Smart Tokens 101

While  developing the Bancor protocol we began to realize that what we are  creating is essentially a new type of currency — one that is natively  liquid. In keeping with industry conventions, we decided to call these  currencies “smart tokens” since they are based on “smart” contracts, and  since “tokens” is how the Ethereum community and literature refer to  all user-generated assets that are ERC20 compliant.

The  most important feature of smart tokens is that they can be purchased or  liquidated (sold) at anytime, directly through their smart contract,  without the need to use an exchange or even be matched to a second party  to exchange with. Now that might sound like voodoo but it’s actually  quite simple. Here’s how it works:

• The first thing to understand is that smart tokens are money that hold money.  This means that the smart contract which operates the token “owns”  units of at least one other token (smart contracts can do that). We  refer to those other tokens as “reserves”, similar to how a central bank  which issues a currency also owns foreign currency reserves.
• Secondly, anyone can purchase  a smart token with its reserve token(s), simply by transferring the  reserve token to the smart token’s contract, which in return issues the  buyer new units of the smart  token. This is similar to the way tokens are issued by ICO smart  contracts in exchange for other tokens (such as Ether). However, with  smart tokens, the reverse operation is also possible, meaning that any  smart token holder can choose to liquidate units and receive a reserve token in return,  effectively removing these smart token units from circulation, and all  this is done directly through the smart token’s contract. The supply of a  smart token increases and shrinks with demand for it.
• The third and most important thing to realize is that smart tokens set their own price,  in respect to each reserve token they hold. The price automatically  increases when smart tokens are purchased for the reserve token, and  decreases when they are liquidated to the reserve token. The exact  formulas and proofs are available in our whitepaper, but essentially  price is a kind of fraction between a smart token’s reserve balance and  it’s supply. Precise mathematics in the contract’s algorithms assure  that a reserve can only be drained when every last unit of the smart  token has been liquidated, and this is done by setting and holding a  fixed reserve ratio (configured by the smart token creator, for example  10%) to the smart token’s market-cap (its supply times its price). This  ratio is called the “Constant Reserve Ratio” or CRR, and each reserve  token held by the smart contract has has a predefined CRR. The combined  CRR of all reserve tokens must be above 0% and up to 100%.

One  may wonder why this functionality is needed at all, given that  liquidity and price discovery can already be obtained through the  trading activity in exchanges. Is there really a need for an alternative  solution?

The simple answer is “Yes”, and here’s why:

Exchanges  can be viewed as “matchmakers” between parties with opposite wants.  Each trade consists of two contrasting transactions, where each party is  buying what the other party is selling. The need to find a party with  opposite wants is the reason currencies and other assets may on occasion  face what’s known as “liquidity risk”.  This constraint makes it impractical for smaller scale currencies (such  as community currencies, loyalty points and other useful credits) to  become liquid.

In  addition, liquidity providers such as traders and market makers are,  naturally, seeking to maximize profits. This means that with the current  exchange solution, liquidity comes at a cost.

Smart  tokens will never face liquidity risk. The participation of traders and  market makers in their trading becomes optional, rather than required.  In fact, smart tokens can be seen as tokens that have a built-in  automatic market maker for themselves, operated by their smart contract.

Deep  into the process of designing the smart token concept, we started  contemplating the implications of a smart token holding more than a  single reserve token. What we discovered is that in such a  configuration, the smart token becomes a bridge between its reserve tokens,  enabling anyone to use the smart token as an intermediary token for  swapping one reserve token for another, using a two-step process in  which the smart token is purchased for one reserve, and immediately  liquidated to the other.

The  ability to hold multiple reserves enables the creation of what we’re  calling “token changers” (smart tokens holding two reserves, each with a  50% CRR) and “decentralized token baskets” (smart tokens holding  multiple reserves totaling a 100% CRR). However, these exciting use  cases deserve their own blog post, so stay tuned for more info on those  soon.

The  smartest thing about smart tokens is that they can become increasingly  smarter over time as new functionality is developed for the Bancor  protocol. Additional smart token features that we’ll be writing about  soon include Delegated Account Recovery (making it less disastrous to  forget your password), and a built-in “Vault”, which cleverly mitigates  the potential damage in the case of compromised accounts. These features  are all intended to make smart tokens easily usable by anyone as we  head towards mainstream adoption. We believe smart tokens can help make  the breakthroughs of blockchain technology more approachable and  relevant to all. We’d love your thoughts on how smart tokens can keep  leveling up.