Blockchain Spotlight – Bonding Curves: Creating liquidity and encouraging investment in new markets
Last time in Blockchain Spotlight, we took a look at curation markets — a technology that allows for people to organize around a common goal and benefit from its success. This week, we’ll delve into a concept born out of curation markets called “bonding curves.”
Bonding curves are a means by which tokens can be bought and sold according to a predetermined algorithmic code, creating liquidity in a market and eliminating the need for a market maker.
Let’s say a given project issues its own native token, as occurs when creating a curation market. Participants must use a separate coin (let’s say ether) to purchase the project token, and those funds (the ETH) are deposited into a communal deposit.
The price to buy the project token is hard-coded according to an algorithmic curve that is set when the project token is initially issued. It may look like this:
Credit: Simon de la Rouviere
At any given point, anyone who has purchased the project token can sell it back into the communal pool and receive funds (ETH) in return. Sometimes, there is a separate buy curve and sell curve, which would look like this:
Credit: Simon de la Rouviere
However the same core principle always applies — if you buy in early, you will receive more tokens for the same price; if you buy in later, when the supply is higher, you will get fewer. The opposite is true for selling: if you sell back into the pool early, you will receive less ETH than if you sell back in later when there is more of the token outstanding.
This somewhat mirrors the way in which traditional markets work, where buying in during the early stages of a project can offer considerable upside. However, unlike traditional markets, there is no need for a market maker. In other words, there is no one on the other side of the trades, since the price at which you buy and sell the project tokens is hard-coded at the outset of the project. Participants are merely buying and selling project tokens, in and out of the communal pool, at preset rates. What that rate is — or, where in the curve the trade falls — depends on the current interest there is in the project token, which in turn is dependent upon the success of the project, again not unlike traditional markets.
One of the biggest problems this system addresses is the need for liquidity in fledgling projects. Many new blockchain-based startups that hold an ICO face challenges in creating a liquid market for their coin post-ICO, due to high exchange listing fees, small marketing budgets through which to generate interest in their project, and even the current bear market trend. As such, there is often a thin and “unhealthy” market for their coin, manifested in low trading volumes and large spreads between the bid and the ask prices.
But with bonding curves, participants always have the ability to buy and sell the project token, even if they are the only person interested in making a trade, since they do so according to the prices set by the algorithmic curve, dependent on the current supply of the token. As you may recall from curation markets, specific project tokens are created (when bought) and burned (when sold) as necessary. The more tokens that are created — meaning, the more interest there is in the project — the further along the X-axis the price would be in the above charts.
You may be wondering why it is necessary to create a separate project token for each project. Why not just use BTC or ETH? Simon de la Rouviere, who pioneered the idea of curation markets, writes that the reason each project should have its own native token is that the value of that project should be accurately tied to its own coin. If a project used ETH as its token, for example, the value of the project would not be properly represented, since the value of ETH is tied to many other outside factors, including the whims of the market.
The term “bonding curves” was coined by the company Zap, which we also discussed in our curation markets article. A brief recap: Zap uses “oracles” to connect real-world data to the blockchain, and utilizes a curation market model to allow participants access to information. Anyone can create an oracle — essentially a feed with data from the real world (sports scores, for example) — on the platform. But in order to access the information it provides, participants must bond to the oracle using the platform’s proprietary coin, also called Zap. Bonding to the oracle produces a secondary token native to that oracle called a “dot,” which is worth one query to the oracle.
This process of bonding occurs through the use of a bonding curve. Let’s say that you are developing a Dapp (decentralized app) where users bet on election results. In order to access that data, you bond to an oracle that provides you with real-time election results, at a price of 1,000 dots (meaning calls to the oracle for data) for 4 Zap tokens; these Zap tokens are deposited into the communal pool for that oracle. Over time, that oracle becomes more popular and there are more calls to it, meaning more dots are minted and it is thus more expensive to produce dots. The price rises to 1,000 dots for 20 Zap tokens. You can now sell your dots — or at least, the ones you have not used yet — at a 5X return. Your dots will be burned and you will receive Zap tokens back from the communal pool.
The success (and trustworthiness) of any given oracle is largely determined by the number of participants who bond to it, either because they intend to initiate a query for data, or to speculate on its future popularity. No matter the reason for their investment, buyers are able to purchase dots with confidence, knowing that the price will not crash precipitously due to low liquidity, as is currently the risk with buying into new crypto projects. As such, participants will be able to use and support new projects with reduced exposure, potentially drawing new investors into the space.
[Disclaimer: Nick Spanos, who is a co-founder of Zap, is also a co-founder of Cryptos.com]