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What is Bonding and how it works?
Bonding is a mechanism in which a User can sell an asset (i.e. Quote Token) in the bond market (for an existing Quote & Base pair created by an Issuer) to a protocol in exchange for discounted Payout Token at a future date.
To incentivize users to sell to the protocol, rather than the open market, bonds are offered at a discounted rate. Bonds also have a vesting period to prevent users from selling all the discounted tokens at once for a quick profit. A continuous Dutch auction is used to price the bonds and is dynamic, determined by the supply and demand of bonds. It trends higher when there is more demand and vice-versa i.e. lower in the absence of demand. This mechanism provides a real-time true reflection of the bond price in the market.
As a result, bonding is also a very competitive space - bonders/ market participants compete with each other to grab the largest discount.
Bonding allows a protocol to accumulate their own liquidity.
- Protocol Owned Liquidity (POL). Having a sufficient depth in POL allows the protocol to provide guarantee to users that there is always sufficient liquidity under normal market operation and during volatile periods. Without POL and relying on external liquidity providers, under distress market conditions, liquidity is often pulled from the protocol (flight for safety), exacerbating the situation with less exit liquidity leading to liquidity death spiral.
- POL transforms liquidity from a liability to a revenue source. Every swap transaction in a pool contributes a 0.3%/0.25% (Uniswap/Sushiswap) fee to the LPs. With POL, as liquidity is permanently locked in the treasury, these fees provide a constant source of revenue for the protocol.
- POL allows for additional yield farming opportunities. For example, Sushiswap offers the Onsen program, where protocols could have their liquidity pair listed for SUSHI rewards. Once successfully listed, the protocols could deposit their SLP tokens into the Onsen menu and farm SUSHI tokens.
Create bond market by defining Payout Token to be paid out and Quote Token to receive.
Purchase future-dated Payout Token with Quote Token at the current market price and receive Bond Token to represent their position while their bond vests. Once the Bond Token vest, it can be redeemed for the Payout Token.