DEXs, or decentralized exchanges, work by matching buy and sell orders in a bid/ask system using order books or a matching engine to fulfill trades.
Bancor functions similar to a DEX in that it allows users to buy and sell tokens without giving up custody of their tokens or private keys. But instead of using an order book to process conversions, Bancor uses a network on-chain liquidity pools.
Each liquidity pool, known as a Bancor relay, is a smart contract that is created, owned and managed by a third-party liquidity provider. A relay manages two pools of token inventories which receive and dispense tokens in order to fulfill trades, and are continuously rebalanced to determine prices.
Bancor is a permissionless protocol, so anyone can create a liquidity pool on Bancor without having to deal directly with Bancor’s core development team. A liquidity provider might be the founder of a token project or a user who simply wants to add liquidity to a token and generate fees from its transaction volume.
So what is liquidity and why is it so important? At its core, liquidity is the ease with which a token can be bought or sold. Tokens that do not have sufficient liquidity tend to suffer from:
- Volatility - large price fluctuations or “slippage” occur as the token is bought or sold.
- Counterparty Risk - users struggle to find available counterparties when they want to buy or sell the token.
- Manipulation - bad actors can easily manipulate a token’s price or its trading volume
Up until now, users have gauged the liquidity of a token by measuring its recent trading volume. If a token has a large number of available buyers and sellers, it is considered “liquid”. Yet the volume of a token can be gamed, and its perceived liquidity can be manipulated.
The Bancor Protocol takes volume out of the equation. Because Bancor doesn’t rely on matching buyers and sellers, and instead use relays as always-available liquidity pools, it is able to remove a token’s dependency on trade volume and ensure constant liquidity for tokens. Even low-volume tokens can offer frictionless conversions for their users — in their earliest days or during periods of decreased volume.
Rather than determining the liquidity of a token by measuring its recent volume, on Bancor, users rely on a metric known as “liquidity depth”. Liquidity depth represents the value of tokens deposited in the token's relay contract.
If a user performs a large conversion relative to a token’s liquidity depth, the conversion will cause the price of the desired token to move as the conversion is processed, also known as price slippage.
While slippage is expected in nearly every token conversion (albeit in infinitesimally small amounts for highly liquid tokens), a unique characteristic of Bancor relays is that they pre-calculate a token’s slippage prior to a user submitting a conversion, giving users the ability to see how much of an asset they’ll receive for any conversion with far greater accuracy compared to solutions based on order-matching.
The Power of Relays
Compared to order book-driven DEXs, Bancor relays offer:
- Constant Liquidity - Relays remove counter-party risk from the equation and ensure always-available liquidity, removing a token’s dependency on trade volume.
- Predetermined Pricing - By removing game-able order books, users can easily measure how much of an asset they’ll receive prior to submitting a conversion.
- Fully on-chain - Conversions via relays occur fully on-chain - from pricing through settlement - ensuring unmatched transparency.
- Community-Driven Liquidity - Third-party liquidity providers are be able to add their idle assets to liquidity pools and earn fees off conversions (further decentralizing and incentivizing the creation of liquidity).
Above all, Bancor relays remove the liquidity barrier which has historically prevented the “long tail” of tokens. For the first time in history, currencies can achieve liquidity regardless of trade volume. This novel invention dramatically lowers the barrier to new currency creation, usability and adoption.