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How would Bancor Protocol behave in a crisis?

The Bancor Protocol is a mechanism that sits on top of a financial market (like a Bitcoin/Ethereum market or a GOOGL/USD market) to guarantee liquidity.

Lets unpack that.

Normal financial markets consist of an order book, containing orders like "I want to exchange 2BTC for 16 ETH" or the other way round. Traders put their assets in the market and when someone places an order that corresponds with an existing order, the software executes the transaction and swops the ownership of the assets. In principle this method is very fair and efficient, although many techniques have been developed to game this mechanism. It brings all the traders into the same place, they can all see the order book, and buy or sell at the best price someone else is offering in a given moment.

Traders in these markets are accustomed to being able to sell (exchange assets for money) at any time. Somebody will usually buy something if the price falls enough. Traders have a special word for the ease with which they can convert their assets to money - they say that the market is 'liquid' meaning it is easy move their value between assets. The more 'liquidity' a market has, the more reliably you can buy and sell without shifting the asset's price. The more confident traders are that they can sell an asset, the more confidently they will buy it, so this way of organising markets can actually contribute towards bubbles. During a market crash though, from a trader's point of view, the market malfunctions. It is easy for traders to forget that 'liquidity' actually means that there are other traders offering money for assets. In a moment of generalised uncertainty, everyone prefers to have money, whose value is defined by the government, than assets whose value appears to have been pumped up, but nobody knows by how much. In this moment, liquidity disappears, and assets literally have no price because nobody wants to buy them and nobody knows how much they are worth. With no liquidity the market 'freezes up', and malfunctions.

Back to the Bancor Protocol. It was designed to guarantee liquidity for small assets (like complementary currencies) where there isn't usually a long line of traders ready to buy when the price is right for them. Remember that liquidity means someone is ready with the money to buy. Guaranteeing liquidity means guaranteeing to buy, which means money has been set aside. Lets say I want to create 'guaranteed' liquidity between Bitcoin (BTC) and Matscoin (MATS). I can put $1000 (or any crypto) into a new pool and the pool will go to a conventional market and buy $500 worth BTC and $500 MATS. Now anyone can come to the pool as a buyer or seller and trade not more than $500 worth. Lets say you exchange $100 worth BTC for MATS. The pool then goes back to the market and does the same transaction at the current price. It will then offer MATS to the next person at 4/5 of the old price plus 1/5 of the new price. this is helpful because when there aren't many MATS being traded, that means the price can be quite volatile and the pool has the effect of guaranteeing a certain price for a certain quantity here and now, and smoothing the price movements overall.

This simple mechanism sitting on top of a conventional market has some strange consequences, and we need to think carefully about what they are. For example, what kind of entity puts their money into the pool in the first place and for what gain? And if someone is guaranteeing a certain amount of liquidity, does that not imply they are taking on risks themselves, so what risks? Liquidity funds must have existed long before smart contracts, so how did they work? And could it be counterproductive to assure traders of liquidity if that means they will bid assets up into a bubble?

The questions get really interesting when we ask how Bancor pools would behave in a crisis. Lets say a flaw was found in BTC and it crashed to 1 cent in a matter of minutes. Lots of money would be lost, but who's money? People with BTC worth 1c on the open market could come to my pool and buy MATS at a rate somewhere between the previous and the current rate. Good for them! But my pool takes a part of the loss. If I saw the BTC price crash would I be able to close my pool? And if so, what does that say about my guarantee of liquidity? And if pool providers are vulnerable to losing money, who is best placed to exploit that risk?

These are only preliminary thoughts. As Bancor now facilitates over half the volume of all decentralised markets, and knowing that the next financial crisis is just a matter of time, I think it is time for some serious impartial research (or at least opinion better informed than mine!) into who is risking what in extreme market conditions.

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