How Do Liquid Tokens Work?
A Liquid Token is a smart contract which acts as an automated market maker by regulating the buying and selling of a token along a predetermined price curve, with a single pool of collateral to back it up.
You’re essentially adding collateral when buying the Liquid Token, and reducing collateral when selling the Liquid Token.
Consider an example of a Liquid Token, TokenA:
- TokenA can be bought at any time according to a price set by its smart contract, by depositing its collateral token into the contract.
- When collateral is deposited, new units of TokenA are minted, increasing the collateral of token A and its supply.
- The price of TokenA increases as its supply grows (according to the Bancor Formula).
- At any point in time, TokenA can be sold back to the contract in exchange for its collateral token, and the sold TokenA tokens are burnt.
Liquid Tokens continuously recalculate their price in relation to their collateral token by maintaining a fixed ratio between the Liquid Token’s total value and the value of its reserve pool. This ratio, known as the “reserve ratio” (RR), can be used to maintain the price stability of a Liquid Token.
The higher a Liquid Token’s reserve ratio, the greater its price stability. For example, a Liquid Token with a 50% reserve ratio has greater price stability than a Liquid Token with a 10% RR, while one with 100% RR is essentially “pegged” to the value of its collateral.
In general, when a user buys or sells a Liquid Token, three variables affect the price they receive:
- The amount of tokens in the Liquid Token’s reserve pool
- The Liquid Token’s reserve ratio
- The amount of Liquid Tokens being bought or sold
See example Liquid Token price calculations in the Appendix.
Liquid Tokens are, by definition, tokens with a dynamic supply, meaning their supply changes each time they are bought or sold. They still follow the laws of supply and demand — that is, when they are being bought more than being sold, their price is rising, and vice versa.
Today, the vast majority of tokens on Bancor are connected to the network through an implementation of the Bancor Protocol called Liquidity Pools.
Liquidity Pools are used primarily to provide automated liquidity to existing tokens, having processed billions in non-custodial conversions since 2017, in tokens like ETH, DAI, BAT & more.
A Liquid Token, on the other hand, is a mechanism for creating new, instantly liquid tokens with dynamic supply. A Liquid Token determines its price by measuring its total value against one reserve (its collateral), and can be configured to maintain any reserve ratio.
The ability to set any fixed (and in the future, dynamic) reserve ratio for a Liquid Token allows for flexibility in terms of experimenting with various bonding curve models. Liquid Tokens can be designed to favor certain market behaviors or promote certain economic incentives. For instance, a user may create a Liquid Token that mimics the price stability of a Top-100 traded token, despite it having significantly less volume and a relatively small amount of tokens in its reserve pool.
Theoretically, any token (ETH or DAI, etc.) can be used as a Liquid Token’s collateral. When Liquid Tokens or Liquidity Pools hold the same token in one of their reserves, they become convertible for one another through transference (A to B, and C to B, so A to C). For example, Liquidity Pools and Liquid Tokens which hold BNT in their reserve are convertible to hundreds of other tokens on the Bancor Network, including across different blockchains.
Up until now, users could launch their own token directly on a blockchain or through various token creation platforms. But, in order for tokens to become liquid and easily convertible for other popular tokens, creators have had to pay hefty listing fees to for-profit exchanges. Even then, most tokens struggle to gain adoption because the volatility of their token is dependent on the volume of buyers or sellers on an exchange, or — if the token is integrated with an automated liquidity protocol — on the capital deposited in the token’s reserve pool.
Liquid Tokens disconnect a token’s liquidity from its trade volume, and give new token projects — which aren’t yet able to fund deep reserve pools — the power to offer affordable conversions to their users.
This new form of automated liquidity has the potential to transform the way users tokenize digital items, communities, ecosystems and more. A real-world use-case for Liquid Tokens is currently being piloted in Kenya, where marginalized communities are creating their own Liquid Tokens to close cash gaps and facilitate trade across villages, while ensuring that a community cannot issue new tokens without adding collateral to the smart contract.
Thanks to a recent wave of evolving liquidity innovations, including Bancor Liquid Tokens, Token Bonding Curves & other reserve-based solutions, the world of programmable value is unfolding before us as tokens move beyond speculation and into everyday consumer applications — enabling new use-cases beyond the horizon.
Thanks to Tomer Bariach for helping with the Liquid Token examples & the math.
About Bancor
Bancor is an on-chain liquidity protocol that enables automated, decentralized exchange on Ethereum and across blockchains. The protocol is made up of a series of smart contracts designed to pool liquidity and perform peer-to-contract trades in a single transaction with no counterparty. Users add liquidity to automated market makers in exchange for trading fees, BNT staking rewards and voting rights in the Bancor DAO. Since 2017, Bancor has processed billions in trade volume across thousands of tokens.
How to get involved with Bancor
- Add your token to the Bancor Network.
- Checkout Github, jump in and contribute code.
- Build a dApp with the Bancor APIs.
- Support us on social media.
- Join our team. We have new positions posting all the time.
Appendix
Section A
The graphs below show Liquid Tokens with varying Reserve Ratios (RR). The blue area represents the total market cap of each Liquid Token at its current price, while the red area represents the amount of collateral stored. (See additional details in the Bancor White Paper.)
Section B
Liquid Token & Relay Price Calculator
Formula for calculating a Liquid Token’s Market Cap:
Reserve/Reserve Ratio = Price * Supply = Market Cap
When a user buys or sells a Liquid Token, three variables affect the price they receive. Each of these variables can be used to pre-calculate the effect on a Liquid Token’s price prior to a user submitting a conversion:
- The amount of tokens in the Liquid Token’s reserve pool
- The Liquid Token’s reserve ratio
- The amount of Liquid Tokens being bought or sold
The table below shows how different Reserve Pool Sizes, Reserve Ratios & Conversion Amounts affect the price of a Liquid Token token, the amount received by the user and the price slippage.
Reserve Ratio
Liquid Tokens A, B, C show the effect of adjusting Reserve Ratio. While Reserve Pool Size and Conversion Amount remain constant, in the case of A & B, a Reserve Ratio adjustment from 50% to 10% results in a jump in price elasticity, nearly twice the Slippage and a user receiving fewer tokens. Further reducing the Reserve Ratio to 2% (in the case of Liquid Token C) leads to additional increases in price elasticity and Slippage. Note that in both instances, reducing the Reserve Ratio by 5X increases the Liquid Token’s Market Cap by 5X.
Conversion Amount
By comparing Liquid Tokens C & D, one can see the effect that Conversion Amount has on the token’s price elasticity, the Amount Received by the user and Slippage. With D, since the Conversion Amount is extremely high relative to the Reserve Pool Size, we see a dramatic increase in Final Price, far fewer tokens received and a large jump in Slippage.
Reserve Pool Size
One can see similarities comparing the outcome of conversions against Liquid Tokens D and E. The Final Price and Slippage are identical, reflecting the constant Reserve Ratio, as well as the Conversion Amount relative to the Reserve Pool Size. Comparing F to E shows that a large increase in Reserve Ratio will increase the Amount Received, while reducing the price elasticity and Slippage.
