at prices that would otherwise be unobtainable due to lack of other buyers/sellers.