What’s going on with Bancor?

Bancor, a decentralized AMM and exchange, has temporarily paused its impermanent loss protection feature to protect the protocol and its users from “manipulative behavior.” In an announcement published on June 19th, Bancor said that it was confident the measures will secure the protocol while it works on introducing better protections.

However, the announcement was quickly followed by rumors about a possible solvency crisis at Bancor that was framed as a “user safety precaution.” Still hurting from the Terra/LUNA fallout and the ongoing crisis with Celsius, the crypto industry is rife with speculation about how Bancor will resolve its liquidity issues.

CryptoSlate talked with the Bancor team about the truthfulness of these claims, the events that led to their decision to pause impermanent loss protection, and the steps they were taking to prevent similar issues in the future.

Bancor is trying to prevent blowback from the Celsius crisis

On June 19th, Bancor announced that it will temporarily pause its impermanent loss protection (ILP) feature. Trading will remain active on all liquidity pools on the network and users who remain in the protocol will continue earning yields. Once ILP is reactivated, they will be able to withdraw their fully-protected value. While withdrawals from the protocol haven’t been affected, Bancor said that it paused new deposits into its liquidity pools to “prevent confusion.”

According to the company’s blog post, Bancor has registered anomalies in its data and has reasons to believe that they’re a result of manipulative behavior.

“Therefore, we are taking bold measures to protect the protocol by temporarily suspending IL protection and other steps to limit further exposure,” it said in the announcement.

However, rumors about a possible liquidity crisis at Bancor spread like wildfire soon after the announcement. The platform was accused of buying time to figure out how to remain solvent after incurring losses on its native BNT token and downplaying the severity of the issue.

what is the point of impermanent loss protection if it just disappears when u most need it LOL pic.twitter.com/GAJyhr6Tib

— Cobie (@cobie) June 19, 2022

Some even believe that Bancor is bound to end up in a death spiral, as its ILP mechanism compensates liquidity providers by minting new BNT, transferring the cost to BNT holders through inflation.

Bancor’s shell game of IL hiding is collapsing. They print new BNT to compensate underwater LPs and call it “IL protection”. The cost is transferred to BNT holders via inflation, which causes further IL to all other BNT pairs, and leads to further inflation. A death spiral. https://t.co/MbqPiL3sKB

— Hasu⚡️? (@hasufl) June 20, 2022

Bancor confirmed rumors that the recent Celsius crisis was at least partially responsible for the issues with IL on the platform. The company said that the cost of providing BNT rewards to liquidity providers has been amplified by the recent insolvency of “two large centralized entities,” which many believe refers to Celsius and Three Arrows Capital.

These two entities were “key beneficiaries” of BNT liquidity mining rewards, having been long-time liquidity providers in Bancor v2.1. To cover their liabilities, these entities have unexpectedly liquidated their BNT positions and withdrawn large sums of liquidity from the system. At the same time, an “unknown entity” has opened a large short position on BNT, Bancor explained in the post.

While this would be a manageable issue for a protocol with diversified liquidity pools, this is a serious risk for Bancor as all of the liquidity pairs on the protocol are against its native BNT.

The decision to keep trading open while hating deposits was also heavily scrutinized. Some critics said that this enables BNT holders to dump the tokens, causing an even bigger discrepancy in the liquidity pools that now have no IL protection.

Bancor responds to controversy

The Bancor team was quick to respond to the controversy surrounding its decision to pause IL protection. Nate Hindman, the protocol’s head of growth, said that the announcement had no intention of downplaying the severity of the situation Bancor faced. On June 20th, Bancor’s product architect and head of research Mark Richardson discussed the implications of the pause at length in a Twitter AMA.

Richardson explained that the decision to keep trading open was a practical one, as reactivating IL protection would require rebalancing over 150 liquidity pools. Halting new deposits, however, was an ethical decision — Richardson said that it wouldn’t be fair to accept new liquidity from users while the situation remains unresolved.

Nate Hindman, the chief of growth at Bancor, told CryptoSlate that there’s no room for speculation about Bancor’s solvency.

“Everything is on-chain. You can see how much the protocol needs to pay out in IL insurance. We are not a centralized protocol where it is a black box and an individual can take risks with user funds. This transparency into exactly how much IL insurance is owed is what helped us quickly identify the situation and take emergency action afforded by the DAO to pause the insurance feature on withdrawals.”

When it comes to accusations about the sustainability of Bancor’s IL protection mechanism, Hindman said that there was a lot of confusion surrounding its insurance model.

“Some people think we compensate for impermanent loss just by printing more BNT. That’s not quite true. In reality, Bancor offers its liquidity providers impermanent loss insurance in return for a proportion of the trading fees earned on the platform.”

The protocol has two ways of generating these fees, with the first being Bancor’s protocol-owned liquidity. Bancor stakes BNT in its pools and uses the fees earned from staking to compensate users for any IL they incur. The second way of generating fees is through a protocol-wide fee that confiscates 15% of all trade revenue on the network and uses the fees to buy and burn vBNT.

The decision to pause withdrawals was a result of a “perfect storm of macro events” that culminated with the rapid dumping of BNT liquidity mining rewards that were “excessively issued” over a period of 18 months. Hindman said that Bancor decided to prevent a handful of large players from dumping their stockpiles of BNT rewards and withdrawing their large liquidity stakes to protect individual users of the protocol.

“Excessive spending on BNT liquidity mining rewards during the lifetime of Bancor v2.1 put massive stress on IL protection amid a perfect storm of macro events. That was the original sin — overspending on liquidity mining rewards,” Hindman told CryptoSlate.

He noted that while Bancor is still confident in the robustness of its IL protection model even in these extreme conditions, the protocol needed to protect itself from the excessive dumping of BNT and the big short taken out on its native token.

The Bancor team is working around the clock on getting the IL protection system fully back online with better protections, Hindman said, but couldn’t provide any further details as to when that will happen. Bancor also acknowledged the need for better open-source analytics that would enable the community to assess emerging risks and react in time to avoid feature shutdowns.