Bonding Curves in DeFi. In decentralized finance (DeFi), bonding curves use mathematical formulas and smart contracts to dynamically alter the price of a token based on its supply. The cost of a token is determined algorithmically by its circulating supply using bonding curves, which are smart contracts. The cost of a token goes up when more are bought and down when fewer are sold or taken out of circulation.
Thanks to this automated pricing mechanism, there is no need for conventional order books or third-party liquidity providers. It guarantees that new tokens will have liquidity by incorporating liquidity into their smart contract. To be more precise, bonding curves use the laws of supply and demand to their advantage. An increase in purchases indicates a rise in demand for a token, and the smart contract responds by increasing its price. Additionally, the smart contract reduces the price when selling behavior suggests a decline in demand.
This algorithmic dynamic adjustment is based on a previously specified curve that models the link between the amount delivered and pricing. Bonding curves enable automated decentralized liquidity responsive to real-time market conditions.
Price Determination in Bonding Curves
Various economic tactics and market dynamics are supported by DeFi’s bonding curves, which change token pricing with supply. Through mathematical modeling, projects can personalize bonding curve tokenomics by designing distinct curves that dictate the relationship between a token’s supply and price. While theoretically any shape might be a curve, the most common varieties include:
Linear curves
Token prices rise directly with token sales volume in a straightforward mathematical model called a linear bonding curve. Under this concept, there is a fixed, predetermined amount by which the price of each token increases as more are issued or sold.
Exponential curves
According to exponential curves, the token’s price is proportional to its supply. Therefore, the price will increase by more than 100% if the supply doubles. Prices can skyrocket with just a little increase in the number of tokens, causing the token’s value to increase substantially.
The early birds get the biggest rewards from these curves. When demand increases, the initial users will probably earn much more money from token sales. Therefore, projects encouraging early participation can benefit from exponential curves. When a project is successful, the initial users stand to gain the most from the risk they took.
Logarithmic curves
At the outset, adding more tokens causes the price to climb sharply due to logarithmic curves. The price gains, however, begin to level out as the supply continues to grow. Thus, there is an initial increase in price followed by a gradual leveling out. Because their tokens increase in value immediately, early investors stand to gain the most from this. The earliest buyers can offer liquidity if they see quick profits initially.
As an alternative to the more common exponential, logarithmic, and linear models, DeFi allows for a wide variety of bonding curve types. Different curves can address several bonding curves regarding economic outcomes and project goals. For example, S-curves are designed for phased expansion and stabilization, Step Curves are used for milestone-based price rises, and Inverse Curves are used to cut prices as supply expands.
Bonding Curve Applications in Crypto
Bonding curves simplify projects, trading, stablecoins, communities, and governance by offering automated token liquidity and dynamic prices. In IDOs, bonding curves are the backbone of automatic liquidity bootstrapping, which lets projects release new tokens with dynamically modified reserves for the liquidity pool. Unlike conventional order books, this technique guarantees algorithmic and real-time liquidity adaption to demand. Bonding curves make blockchain’s dynamic price flexible, enabling token trade and distribution.
For autonomous market building, platforms like Uniswap and Curve use bonding curves, which improves liquidity and allows for more efficient trading of many tokens, particularly those that could have low liquidity otherwise.
Bonding Curves in DeFi: Stablecoin systems rely heavily on bonding curves to guarantee the decentralized stability of digital currencies by accumulating reserves and keeping them pegged through algorithmic supply changes. Nevertheless, this strategy has hazards, as algorithmic stablecoins depend solely on bonding curves and programmed supply fluctuations to keep their value fixed.
For example, in May 2022, due to a severe bank run, the algorithmic stablecoin TerraUSD (UST) reserves were depleted, and the coin lost its 1:1 dollar peg. This demonstrates that decentralized algorithmic stablecoins face stability issues compared to asset-backed solutions. Algorithmic stablecoins may be unable to defend its peg in the event of a sharp decline in demand. Therefore, bonding curves permit decentralized stability measures; compared to collateralized alternatives, they have not demonstrated complete resilience to bank runs.
Continuous token models enable autonomous market development, real-time demand-based pricing, and automated liquidity bootstrapping in DeFi. Bonding curves facilitate this. They help administer decentralized autonomous groups by facilitating bonding curves for voting token purchases. However, This mechanism guarantees that pricing represents the level of commitment to the DAO and matches investment with governance participation.
Decentralized Exchanges (DEXs) and Bonding Curves
Bonding curves enable customized, automated decentralized liquidity and pricing for varied decentralized exchanges (DEXs).
Uniswap
Uniswap’s automated market maker (AMM) protocol utilizes a particular bonding curve based on a constant product formula. To guarantee liquidity, this formula keeps the product of the quantities of the two assets in any particular liquidity pool constant. Supply and demand will decide the price if the pool includes Ether (ETH) and another token since their product amounts are constant. This method offers continuous liquidity and price discovery without relying on conventional order books.
Curve Finance
Stablecoins are the main focus of Curve Finance in DeFi, which uses a tailored bonding curve optimized for assets with identical values. For tightly pegged assets, such as stablecoins tied to the US dollar, its bonding curve is made to minimize slippage and keep prices stable. Stablecoin swaps benefit from the flatter curve, which reduces the effect of trades on price movements for assets with comparable values.
Balancer
Bonding Curves in DeFi: By employing a more flexible variation of the constant product formula, Balancer enables users to create unique liquidity pools, including up to eight assets with varying weights. Users can use this adaptability to build liquidity pools and self-balancing portfolios according to their specifications, complete with a bonding curve specifying the correlation between the quantity and price of assets in the pool. Balancer’s method extends bonding curves beyond two-asset pools to support more trading and portfolio management strategies.
Bonding Curve Implementation Issues
Bonding curves face modeling, security, and legal challenges when creating, deploying, and regulating automated token pricing systems. These systems require testing, auditing, and compliance analysis. Designing curve shapes that align incentives and stimulate market behavior requires extensive modeling and testing. Overly steep or shallow curves might affect prices.
Smart contracts implementing bonding curves should undergo security audits to maintain price integrity. Improving smart contracts can help reduce the costs of automated trading gas. Bonding curve smart contracts must be well-designed to be safe from manipulation or arbitrage. Tests, audits, and bug bounties are used to mitigate this risk. Research is underway to apply algorithmic modifications to dynamic curves in response to market conditions.
We still don’t know how to regulate bonding curves. Most governments have not clarified if AMMs, similar to bonding curves, are regulated markets for trade or ICOs. Tokens sold through bonding curves entitle projects to specific rights, which must be examined country by country. Different jurisdictions have different restrictions on crypto assets and securities.
Token holders may need to follow securities laws if they obtain profits or control. Other jurisdictions may classify utility tokens more leniently, even if they include profit or governance rights. Projects should analyze target market regulations. Many projects employ utility tokens. This model gives token holders access to the project’s goods and services without profit or governance rights. This limited token design often circumvents security laws. However, KYC and AML requirements may not apply to utility tokens. These laws require identity and funding source verification.
Projects should consult lawyers to handle this challenging scenario. Cryptocurrency token regulations vary by country, and the legal basis for bonding curve systems and token implementations may become more apparent.
Also Read: What is DeFi? Guide to Decentralized Finance By Esteemcrypto
