Smart Tokens™ are the heart of the Bancor Protocol. They operate as regular tokens, in compliance with the ERC20 token standard used on the Ethereum blockchain, but include additional logic that allows users to always buy and sell them directly through their own smart contracts at prices that programmatically adjust to reflect supply and demand. Effectively, Smart Tokens come with a built-in liquidity mechanism that ensures they are continuously convertible for other tokens. To achieve this, each Smart Token connector holds a balance of the token it is connected to (for example, the BNT Smart Token has a single connector to ETH, which holds a balance in ETH). Buyers can use any of the connected tokens to purchase a Smart Token by sending them to the Smart Token’s contract, which then adds them to its connector balance and in return issues new Smart Tokens, which are automatically sent back to the buyer. In this case, both the connector balance of the Smart Token has increased, as has the Smart Token’s supply, since new units were issued. Similarly, a seller may send back a Smart Token to its contract, which will then remove these Smart Tokens from circulation and withdraw a corresponding amount of connected tokens from the connector balance, which will be automatically sent to the seller. In this case, both the connector balance and the Smart Token’s supply have decreased.
In order to know what amount to issue to a buyer or withdraw for a seller, a Smart Token continuously recalculates its price vis-á-vis each of its connected tokens, in relation to the supply of and demand for the Smart Token. The Bancor Formula (elaborated below) does so by maintaining a fixed ratio between (referred to as weight, discussed below) the value of the Smart Token and the value of its connector balance(s). The adaptive supply of a Smart Token (recall that it is newly issued when purchased and removed from circulation when sold) is a unique and enabling feature which allows for supply to adjust to demand (without dilution to unit price) and for Smart Tokens to be continuously available for purchase. In the future, the Bancor Protocol will also standardize Smart Token configurations with traditional fixed supplies.
While it may sound precarious to allow a token to issue and remove itself (expanding and contracting its own supply), the software logic for doing so runs in a transparent (publicly viewable) smart contract on an immutable (unchangeable) blockchain. Furthermore, as Smart Token supply programmatically increases only when the connected token balance increases in any of its connectors (via a purchase), ensuring that Smart Tokens will always be linked to some proportionate value of another token, preventing unanticipated inflation.
Currently, a Smart Token can be connected to any ERC20-compliant token by holding a balance of this ERC20 token in its connector, through its smart contract. This makes the Bancor Protocol backwards-compatible with a large part of existing tokens today. In the future, support is planned to allow Smart Tokens to connect to tokens across various blockchains.
In effect, Smart Tokens function as completely automated and decentralized market makers that, by operating in a network architecture, on a blockchain, can function as effective and autonomous convertibility conduits, without relying on the existing labor-based (i.e., manual) trade approach and accompanying profit-seeking motive