Why Bancor is Such a Bad Deal for ICOs

On June 15, 2017 the Bancor Foundation raised $153mln to implement an impartial protocol to programmatically adopt the supply and price of ERC20 coins to the current demand.

From the Bancor Whitepaper (front page, original TMs preserved):

The Bancor Protocol™ enables the creation of networks of smart contract-based “Smart Tokens™.” Smart Tokens™ hold balances of one or more other tokens--“Connectors”--and have a built-in autonomous conversion mechanism that allows any party to instantly purchase or sell the Smart Token™ for one of its Connectors, directly through the Smart Token™ contract, at a price calculated by a formula which balances buy and sell volumes…
The formulaically-determined pricing, plus the ability of Smart Token™ smart contracts to create and destroy Smart Tokens™ in response to every purchase and sale through the contract itself, means that it is always possible to purchase a Smart Token™ with its Connector, and, so long as there is a balance of the Connector, to sell the Smart Token™ for its Connector.

I would like to draw your attention to the last line: “so long as there is a balance of the Connector, to sell the Smart Token™” for the purpose of this discussion.

Basically, Bancor is an ERC20 coin that can issue and redeem other ERC20 coins at a predetermined price. To facilitate this mechanism, founders gearing for ICO should deposit a collateral into Bancor wallet through which ICO token could be sold (destroying the ICO token in the process and depleting the collateral reserve) or bought (issuing the ICO token and replenishing reserves).
From economics perspective, Bancor is no more than a decentralised exchange. Which is actually good news for the ecosystem, however the Whitepaper goes on to state that with Bancor, ICO tokens can achieve predictable price changes and lower volatility, giving and impression that Bancor implementation can serve as an effective backstop in times of panic. In other words act as Federal Reserve.

Now the authors are actually shrewd enough not to explicitly state that, but at $153mln raised, one is hard to pressed to justify Bancor valuation as being purely attributable to the decentralised exchange of one tokens into another, notwithstanding all the trademark signs.

Below I’d give reasons why integrating a Bancor ERC20 into your ICO (irrespective of you being a founder or an investor) is a bad idea.

1. Founders lose flexibility of ICO funds:

In order to communicate and maintain value of ICO token during ICO, founders would be forced to use Bancor as an ICO token distribution faucet. This is because running both the ICO wallet and Bancor wallet at the same time opens arbitrage opportunities to exploit the price differentials. If ICO wallet price is lower than that of Bancor wallet, trader can buy from ICO wallet and sell into Bancor wallet. Why is it bad? Because of the value transfer.

Remember, that in order for Bancor wallet to function it must have a positive balance, thus founders would have to put a collateral (likely in the form of Ethereum) to fund the Bancor wallet. By buying at ICO wallet price and selling to Bancor wallet price, the trader effectively receives this price differential x quantity of tokens worth of value taken out of founders’ collateral (which the founder’s are ultimately raising from the investment public). In times of highly anticipated ICOs that would lead to less money raised by the founders (as part of the tokens will be recycled by such trades) and more friction and commissions (every function call to buy or sell via Bancor is not free).

On the other hand by sequentially managing the wallets – opening the ICO wallet first, thereafter the Bancor wallet, founders would still have to commit a percentage of their raised capital to manage the risk of possible downward price pressure if public decides to sell the tokens. Currently this risk is borne by ICO investors (if it is a flop, they lose money) and managed by exchanges by clearing the supply at a lower prices. With formulaic pricing, everybody would not only know the prices, but also the depth (as determined by the committed percentage). Post too little of a commitment into Bancor wallet and run the risk of being unable to support the token price, post too much and you have just robbed yourself of part of the raised funds.

Thus, the optimal strategy would be to run the Bancor wallet at the outset by providing the token price floor. That also means that all the raised money would be initially retained in the Bancor wallet with further funds split, which leads us to the second point:

2. Implementing Bancor into ICO permanently increases capital requirements.

As previously noted, Bancor requires a collateral to function and there was no mention in the Whitepaper of the withdrawal mechanism for founder to tap into Bancor wallet post ICO. Furthermore, such backdoor is unlikely to be ever implemented as it would undermine the core of Bancor’s idea and thus defeat the whole purpose.

Absent of such feature, the founders would be forced to post a sizeable part (to protect of possible sell panics) of their raised capital into the Bancor’s wallet permanently. This coupled with inclination to post more funds rather than less (as explained in 1st point) would mean higher ICO valuation to cover the cost of providing the Bancor formulaic pricing feature. Needless to say, that such costs will ultimately be born by ICO investors.

3. Your upside as an Investor will be severely hindered by Bancor wallet implementation.

Remember, that Bancor wallet can infinitely print more tokens at ever higher prices. That means in upward revaluation on outside exchanges, traders could buy from Bancor wallet unlimited new tokens and sell the on exchanges immediately for a profit. This would drive the price down, dampening the price gains and putting the long term (and early investors) at the disadvantage. Finally,

4. Bancor is not a magic bullet in stopping the volatility of the market.

This is because Bancor intrinsically is unable to act as a buyer of last resort in time of panic. It is a simple ERC20 token acting as an overlay between Solidity programming language and percentage of the funds raised to be left as a cushion.

It cannot achieve full convertibility (like a dollar), because put at the limit it’s backstopping power is limited by the amount of the deposit held in Bancor wallet. Once this deposit is exhausted (and it will be exhausted first), the token price will be settled on the exchange (at much lower price), just as is the case now.

However, this is not the whole part of the story.
By implementing the Bancor into ICO developers are actually making the resulting tokens more susceptible to downside risks. This is because once the Bancor wallet is exhausted there would be no one left to buy accelerating the token price freefall. A trader taking a short position thus stands to gain much more by trying to “break” the Bancor wallet then otherwise.

Furthermore, thanks to transparency afforded by the blockchain other traders can gauge the Bancor wallet size and join the momentum amplifying the trade.

The history seen such precedents on much more massive scale, among most prominent is George Soros breaking the Bank of England in 1992. He did not do it alone; he was however, the most vocal voice with a sizeable position alongside which the other traders put the money on their own accord. The resulting onslaught is now being remembered as Black Wednesday, while Soros solidified his status in the currency speculators’ Hall of Fame.

Thus, I’d argue that whoever is implementing the Bancor protocol is their ICO is doing disservice not only to their founding partners, but also the ICO investors and wider crypto community.

This is stemming from the simple fact that Bancor could not act (by design) as a reserve currency and therefore provide the assurances stated in its Whitepaper.

Interestingly enough there is one crypto currency, which while not being advertised as being a reserve currency, functionally is on the way of becoming one along with needed infrastructure, making it a fertile ground for Bancor’s inherently good idea, as envisioned by J.M.Keynes.

This crypto currency and what it means for ICOs underpinned by it will be explored in my next post.