Bancor has proposed an interesting solution to the biggest problem Bitcoin has as a store of wealth. Volatility!!!
One of the biggest problems with crypto currencies being used as currencies (this does not include crypto-technologies that provide a wider use with the exception of its use as a currency) is the high volatility that exists in today's market. The main reason, as I see it causing this volatility, is that there are not enough market makers actively participating in creating liquidity. The reason there are not enough market makers is due to most investors inability to accurately price crypto currencies. And thus we have a circular problems... crypto currencies require a stable price (or more accurately a predictable price) in order to be "risk free" enough for people to participate in market making activities.
This is best understood with an example. Let's say John is trading bitcoins in early 2015. He may set the prices in a wide range assuming the current price is fair and that this is a volatile commodity. John picks $200 and $800 as his trading range. John will facilitate the liquidity at these prices points. He will buy at $200 and sell at $800. When bitcoin prices jump 500% to $1,500, John will have sold all his bitcoins at $800 and be reluctant to re-enter the market as bitcoins seems high in price.
What john fails to realize is that the rate of inflation for bitcoins has changed. John must now find a way to price the bitcoin, knowing his past experience will be of no help. This creates risk at any entry point since John is not sure if it is a fair price.
This risk which results in a reluctance of market makers to provide liquidity (which results in a lot of price jumps) is due to there being no accepted method of pricing bitcoins. In steps bancor.
Bancor uses a solutions that was also used in the bitcoin problem during its creation. Bitcoin couldn't be a currency had no value when it was originally created. But if bitcoin could have a value then it would become a currency. Solution, do a transaction at an arbitrary price. This sets a price, and thus bitcoin is now a currency. This will however result in an arbitrage opportunity that many early adopters of bitcoin realized. The original price was arbitrarily picked, so it is not likely the true price. Now that bitcoin was a currency it was much more valuable.
Bancor uses a similar solution to the wider issue at hand. No fair price exists. But if an institution existed that was well capitalized and willing to create liquidity at what it believed to be a fair price, then market makers would be able to participate in trading knowing that they can always use Bancor's pricing model to set their price. This solution is prone to the same arbitrage that resulting in this approach being used with bitcoin.
But once the arbitrage settles down, and the spreads between Bancor's price and market prices is smaller, both Bancor and market makers can profit dearly by participating in market making activities. All the while reducing volatility and increasing liquidity for the greater community.
Solving circular logical problems by assuming you start mid cycle, permitting a slight loss to arbitrage to begin, remains an interesting phenomena, and I remain very interested in its many uses in the crypto technology space. Ironically, this is a trick taken from the solution that replaced Bretton Woods system where America set up a global financial fiat system that would only work if countries would accepted USD as having value despite it not being backed by anything (this too resulted in a short arbitrage in gold prices). I.e. USD had value around the globe simply because it had value around the globe.
Here's hoping Bancor can bring liquidity and stability to the crypto currency space.
Dahlsom