A blockchain oracle is a third party data-feed that serves as a bridge between blockchains and data that exists off-chain. As the crypto industry surges with an influx of builders and ideologists, the need for a reliable oracle becomes increasingly urgent. The reliability of the data presented by a smart contract can make or break the level of trust on the client side for a new project.

 In the ‘real’ world of centralized governance, when you form a contract with predetermined conditions for a transfer of value, you have an arbitrator. An arbitrator validates whether the terms and conditions are met before the transfer. Unfortunately, due to the consensus mechanism of different blockchains, smart contracts structurally have no way to directly interact with external data providers to validate the outcome of non-blockchain-related events. This gap in data accessibility limits the capabilities of blockchain adaptability and growth. 

Oracles are an absolute necessity for the growth and reliability of smart contracts, especially within the decentralized finance space. It’s arguable that the massive growth in blockchain adaptability over the last few years is attributable to the reliability of data transfer that oracles have brought. With that being said, oracles have one major problem, referred to as the oracle problem. 

The Oracle Problem:

There are several security risks with oracles. Most smart contracts rely on outside data to execute properly. The data that the oracle receives is pulled from an off-chain centralized API or data feed. This is ironic relative to the decentralized nature of blockchain technology. It leaves room for corruption and exploitation. In a nutshell, the oracle problem proposes the following question: How do you bring off-chain data onto the blockchain in a decentralized, reliable, and secure way?

The ‘Oracle Problem’ is a construct of overgeneralized issues, with current solutions limited to the scope of the problem viewed by their proposers. In this article, we dive into the different oracle models that currently exist, and how they propose to address these issues. 

Chainlink:

Figure A. An overview of Chainlink’s internal architecture

 Chainlink is a decentralized network of oracles that provides smart contracts with the definitive truth about the external world, enabling them to produce and present reliable outcomes. Unlike centralized oracles, Chainlink pulls data from its decentralized network of thousands of oracles (DONs), which are operated by independent, security-reviewed, and performance-proven Node Operators. Chainlink is different from other oracles because its inherent architecture allows for a focus on data validation, and consensus about individual off-chain values. They do this through a combination of multiple security techniques that promote a trustless, reliable, and secure data service.

Chainlink Network Architecture

Chainlink connects any blockchain to any input and output.

The diverse use-cases of smart contracts create problems that are equally  immense and quickly growing. It would be naive to assume that there could be a single means of securing and validating every use case. This brings up a justifiable point; if we know that a single oracle model can’tprovide the level of flexibility required by smart contracts, then it’s only natural to think that it’s only a matter of time before competitors start to spring up in different verticals. While this is true, Chainlink’s heterogeneous architecture enables developers to create their own solutions, maximizing the amount of value Chainlink can capture. Chainlink currently secures a total value of $64 Billion and is being utilized by several different niches. For a more detailed list of current use-cases, read more here.

The Advantages of a Heterogeneous Design

A monolithic architecture utilizes a single collection of nodes work in conjunction, using the same validation structure for computational processes. This is similar to how the consensus mechanism of a blockchain works, where all the nodes in the network execute a replicable set of operations. This model makes sense for validating signatures and hashing blocks, but not so much in the realm of oracles. If an oracle were to deploy this architecture, its scalability, efficiency, and security  become extremely limited. Being limited to one oracle network model creates a single point of failure, introducing security risks. Additionally, because off-chain data feeds are often paywalled, and a monolithic approach would require every node to access the same data packages, it would not be economically feasible. 

Chainlink is not a monolithic oracle network; it utilizes a permissionless framework. It is a highly customizable and modular network that allows any number of individual oracle networks to be created with specific parameters. These different network models run simultaneously and are independent of each other. Utilizing a design that eliminates standardization across all oracle networks allows Chainlink to scale horizontally by enabling node operators to have the capability to specialize in specific types of services—creating a competitive environment that naturally incentivizes growth and innovation. 

Key Takeaways:

• A monolithic architecture will likely result in cheaper end-costs fornode operators, as there are no shared costs between oracle networks.

• Removing standardization across oracle networks introduces a competitive environment where node operators can specialize in different data type services.

• Permissionless marketplaces such as (market.link) and (reputation.link) allow participants to select node operators based on historical KPIs on individual nodes- such as historical performance, average response latency, revenue generated, etc.

The advantage of Chainlink’s modular design is that it inherits the ability for each component of the protocol to be upgraded. This further supports the point that is arguably the easiest way to evaluate Chainlink’s future; it’s, by design, scalable.

Scalability

Off-Chain Reporting (OCR)

With the recent introduction of Off-Chain Reporting (OCR), Chainlink’s price feed networks can now bypass the issue that comes with Ethereum-based protocols. Ethereum is an expensive network to interact with. As a result, financial problems can arise given how computationally expensive maintaining real-time data feeds is. OCR solves this by taking these expensive on-chain computations and offloading them off-chain into what is essentially a coetaneous network. In doing this, OCR reduces operating costs by up to 90%, and enables smart contracts to perform more advanced computations. Additionally, with the help of OCR, the amount of real-world data available to smart contracts is massively increased, leading to an acceleration in blockchain innovation. 

Cross-Chain Interoperability Protocol (CCIP)

A significant downside of distributed blockchain ledger technology is a lack of co-operability. Instead, each blockchain network functions in isolation, and, without cross-chain technology, would have no way to interact. Chainlink’s CCIP looks to help close the gap between chains by leveraging Chainlink’s architecture to introduce decentralized interchain messaging and secure cross-chain token movements. 

In legacy systems, it’s standard that multiple coding languages are used in conjunction (e.g., HTML websites typically consist of HTML, JS, CSS, and Python). CCIP brings an analagous  standard to the blockchain, enabling developers to build in a more familiar environment by pulling in any code they deem optimal for their smart contracts, regardless of the chain the code originates from. 

In August 2021, Chainlink’s CEO Sergey Nazarov introduced CCIP in a keynote presentation. He stated that CCIP helps accommodate the cross-chain interoperability needs of CeFi services as demand for DeFi access grows. During this keynote talk, Celsius Network’s co-founder Alex Mashinsky referred to CCIP as a long-term solution for CeFi service providers to guarantee the scalability of their services through an all-inclusive multi-chain DeFi integration.

Tokenomics

If you’ve made it this far, you should clearly understand that the amount of network value Chainlink can capture is immense. At the end of the day, what everyone is looking to understand is: How much of that value is captured by Chainlink’s native token, $LINK?

$LINK Distribution:

• (35%) goes towards Chainlink node operators for data services.

• (25%) is held by the team for continued development. 

• (40%) is currently in circulation.

• About (8.5%) of the circulating supply is currently sitting in exchanges, with very little change over the year. In fact, the supply within exchanges has been slowly rising over the past six months, suggesting a subtle accumulation.

$LINK % of Supply Held By Exchanges

• There are over 650k unique addresses for $LINK, a 4% increase(+26,800 unique wallets) since January 2022. This suggests that, despite an uncertain market environment, there has been steady growth in interest among investors.

$LINK % of Supply Held by Top 1% Wallets

• The supply held by the top 1% of addresses has been steadily climbing since January 2021, which suggests that LINK’s top holders remain bullish and are continuing to DCA into their positions even with the recent decline in price. This also demonstrates bullish sentiment from the LINK community.

$LINK Use-Case:

Just as $ETH is the fuel that powers Ethereum, $LINK is an ERC677 utility token used to secure and bootstrap the growth of the Chainlink Network. The $LINK token has three main use-cases:

• First, $LINK is used to bootstrap the Chainlink Network by utilizing an oracle reward system similar to block rewards.

• Chainlink nodes are required to stake $LINK tokens as a form of collateral in order to ensure crypto-economic security. 

• Users are obligated to pay Chainlink nodes in the native $LINK token for fulfilling their service agreement.

Security Through Staking

Implicit-Incentive Framework (Implicit Staking)

The first crypto-economic security element introduced with Chainlinks staking is their implicit-incentive framework (IIF) or Implicit Staking. IIF is a mechanism implemented to help enforce crypto-economic security for the Chainlink Network. The dynamic of implicit staking has been proven effective by successfully securing Bitcoin and other blockchain networks for several years. 

By having every single node operator on the Chainlink network get paid in $LINK tokens, a positive feedback loop is created where there’s a financial incentive for nodes to perform honestly. Furthermore, $LINK tokenomics make $LINK a proxy for measuring the value of the network’s transferred data. Any malicious act will cause the network’s reputation to decrease, consequently decreasing the value of $LINK and the value of node incentives. 

Explicit Staking

Explicit staking is a crypto-economic mechanism that aims to improve the security and reliability of oracle networks. This is accomplished by leveraging the $LINK requirement for node operators to use $LINK as a security deposit to ensure that the transferred data is properly delivered. Depending on the API data request, there will be a predetermined “penalty fee” taken from the node operator’s collateral if it fails to deliver on its service request.  

The main difference between Implicit staking and explicit staking is that explicit staking creates guarantees about fulfilling specific individual service agreements. In contrast, implicit staking guarantees are generalized toward the functions of a protocol.

Final Thoughts & Considerations

• While implicit staking is currently live (node operators are currently being paid in $LINK), explicit staking is not. Nazarov announced earlier that it would go live sometime this year (‘22) but has not given any date specifics.

• Chainlink staking is very similar to PoS (Proof of Stake). In theory, staking will create a complete shift in the supply & demand dynamics of $LINK(increased demand, less supply). As a result, validators are incentivized to hold & re-invest their $LINK rewards to secure a more significant part of the network and earn more fees. 

• Investors who wish to gain exposure to Chainlink staking incentives without running their own nodes can do so by investing in LinkPool ($LPL).LinkPool is a leading Chainlink node service provider whose goal is to lower the barrier of entry required to run a Chainlink node. 

• It has been recently brought to light that Chainlink’s Aggregator contract, which has control over all/any of Chainlink’s price feeds, relies on a 3/20 multi-sig. This has raised some questions within the community regarding security & centralization. 

• While never officially addressed, there have been ongoing rumors based on On-Chain activity that’s suggested that Chainlinks team has been market-selling $LINK over the past couple of years to help keep nodes afloat until they become self-sustainable. Additionally, Nazarov made a statement late last year in December confirming that nodes are now profitable on their own.

Enter API3, The Oracleless Solution.

Application Programming Interfaces (APIs) are a standard in legacy tech for the development of software applications. Founded in December, 2020, API3 is a platform that enables data providers to bridge their existing web2 API onto the blockchain. What others call the ‘Oracle Problem,’ API3 calls the API Connectivity Problem. 

As mentioned earlier, the Oracle Problem is a generalized abstraction of problems that refer to the transparency, vulnerability, and decentralization of data bridging solutions on the blockchain. API3 believes that the root of the problem is that there is no inherent way for existing APIs to be connected to the blockchain. With that in mind, their oracle solution aims to directly bridge the gap left by developers being unable to access traditional APIs by utilizing an innovation called Airnodes. 

API3 Network Architecture

Airnodes

Not to be confused with a blockchain node, Airnodes are a piece of cloud service infrastructure that allows data providers to deploy their existing web2 API onto the blockchain, creating what API3 calls a dAPI (Decentralized API). To understand the advantages of this new framework, we must first understand the difference between first-party data and third-party data.

First-Party Data vs. Third-Party Data

The distinction between First-Party oracles and Third-Party oracles is an important one to be made when evaluating the value of transmitted data. First-party oracles relay data directly from data providers. In contrast, third-party data introduces an intermediary that aggregates the first-party data and forwards it to the end-user (ownership vs. non-ownership). The thesis for API3 is that by eliminating oracle networks, and instead allowing data providers to run their own nodes, the quality of data will consequently be improved. Generally speaking, oracle networks have no incentives that force them to source higher quality data versus cheap and easily accessible data. 

At first glance, it’s easy to categorize this as a more centralized approach to bringing data onto the blockchain. However, after further research, I’ve concluded that there are a couple of key advantages to API3’s model versus oracle networks. 

Transparency

The irony here is that the entire premise of the blockchain’s distributed ledger technology is that it’s a transparent, publicly accessible ledger. Even so, over the years, DeFi has found itself in several situations where a lack of transparency becomes an issue. Such is the case with third-party data oracles. 

It would be difficult to state with certainty that existing oracle networks are sourcing cheap, low quality data. Herein lies the issue-there is no transparency in where the data being pulled into oracle networks originates. So, whether a group of oracle nodes is made up of multiple data sources of high or low quality, users are none the wiser. This is directly contrasted byAPI3’s model, where the nodes are run by public facing, reputable data providers. 

Security

Going back to transparency, oracle networks themselves aren’t individual data providers. A decentralized platform introduces new attack vectors, as data can be skewed by multiple bad actors working together. Furthermore, a particularly bad actor can execute what’s called a Sybil attack– An attack where trust can be built in the short term within multiple identities in order to establish a reputable record to optimize the reliability of an attack vector route. 

The two main options for recourse from a malicious data provider are service coverage by the API3 collateral pool (similar to Chainlink’s explicit staking, note that this hasn’t been released yet). Additionally, there are potential legal remedies directly against the public data provider. However, inserting a network of third-party oracles between the data source and the users removes the data provenance. This means that the legal remedies against data sources are no longer a viable option for users. 

Ease of Use

Airnodes are a serverless oracle node that was designed with simplicity in mind. As a result, the level of involvement between the deployment of an Airnode and an API provider is minimal and requires very little technical understanding. In fact, data providers don’t have to interact with the blockchain or handle cryptocurrencies at all. With its simplistic design, API3 is a more straightforward proxy for tradfi data providers who have yet to dabble in crypto, increasing the potential for new forms of data being bridged into the blockchain. 

Tokenomics

$API3 Token Distribution

• (30%) distributed to the API3 founders and team, vested over three years with a six-month cliff.

• (20%) for the API3 DAO to build the project’s community and ecosystem, vested with a six-month cliff over three years.

• (20%) for public investors unlocked after the initial DEX offering

• (10%) for API3 partners (e.g., data providers) vested over three years with a six-month cliff.

• (10%) for seed investors vested over two years

• (5%) for pre-seed investors, vest over two years 

• (API3 Inflation) API3, which recently switched from a fixed interest rate, currently maintains a floating target inflation rate. This was implemented to attract a target amount of API3 staked, used to secure the network. The API3 tokens that are staked act as an insurance fund. The inflation rate is currently at 4.21% annual supply growth.

APi3 Exchange vs Active Wallets with high DEX activity balance comparison. Source

• (9.86%)  of the circulating supply is currently sitting in exchanges. This number has been increasing gradually over the past six months, suggesting that speculative investors have been rotating out of their position. The economic state of the markets since January plays a part in this. With that said, when gauging investor sentiment, we generally would want to see the inflow of tokens onto exchanges decline, suggesting that investors are building long-term positions, regardless of the market environment (as we saw when looking at Chainlink’s exchange token flows).

API3 Token Price & Volume. Source

• Momentum has clearly slowed down. Since late February, volume has been on a downtrend, with every spike in volume leading to sell-offs. It’s important to note that API3 is still very much in its infancy. Many things are still being built, and the team is growing quickly. With that said, being a new protocol means that it has yet to establish itself in the space against big players such as Chainlink. Therefore the volatility of the token will reflect that as the protocol matures and liquidity increases.

API3 % Supply Held By Top 1% Wallets

• While momentum has been slowing, top 1% token holders have been steadily increasing their position size, suggesting that despite the volatility, sentiment amongst long-term investors remain bullish.

$API3 Token Use Cases

Unlike $LINK, which is a utility token, $API3 is a governance token that has three core use-cases.

Staking

API3 incentivizes staking by granting inflationary rewards. This is implemented to increase the amount of $API3 tokens that are used to secure the network, ultimately attributing to the network’s growth. The increase in supply is offset by the burning mechanism, in which the API3 DAO requires users to burn API3 tokens to gain access to data services. 

Collateral

Similar to Chainlink’s explicit staking mechanism, $API3 tokens will be used as a form of collateral to guarantee services. Participants are financially incentivized to ensure a quality, honest service. API3 has partnered with Kleros, a decentralized arbitration dispute service, in order to decentralize their insurance services and provide guarantees in the form of insurance claims. These insurance claims are paid out in the native $API3 token, ultimately introducing additional sell-pressure  given the assumption that users will sell their tokens immediately to recover losses from damages.

Final Thoughts & Considerations

• API3 is one of the only oracle solutions looking to do something completely different from the traditional route of decentralized oracle networks. Relative to its competitors, it is still very much in its infancy and has plenty of room to grow. With that in mind, volatility is to be expected, and investing in the $API3 token in its current state is considered high risk. 

• API3 has recently partnered with ANU to bring real randomization to the blockchain via QRNG (Quantum Random Number Generation). It is a free service and can be found here.

• To learn more about API3’s technology, including a more in-depth view on Airnodes, dAPI, Beacons, and more, read through their documentation located here

Band Protocol

Band Protocol is a cross-chain decentralized oracle platform that aims to bring high-quality data onto the blockchain. Band Protocol is second to Chainlink in integrations, and has seen up to $16.73 Billion in Total Value Secured (TVS). The protocol leverages Bandchain, an independent Cosmos-SDK-based blockchain network that was designed to be a blockchain-agnostic network for handling oracle computations. While there are similarities between Band Protocol and Chainlink, key architectural distinctions differentiate them.

Band Network Architecture

The Cosmos SDK is a generalized framework that facilitates the creation of modular blockchain applications on top of Cosmos Tendermint BFT consensus mechanism. Band Protocol leverages Cosmos innovative network architecture by creating its own SDK-Based blockchain, BandChain. Band Protocol’s oracle differentiates itself from other oracle solutions in three ways:

Speed & Cost – Without additional upgrades, the scalability of an oracle solution is bottlenecked by the native blockchain that they’re based on (e.g., node operators on Ethereum are likely not profitable due to expensive gas fees). Band protocol addresses this by designing Bandchain specifically for oracle computational requirements. Similar to Chainlink, when a smart contract requires external data from Band protocol, they’re required to pay node operators in the oracle’s native token. However, with Band protocol being hosted on Cosmos, these transactions are faster and more cost-efficient relative to an oracle like Chainlink, which is hosted on Ethereum and has speed limitations due to factors such as network congestion.

Interoperability -Band protocol is blockchain-agnostic; it is able to query data seamlessly with any IBC-compatible blockchain. This has enabled Band to gain a first-mover advantage on multiple blockchains such as Avalanche, Celo Network, Oasis Network, Optimism, etc. 

Flexibility – Like Chainlink, Band Protocol’s data source scripts are very customizable and flexible to meet a smart contract’s requirements. Furthermore, participants can program an oracle script in multiple programming languages, enabling a fundamentally appealing developer environment. 

Tokenomics

$BAND Token Distribution

• (10%) Distributed to seed sale investors

• (5%)  Distributed to private sale investors

• (12.37%)  Distributed to public sale investors

• (25.63%)  Used for node incentives

• (20%)  Distributed to Band Protocol’s staff

• (5%)  Distributed to advisors

• (22%)  Distributed to Band Protocol’s foundation.

$BAND Token Use-case

• Collateral – Band protocol nodes are required to stake $BAND token as collateral(down payment) in order to ensure crypto-economic security.

• Governance – $BAND token holders are able to vote for Bandchain parameter changes & protocol upgrades. Additionally, token holders can delegate their tokens to data providers and take part in data provider management(a second tier of governance)

• Staking Rewards – Network participants can delegate their $BAND tokens to data providers to earn a portion of their data sales & inflationary rewards. The inflationary mechanism was introduced to increase the amount of $BAND tokens staked on the network, further increasing network growth and security. The annual inflation rate ranges from 7%  to 20%, and is adjusted based on a 66% total supply staked target. 

• Data Payments  & Network Fees-  Node operators are paid in the native $BAND token for their services. Furthermore, all transactions on the Bandchain network use payment (gas fees) in the form of native $BAND tokens.

Band Protocol – Final Thoughts & Considerations

• Band Protocol is the second most integrated oracle next to Chainlink. Like Chainlink, it was founded in 2017, but it wasn’t until 2019 that it first launched its v1.

• There are currently no inherent burning mechanisms to offset the token inflation rate. The team has not expressed any intention to add a burning mechanism. Still, there have been mentions within the community that a validator incentive program is in the process of being designed. An argument can be made that relying on an incentive program isn’t an efficient way to combat a supply increase, since you are essentially betting that enough participants are bullish enough on the token to want to lock it up for extended periods. This is especially true in bearish market conditions.

Pyth Network

The last oracle that we’ll mention in this paper is a new, up-and-coming protocol, Pyth Network. Pyth is a Solana-based oracle network with similar ideologies to API3. By utilizing Solana’s architecture, Pyth can reliably stream data at a sub-second latency (currently 400ms), with relatively low costs compared to its competitors. Furthermore, instead of using third-party data (like Chainlink), Pyth incentivizes market participants(Market Makers, exchanges, hedge funds, etc.)to provide pricing data directly on-chain. The team at Pyth believes that from a regulatory standpoint, third-party data oracle networks aren’t as sustainable(long-term) as they seem. With that in mind, they’ve sought to be a first-mover in their target market of first-party on-chain data aggregation feeds. 

Price Aggregation

As we know, there’s a lack of transparency with third-party data oracles. Additionally, regardless of the number of nodes being run on an oracle network, if the data is coming from the same provider, there are significant risks regarding data accuracy. These risks are especially apparent in TWAP oracle models used by AMM Dexs(such as Uniswap), as relying on data from a single exchange introduces a lack of market coverage that doesn’t consider the liquidity fragmentation across different pairs. Pyth addresses these underlying oracle issues by:

Confidence Interval – Publishers will generally be market participants and financial institutions. Different exchanges and platforms have access to different types of data and may use different methods of pricing assets. Pyth networks require publishers to report a confidence interval for each price they publish. The confidence interval represents the perceived strength of that input data as per the publisher. The confidence intervals among publishers are then aggregated, creating an aggregated confidence interval for each price. Not only is this a benefit to the consumer, who can then view the aggregated confidence levels and scale accordingly, but it also enables an environment where publishers are transparent regarding the varying levels of accuracy between different priced assets, leading to a lower chance of being slashed. Refer here for further reading on confidence intervals. 

Example of the aggregated pricing process. The lower thin bars represent prices and confidence levels, and the bold turquoise bar represents the aggregated result. 

Aggregated price feeds  – Pyth network’s price feed provides complete coverage by aggregating all of the publisher price data and weighing each data point. Publish weights are determined by the data staking mechanism and are automatically rebalanced weekly. Combined with aggregated confidence intervals, Pyth’s price feeds provide a future-proof oracle mechanism that automatically tracks new liquidity fragmentation across publishers. To read more about how staking weights work, including the underlying math, it is explained in great detail within Pyth’s whitepaper on page 9, section 4.1. 

Price & Confidence Interval EMA  – Pyth Network provides a time-weighted EMA for both aggregated prices and time intervals. Information regarding Pyth’s implementation can be found here, along with further reading on Price/Confidence EMA here.

Pyth Network Architecture

While Pyth and API3 both subscribe to the idea that first-party data is a more reliable framework, each protocol leverages its solution for different purposes.  To better understand how Pyth intends to use its architecture to scale its solution, we must understand who the network participants are and how Pyth intends to incentivize them. 

Publishers – Data providers, typically exchanges, market makers, financial institutions, or any entity that regularly prices assets. Similar to other oracle models, data providers capture a portion of the fees generated by the products they price. The appeal is that the Pyth network is introducing an additional revenue stream for market participants, receiving payments for sharing data that they would already be generating within their everyday operations. Pyth network intends to utilize its own version of explicit staking; Publishers are required to stake $PYTH tokens as collateral; if their data deviates away from the truth, the deposited collateral gets slashed. A list of current publisher partners can be found here

Consumers – Users who contract Pyth Network for their data needs. Users can be both on-chain and off-chain applications. Consumers pay for Data services which are then distributed to Publishers and Delegators (mentioned below). In doing so, consumers are hedging their risk for using Pyth price feeds as any oracle issues that occur would be reimbursed from Delegator/Publisher collaterals. Unlike Chainlink, consumers aren’t required to pay for their service agreement in the native oracle token. Instead, the fees can be paid in any governance-approved asset. The benefit of having multiple forms of payment versus native token payments is that it eliminates the sell-pressure that comes from node operators’ market-selling tokens, weighing down the price.

Delegators – Token holders who are incentivized to stake their $PYTH tokens into the network by earning a portion of fees paid out by consumers(reward distribution is initially set at 80/20, delegators are the majority). This rewards mechanism is referred to as ‘Data staking.’ The tokens locked up by delegators serve as collateral that guarantees data quality relayed on the network. While it may be more attractive for a delegator to delegate all of his stakes to a long-standing reputable publisher, delegators are encouraged to diversify their delegation between publishers to further increase general network security. In a case where a consumer is affected by inaccurate data, they are able to generate a claim. The governance-voted results of a claim determine whether delegators’ stakes get slashed. There are currently no APR projections as staking isn’t live. However, one could assume that the incentives would have to be sustainable, and significantly greater than the perceived value at risk. For more details regarding Pyth’s reward distribution system, refer to page 8, section 4 of Pyth Network’s whitepaper. For more information about their claims system, which utilizes HUMAN protocol,  refer to page 6, section 3.1.

Tokenomics

• (22%) Intended distribution for on-chain rewards. 8% unlocked immediately, with the remaining 14% vested over seven years with a 1-year cliff.

• (33%) Intended distribution for Ecosystem participation. 5% unlocked immediately, with the remaining 28% vested over seven years with a 1-year cliff.

• (25%) Intended distribution for Pyth’s team & advisors. All of which are vested over seven years with a 1-year cliff.

• (10%) Intended distribution for launch partners. 2% unlocked immediately, with the remaining 8% vested over seven years with a 1-year cliff.

• (10%) Intended distribution for $PYTH token’s private sale. All of which are vested over seven years with a 1-year cliff.

Pyth Network – Final Thoughts & Considerations

• There are a number of different oracle solutions currently available. However, the surface has barely been scratched regarding the amount of data that has yet to be transferred onto the blockchain. With that in mind, while other oracle networks are looking to scale horizontally by spreading themselves into multiple sectors, Pyth knows its target market and has chosen to focus its efforts on scaling vertically into its niche.  

• Pyth is still very much in its infancy. The current iteration of the network only has data feeds available, which are free to use by consumers. When speaking to the team at Pyth Network, they mentioned that they aren’t even entirely sure who is using their data. As of the time of writing, there are 47 identified integrations found here.

• The $PYTH token has not yet been released. Therefore, public information regarding the token is limited to the distribution schedule listed above.

• Pyth has significant backing, including major contributor, Jump, one of the largest quant trading firms in the world.

Enter Bancor V3

On November 28th, 2021, Bancor officially announced the next iteration of their protocol, Bancor v3, with the year gap in between releases officially proving Bancor’s willingness to play the tactical game. The new protocol iteration is the consequence of over a year’s worth of research and feedback analysis, the same approach the team took with their upgrade from v1 to v2.1.

Bancor V3 proposes a considerable upgrade to the architecture of the protocol with the purpose of correcting all the primary issues present in V2, and improving user experience through the introduction of several new features, including single-sided staking, Impermanent Loss Protection (ILP), Auto compounding, and more.

Let’s dive into each of these key additions in depth.

Return to the Insurance Protocol (IL Protection)

Bancor v2.1 Vesting Period

Currently, on Bancor v2.1, there’s an insurance vesting period of 100 days, starting with a 30-day cliff. This vesting schedule was instituted based on the findings of an earlier economic paper, which showed that the impermanent loss faced by an LP acted as an American perpetual at-the-money option. 

When the original model was put together, Bancor was forced to assume the speculative risk they would potentially face through launch of their new tech. The desire to achieve a conservative outcome enabled them to gather data while remaining protected.

They’ve since re-evaluated their model’s results using the last 12 months of data, and found the actual results were far more optimistic. The model was then repeated without the instilled assumptions, utilizing a Monte Carlo simulation method. This created a data-backed realization that the protective elements present in v2.1 (the 100-day insurance vesting) were unnecessary measures that could be replaced by a 7-day cooling period and a small 0.25% LP exit fee. Both of these features were put into place for the protocol’s security.

Bancor v3 ILP

In the Bancor v3 update, when an LP wants to remove their liquidity, they have to wait a full seven days to complete the withdrawal. The user also forfeits all yields accrued during the waiting period. Upon a successful withdrawal, the fees & rewards generated over those seven days get distributed to the rest of the liquidity providers. This results in an increase in APY and protocol-owned BNT, which gets locked permanently in the treasury.  In situations where the LP decides to cancel their withdrawal request, they would then immediately receive all the previously forfeited rewards/fees.

Using data collected from the past 12 months, Bancor found that a hypothetical arbitrage exploit could be used to extract value from the protocol in instances where volume>100%. A simple way to nullify an attack vector—if it exists—is to implement a required waiting period once a withdrawal is requested.

While some may see this as an inconvenience, this model effectively reduces the waiting period for full insurance by 93% without having to compromise protocol security. Not a bad trade-off.

To summarize:

• Bancor can now provide full Impermanent Loss Protection from the moment an LP makes their deposit, compared to 100 days prior.

• There is now acooling period, where LPs will have to wait seven days before withdrawing their funds. This reduces the amount of wait time by 93% compared to V2.1

• They’ve introduced an exit fee for their pools for the first time. The fee itself is nominal, sitting at .25%

Single-Sided Pool Token

Bancor has done a complete overhaul of its pools to optimize user interactions with the protocol, and the utilization of pool tokens. 

• When a user decides to LP on Bancor they’re now issued a PT (Pool Token) with the prefix of ‘bn.’ This means if our friend Joe were to stake LINK, he would receive bnLINK in return. The newly minted PT represents the fully protected value of Joe’s deposit(including the fees generated on the position).

• Unlike in v2.1, Pool Tokens in Bancor 3 are not linked to the value of the reserve balance. The valuation of the Pool Token is sourced through a separate ledger, called the Staking Ledger, which tracks and records amassed fees/rewards. Instead of owning a share of the liquidity pool, stakers possess a portion of this ledger.

• The (PT) serves as a yield-bearing token, so its value should always be greater than the underlying staked amount.

• Pool Tokens are denominated in the deposited token (e.g., bnLINK). This makes them an ideal form of collateral, as the value of the PT is consistently increasing due to the distribution of rewards & fees. While nothing has been decided yet, Bancor has stated that their Pool Tokens meet the requirements to be used as collateral on Aave. It will be interesting to see the different strategies created around this lending/borrowing market.

Auto-Compounding and Standard Rewards

Expensive network fees are arguably one of the most significant barriers to entry in the realm of Ethereum-based protocols such as Bancor. Bancor v3 introduces a significantly more gas-efficient auto-compounding model compared to its predecessor.

Out with the old, in with the new

The diagrams below show us a visual representation of the reward processes as they exist on Bancor v2.1 and Bancor v3.

Diagram A displays the reward system used for Bancor v2.1. It’s a multistep process, during which multiple transactions are necessary for a user to compound their rewards. Due to its convoluted structure, claiming rewards is quite an expensive activity for LPs, making it nearly impossible for smaller liquidity providers to profitably compound their earnings.

Diagram B represents the restructured rewards process as it is in V3. The need for the user to interact with the protocol has been completely removed from the equation. All a user has to do is hold the pool token (i.e., bnBNT), which that they was minted upon depositing into a pool. This is possible through utilization of the staking ledger mechanism, mentioned earlier, which tracks and records all fees & rewards associated with liquidity providers.

Let’s recap a bit. From what we’ve discussed so far, we know that bnBNT sources its value from the staking ledger. The ledger derives that value by looking at its balance, relative to the total staked balance of BNT. With this in mind, all the protocol has to do to distribute protocol-owned BNT to stakers is burn its bnBNT- creating a drastic simplification of the process shown in Diagram A.

It’s important to note that this rewards system, in its current state, will only work in scenarios where the staked TKN is the same as the reward TKN. So, a pool paying out AVAX rewards for Joe’s LINK deposits wouldn’t be able to facilitate these rewards.

External Services

At its core, Bancor’s mission has always been to bring fundamental value to the space. With the release of v3, they now have the option to offer impermanent loss protection and auto-compounding as a third-party service to different protocols.

Auto-compounding as a service

Providing liquidity incentives to protocols will be a prominent feature of Bancor v3. Projects will now have the capability to create their own rewards schedule by utilizing the rewards model depicted in diagram B.

How does that work?

Protocols form schedules by providing liquidity to a pool, and subsequently burning the pool tokens that it acquires in accordance with the predetermined vesting contract. Once pool tokens are burned through the Bancor vortex, the protocol releases ownership of the underlying token by distributing their represented value to the rest of the liquidity providers. 

What are the benefits?

• The ease of use of this system creates a marketable environment for retail investors to participate in. All a user has to do is hold their pool token, and they’re automatically taking part in the rewards program.

• Reward programs are highly customizable, and can be done directly on Bancor’s platform without the need for a protocol to spend money/time on outside resources.

• Even as they’re being distributed among stakers, rewards are immediately used as liquidity. This results in an efficient way to automate the process of building liquidity.

Limitations

• The auto-compounding program is ideal only for cases where the staked token is the same as the reward token.

• A modified version of the industry-standard rewards contract is available for situations where the staked TKN and reward TKN are different assets. In this case, auto-compounding must be done manually by stakers.

Impermanent loss as a service

Insured liquidity positions are one of the flagship components of Bancor v2.1. In v3, token issuers can utilize Bancor to offer impermanent loss protection for their token.

The structure can be broken down into the following points:

• An external protection balance gets funded by the protocol. These funds will be used to reimburse stakers experiencing IL.

• The external protection balance cannot be withdrawn, but it can be replenished.

If the external protection balance runs out and has yet to be replenished, Bancor becomes liable over any further losses. In these situations, the Bancor DAO has the ability to direct liquidity away from unprofitable pools, and even propose a shutdown.

vBNT and the Bancor Vortex

vBNT is the governance token used within the Bancor DAO. It can be acquired by staking BNT to receive a 1:1 distribution, or by market buying vBNT directly on the market.

One issue with the 1:1 distribution model proposed in Bancor v2.1 is the lack of consideration for accrued fees. Unless users manually compound all of their pool rewards, their voting power remains the same regardless of how time spent LPing. That said, the actual negative impact that this would have on operations is minimal.

Governance aside, the key fault of vBNT was in its interaction with the Vortex. The Bancor team describes vBNT as a credit rating, as it essentially represents an individual user’s borrowing power within the ecosystem. Users with more vBNT can always borrow more than those with less vBNT. Through this lens, it became increasingly apparent that the 1:1 issuance model remained an issue. There had to be a better way.

Single-Sided Pool Tokens

Bancor sought to create a way to automatically sync vBNT issuance to underlying stakeholders’ relative status. To do so, they needed to create a clever system that accurately represented the value of a user’s stake, along with its value as it accrued rewards.

The deployment of single-sided pool tokens in Bancor v3 introduces a reliable and effective solution to the vBNT: BNT issuance issue. We know that through the use of the staking ledger, pool tokens can accurately represent the total value of a user’s staked position, even as it earns fees. We also know that these pool tokens are fungible and composable, making them the ideal counterparty for vBNT issuance.

Benefits

The implementation of this change encourages an environment that coincides with our theme of ‘fairness’, as the issuance of vBNT is always proportional to the stakeholder’s relative status. This means that your borrowing power, or credit line, will grow as your stake value appreciates.  

Bancor Vortex

The Vortex going live added an essential weapon to Bancor’s monetary policy arsenal. Vortex enables the protocol to adjust the burn rate of vBNT by collecting up to 15% of swap revenues. Remember, for every vBNT that exists, there’s 1 BNT equivalent. So, a consistent burn of vBNT is equivalent to locking away BNT into the protocol forever.

The v3 difference

There was nothing inherently wrong with the Vortex in Bancor 2. It did what it was meant to do; but, there’s always room for improvement. In Bancor 3, the Vortex’s mission remains unchanged and Bancor’s ability to optimize the methodology has risen.

The simplification conundrum

A consistent theme that I’ve noticed while poring through the restructured frameworks of Bancor v3, is the emphasis on simplification of the internal processes for each of their systems. In Bancor v2, the Vortex collected fees in various tokens. Those tokens were then exchanged later for BNT, taken from the token’s respective BNT pool. That BNT is then used to buy and burn vBNT, ultimately reducing the circulating supply of BNT.

Now, this process got a significant upgrade: removing the need to collect fees in different tokens. Instead, TKN fees are immediately swapped for BNT on a continuous basis. This meaningfully enhances the gas efficiency of burns, and raises the protocol’s ability to burn more vBNT.. 

But wait…there’s more!

The Vortex burner plays a significant role in Bancor v3’s rewards program. Ownership of BNT to users is directly connected to the Vortex trigger. This means that rewards are distributed (auto-compounded) every time the vortex burner gets triggered.

Flash Loans

Bancor has expressed that they’re looking at different ways to generate fee revenue not limited to trading volume. One of these sources is the introduction of flash loan support on Bancor v3. To do this, Bancor would essentially front liquidity themselves inside pools via loans for users.

This implies an improvement in the efficiency of arbitrage capabilities for these pools. The restructure of Bancor 3’s architecture allows for a significantly increased TVL capacity, which consequently means higher LP fees generated.

Infinity Pools

After spending some time digging through Bancor’s discord, It became apparent that infinity pools are one of the more controversial topics of the v3 upgrade. Because of how insurance worked, pools had a cap on them, which means that there was a limit to the number of users a pool could support.

This was inconvenient for both the client and the protocol. Having strict limitations on the amounts of users significantly impacts network scalability. This issue is entirely nullified with the Bancor v3 upgrade, which utilizes Infinity Pools to provide unlimited liquidity provisions.

How does it work?

Tokens are stored in a single secure vault, which delineates the staked assets from the available trading liquidity. It’s important to note that Liquidity pools do not store tokens, rather they’re a logic layer that exists above the vault that controls the exchange of assets between the user and the vault. 

There are two critical components to each pool:

• Superfluid liquidity

• Trading liquidity

The trading liquidity is simply the liquidity used to support exchanges. Things get interesting when we start to dig into the superfluid liquidity component. Technically, this liquidity can be used simultaneously for any purpose (such as market-making and other yield strategies). Furthermore, the team has expressed that this feature will play an essential role in what they’re rolling out in their upcoming phases of V3.

Omnipool

The lords of the simplification conundrum have struck yet again. The Omnipool is a single network staking pool that serves as a replacement for Bancor 2’s current liquidity structure.

Why do we need more change?

In its current version, Bancor has individual liquidity pools, each containing a unique combination of BNT counterparty assets.(e.g., LINK/BNT, USDC/BNT, ETH/BNT). This model is set up to create a natural price discovery process. To help paint a picture of the routing process of transactions, let’s look at a scenario where a trader is looking to swap his $LINK for $USDC.

Step 1. John decides he wants to sell his $LINK for $USDC.

Step 2. John initiates the transaction; upon doing so, his $LINK gets sent into the (USDC) pool.

Step 3. The (USDC) pool will then send $BNT into the (Chainlink)  pool

Step 4. The (Chainlink) pool will now send Johns $LINK  out.

As demonstrated in the scenario above, the current process of swapping between supported assets requires multiple transactions. By consolidating all the protocol’s liquidity into one spot, Bancor has delivered an optimized liquidity routing process that offers significant improvements to gas fees, which could ultimately lead to increased trading activity.

Multi-Chain Roadmap

Back in 2018, Bancor had announced that they were going cross-chain with EOS. Fast-forwardmultichain a few months later, and they became the very Defi protocol in history to have a multichain deployment. Over the past few months, Bancor has, on several occasions, teased a multichain future. During my call with Mark Richardson, I asked him his opinion on what he thinks qualifying traits are when scouting different chains. His response was, how secure is the chain, is it decentralized, and is the ecosystem well established with quality teams that are likely to be there for the long term. From what I’ve gathered, the team believes that the most likely L1 they will deploy to will be Polygon or Avalanche. However, Arbitrum and Optimism are also being considered, and non-EVM chains cannot be ruled out. Regardless of the ultimate selection by the Bancor DAO, it is highly likely that V3 will be multichain soon after the Phase I Dawn release.

This report is not investment or trading advice. Please conduct your own research before making any investment decisions. Past performance of an asset is not indicative of future results. The Author may be holding the cryptocurrencies or using the strategies mentioned.

Bancor is among the most overlooked and misunderstood DeFi native projects, and its complexities can leave even the savviest DeFi natives scratching their heads. With that said, it’s maintained a TVL of >$1B for over a year now, and continues to have one of the strongest and most intellectually diverse teams in the space.

Exclusively for this series, I had the pleasure of speaking with Bancor team members Mark Richardson (Head of Research) and Nate Hindman (Head of Growth). That interview will be covered in the sequel. For this in-depth analysis, I will be simplifying the core components of Bancor’s architecture.

Before we dig into where Bancor is headed, we must first understand the intricacies of their past.

A Bit About Bancor’s History

Before there was Defi, there was Bancor. It got its name from John Maynard Keynes’ currency concept, called the ‘International Clearing Union’ (ICU). The ICU used ‘bancor’ as a unit of account to encourage international trade in the 1940s. While Bancor was founded in 2016, it wasn’t until February 13, 2017, that Bancor released its first whitepaper. Fast forward four months to June 12, 2017, and, at last, the prodigal child was born. They officially launched with what was, at the time, the largest ICO (initial coin offering) ever, raising over $153 million**.**

Bancor is one of the founding fathers of DeFi. It all began when they noticed that the influx of tokens pouring into the space needed a marketplace to harbor and facilitate their exchange and pricing – somewhere safe and far away from the constraints of a centralized monetary system. In 2016, this thought led to the creation of the AMM (Automated Market Making) model, the crypto primitive that sparked DeFi Summer and led to the glorious bull run of 2020.

Innovation is never a straightforward task. In 2018, Bancor suffered a security breach that allowed the hacker to steal $10 million worth of protocol-owned BNT, $12.5 million ETH, and $1 million NPXS tokens. The company responded by freezing the BNT tokens that were stolen and spoke with multiple exchanges in an attempt to track down and retrieve the rest of the stolen tokens. Unfortunately, at the end of the day, they were only able to save the BNT, netting a total exploit loss of $13.5 million.

This sparked a controversy within the space.It wasn’t the exploit that people were upset about- it was the team’s ability to freeze BNT whenever they wanted. That mechanism created a single point of failure and brought protocol security into focus, something no investor wants to question. Bancor listened to the community and immediately began to take action.

That was their first and last exploit. Since their infancy, the team not only changed their OPSEC system and removed the BNT freeze function from the protocol, but also completely revamped their codebase. As a result, the protocol has run smoothly with no security issues since.

Enter Bancor v1

Bancor invented liquidity pools, calling them “relays” or “smart tokens” at the time. The bonding curve mechanism that we all know and love came from this, and enabled protocols like Uniswap or Sushiswap to exist in the way they do now.

Before we dive deeper into Bancor, it’s essential that we take some time to emphasize how vital the AMM model truly is.

What exactly is an Automated Market Maker(AMM)?

An AMM is the underlying protocol that makes up decentralized exchanges (DEXs). In centralized exchanges, you have order books managed by professional market-making entities. An AMM eliminates both the need for a custodial entity to create markets, and the necessity for trade counter-parties. 

So what’s the benefit of using an AMM?

AMMs were created to decentralize the decision-making process of pricing different assets. With AMMs, Bancor developed an alternative to the traditional order-book-based model and facilitated liquidity bootstrapping on-chain by utilizing algorithmically-managed token reserves. 

Gone are the days where you have to wait for a centralized exchange to provide consistent liquidity. With liquidity pools (LP), anyone could provide trading depth using their favorite tokens, and were incentivized to do so via liquidity mining rewards paid out from exchange fees. This created a healthy environment in which AMM liquidity pools were mutually beneficial to both the token holders and the token issuers. New tokens were enabled to generate liquidity without spending money on bootstrapping initial liquidity themselves, and hiring market makers to help maintain it.

How do AMMs work?

AMMs work by creating a bonding curve consisting of the equation x*y=k. In this formula,  x represents the value of ReserveTKN1 and y represents the value of ReserveTKN2. K remains a constant. Let’s go through a mini case study to best paint the picture of how the AMM bonding curve works.

AMM Equation using our example

In this example, Bob is a Link Marine who bought his very first $LINK back in 2018 and, to date, hasn’t sold a single penny’s worth – we like Bob. However, it’s now early May in 2021, and Bob feels like the market will reverse soon. Because of this, he decides to break his wedding vows and cash out some of his $LINK into something he deems is a safer benchmark asset, like ETH. What happens in this situation is Bob is removing ETH from the LINK/ETH  pool while at the same time adding LINK to it. Our bonding curve responds to this by increasing the price of ETH and decreasing the price of LINK in order to keep the pool balanced. 

It’s important to note that the AMM does not change its price based on the other markets around them. The price of an asset inside the pool only moves as the ratio of the reserve shifts. This creates discrepancies between the price of an asset across different AMMs, opening up arbitrage opportunities. These mispricing events are normally scooped up by bots, but opportunities still exist on the lesser-known AMM-based DEXs for the keen investor. While AMMs have been incredibly successful over the past few years, they do come with their own set of shortcomings. 

Being The First Has Its Perks

After Bancor launched their V1, they sat in a unique position to lay back and observe the world as it interacted with DeFi. They witnessed more and more DEXs adopt their formula, and determined that the most prominent issues revolved around slippage, forced token exposure, high network fees and the big one – impermanent loss. 

Let’s talk about slippage and why it’s important.

Slippage occurs when there isn’t enough liquidity to fulfill an order at the exact price it was executed. This can cause a substantial shift in the price of an asset from the time an order is placed, to when it gets completely filled. This is especially true when a user is trying to place a market order with relatively large size. This forces larger investors to default to execution strategies such as TWAP(Time Weight Average Price).

Slippage can also occur when trading activity is high. This is especially true for ecosystems such as Ethereum, which currently uses a PoW (Proof-of-Work) consensus, limiting their capability to process transactions. When executing a trade on a DEX, your transaction is put in a queue. The longer the queue, the longer it takes for your transaction to process on the blockchain, and the greater a chance of a disparity between the price you thought you were getting, and the price you actually got filled at.

Impermanent Loss

Impermanent Loss is the difference in value between holding tokens in your wallet and a liquidity pool. Earlier in the article, we talked about how AMMs are consistently rebalancing themselves based on token withdrawals/deposits. This means that as prices of the reserve tokens start to fluctuate, the side that’s rising is being sold by the AMM and put into its counterparty asset in order to keep the liquidity pool at a predetermined ratio.  

Why would anyone subject themselves to IL?

Believe it or not, it took people a long time to wrap their heads around the idea of impermanent loss. When the idea of being a liquidity provider started blowing up in mid-2020, it was very easy to put on rose-colored glasses and repeat maxims like “it isn’t a realized loss until I sell!”.  As staking grew, and all everyone cared about was “passive income” through yield generating assets. The idea was, if the trading fees that you generate from LP were greater than your IL, then the strategy was profitable with very little effort – or so it was thought. 

Due to the lack of transparency from DEXs on IL, there have since been multiple external studies showing the truth behind LP profitability. Bancor and Topaz Blue published a study stating that 49.5% of LPs lose money. The Defiant found that 52% of LPs utilizing Uniswap V3 were also unprofitable. Considering the volatility that crypto has seen over the past 2 years, these numbers aren’t the least bit surprising in hindsight.

While IL is a natural occurrence stemming from crypto’s’ current state, the real innovation since has come via protocols finding clever ways to tackle issues and improve user experience.

A Better Model – Enter Bancor v2.1

As time wore down the novelty of Bancor V1, different protocols have taken the standard CPMM formula and devised their own. Noteworthy unique approaches include Curve, which utilizes a hybrid CFMM. That said, most AMMs still have a prescribed counterparty asset that LPs are required to contribute- think ETH (Base Asset) / USDC (Counterparty Asset). This is extremely inconvenient for LPs, as it means they are forced to divide up asset exposure to meet the requirements for providing liquidity inside a pool. 

Bancor v2.1 addresses this issue directly by giving LPs the ability to provide liquidity to a pool while maintaining 100% exposure to a single asset(single-sided staking). Through this, Bancor substantially reduces slippage and  promotes extremely deep liquidity. Now, liquidity of a token dispersed between multiple pools (e.g. TKN/ETH, TKN/WETH, TKN/LINK), all of the liquidity for a single token is concentrated into one pool.

These pools then consistently accrue fees for both LPs and the protocol. Once a user withdraws their liquidity position, the fees earned by the protocol are then used to pay back the LPs impermanent loss. In a situation where the impermanent loss of a pool is greater than the fees that it’s generated, the protocol then mints BNT from the DAO co-investment in order to pay back the remaining IL. At first glance, this sounds like a great way to dilute token supply, but small changes have big consequences. In this next section, we look into BNTs tokenomics to clarify our understanding of these effects. 

Tokenomics

All of the features that came with the v2.1 upgrade are made possible through the utilization of  BNTs elastic supply, which allows the protocol to mint and burn BNT as it deems necessary. 

Whenever a protocol wants to whitelist their token on Bancor, they need to formally make a proposal within the Bancor DAO for BNT holders to vote on. If the proposal passes, the DAO then votes on a co-investment (in BNT) for the liquidity pool. In this instance, the DAO is essentially given the ability to mint BNT, which is used to match user deposits into the pool and guarantees impermanent loss insurance. 

An Example of how this works

Joe is looking for somewhere to earn yield on his $LINK. He notices that there’s a LINK pool on Bancor that allows him to stake his $LINK single-sided(LINK/BNT). Joe then proceeds to deposit $100,000 worth of $LINK into that pool. The protocol simultaneously mints an equivalent dollar amount in BNT to match Joes’ position in the pool. Now, both the protocol (Chainlink) and the user (Joe) are accruing fees. 

In another scenario, if Joe withdrew his liquidity, the protocol would then burn the corresponding BNT. On paper, it sounds like a zero-sum game, but it actually makes up a key deflationary component of Bancor v2s tokenomics. While Joe was staking his LINK inside Bancor, the LINK/BNT pool was generating fees that were being paid out in BNT. Assuming that the fees generated were greater than the Impermanent loss, the network would end up with more BNT than it had initially contributed when Joe made his deposit—resulting in a deflationary system that consistently burns BNT as LPs withdraw their position. 

Since BNT is the denominated asset for pool rewards, some investors fear the consistent sell pressure that comes with the inflationary nature of ‘farm tokens’. Coupled with the other inflationary elements we’ve touched upon, skepticism about effectiveness of the deflationary systems is completely warranted. While there are going to be times when inflationary feedback loops outperform deflationary feedback loops,the aim is to have risk diversified among several pools, resulting in an averaged net positive result.

The Bancor Vortex & vBNT

The Vortex launched on Feb 17th, 2021, a couple months after the release of Bancor v2.1. With its launch, it introduced new ways for users to interact with BNT, along with a few additional deflationary features to supplement BNTs tokenomics. This was accomplished through the use of a derivative that was introduced with this update-vBNT.

When $BNT is staked on the platform, the protocol mints vBNT at a rate of 1:1. This token represents the depositor’s share of the pool, while also offering a few additional use-cases, such as:

• Liquidity- vBNT is liquid with BNT,which is liquid with every single token on Bancor. Stakers now have the option to leverage their vBNT by swapping it for any platform asset.

• Governance – vBNT is the token used to vote for protocol changes and whitelist proposals in the Bancor DAO. This allows staked users to vote.

• Yield – Stakers earn yield with vBNT by staking it in the vBNT/BNT pool, securing a share of the swap fees.

Let’s bring Joe back to demonstrate use cases for the Vortex, and highlight a few important nuances.

• Our friend Joe deposits 500 BNT in the LINK/BNT pool. The protocol mints 500 vBNT to represent pool share. 

• Joe sees that $AAVE dropped to a key support level, and thinks it’s a good time to buy. So, heswaps his vBNT for $AAVE

• Joe then decides that he wants to hold onto his newly bought $AAVE for a while, and decides to use it to provide liquidity to the BNT/AAVE pool. 

• Fast forward 12 months and now, due to all of the fees Joe has accumulated, his BNT stake has tripled and is now worth 1500 BNT. He decides it’s a good time to cash out and buy that house he’s been looking at. 

• In order for Joe to withdraw his LP, he needs to have the same amount of vBNT in his wallet that was given to him when he first deposited -in this case, 500 vBNT.

• Joe uses some USDC in his wallet to buy 500 vBNT. Hecan now withdraw his staked BNT from the LINK/BNT pool. This burns the 500 vBNT, and returns 1500 BNT.

Notice that despite the amount of BNT that Joe had staked in the pool tripled, the amount of vBNT he needed in his wallet to withdraw his BNT stayed the same.

Dune Chart – if you had sold your vBNT during the summer of 2021, it would cost twice as much to buy it back at the current vBNT price.

While the implementation of leverage on Bancor was a great addition to the protocol, it’s still leverage, and there are always risks. Borrowing against staked BNT is effectively a bet against the vBNT/BNT peg. Cost to play s the result of the difference between the price of vBNT at the time you swapped it compared when you buy back in.

Bancor foresaw difficulties with the complexity of the system. Despite best efforts to emphasize risk, there were bound to be groups of people who put on irresponsible leverage. With these users in mind, Bancor introduced a few different deflationary tokenomics to vBNT to help offset some of the risk involved with leverage and help the protocol as a whole. 

Feel the BURN

On April 4th, 2021, Bancor announced that Bancor Vortex Burner was officially deployed, which meant vBNT burning was live. vBNT burns enabled: 

• Increased liquidity depth, by locking a portion of every swap into the protocol.

• Reduced borrow risk, by offsetting the continuous upside pressure of vBNT with consistent burns.

• Permanent reduction in the circulating supply of BNT, by continuously buying and locking up BNT for good.  

• Increased the amount of protocol-owned liquidity throughthe treasury, giving them the ability to sponsor more room for a liquidity  pool and pay for insurance.

The full vortex going live introduced an important element in Bancor’s monetary policy. Vortex enables the protocol to adjust the burn rate of vBNT, by collecting up to 15% of swap revenues. Remember,for every vBNT that exists, there’s 1 BNT equivalent. So, a consistent burn of vBNT is equivalent to locking away BNT into the protocol forever.

It’s been less than a year since the burning has started, and to date, there’s been a total of $4,314,188.26 vBNT burned and $ 7,325,296.08 $BNT locked inside the protocol. 

V2.1 Limitations

It’s no question that Bancor v2.1 succeeded at delivering a solution to the limitations that came with the first generation AMMs. While this may be true, that isn’t to say that this version of the protocol didn’t come with its own limitations. We ran through a few of the key factors below:

Enter Bancor V3

Bancor V3 proposes a considerable upgrade to the architecture of the protocol with the purpose of hitting all of the primary issues present in V2 and improving user experience by introducing several new features including:

• Instant impermanent loss protection

• A redesigned framework for Single Side Pool Tokens

• Unlimited cap for deposits with the introduction of “Superfluid Liquidity” and Infinity Pools

• Flash Loans

• Deeper liquidity & reduced transaction costs by using Bancor’s new Omnipool

• Dual-sided reward issuance.

• Auto-compounding rewards on a contract level.

• External impermanent loss protection

• New integrations, Multichain & L2 Support, a revamped UI, and more.

Be on the look out for the next section of this two-part series where we break down each of these components in greater detail.