Crypto protocol Balancer can be compared to weighted index funds in traditional finance. Index funds are investment strategies that focus on holding certain balances of different assets.
Automated market makers (AMMs) represent a core technology of the decentralized finance (DeFi) ecosystem. Essentially, AMMs are smart contracts that enable automated management of the crowd-sourced liquidity pools that furnish decentralized exchanges with tokens. Additionally, anyone is free to deposit their own tokens in an AMM liquidity pool, and receive a share of trading fees and liquidity pool tokens in return. These tokens represent an ownership share of a pool and can even be reinvested elsewhere in the DeFi ecosystem. AMM tech is responsible for up to 90% of trading on decentralized exchange (DEX) platforms (as of September 2020), and is a driving force behind DeFi innovation and adoption. 2020 saw a five-fold increase in DeFi users, with more than $11 billion of assets locked in DeFi contracts as of October 2020.
There are three main approaches set forth by AMM platforms thus far. The original AMM is Uniswap, which popularized token pairs equally weighted at 50/50. Curve iterates on the AMM model with like-asset optimization, which ensures stability by limiting token pairs to similar assets. Finally, the Balancer protocol evolves AMMs with nearly unlimited options for customizing token balances and fees. While all three platforms provide different value propositions, the flexibility, functionality, and pace of development found in AMM technology is clearly evident.
Balancer: An Automated Index Fund
Crypto protocol Balancer can be compared to weighted index funds in traditional finance. Index funds are investment strategies that focus on holding certain balances of different assets. For example, the S&P 500 is an index that tracks the 500 largest companies on the stock market. Owning a share of an S&P 500 index fund means the value of your share mirrors the makeup of the entire index. When a stock is added or removed from the S&P 500, your index fund is rebalanced to match the change. Index funds provide broad exposure to assets with increased diversification to help manage risk, but they also require that you pay fees to the fund’s manager for continuously trading stocks to rebalance and reflect the ever-changing index.
Balancer crypto pools function as weighted index funds for the DeFi ecosystem, and can maintain portfolios of up to eight different ERC-20 tokens. Instead of manually rebalancing liquidity pools like a traditional index fund, Balancer uses its constant mean market maker equation to automatically rebalance assets within pools via algorithm every time a trade is made — thousands of times per day. In fact, this constant state of rebalancing helps ensure an active market with trading opportunities, which benefits both liquidity providers and traders. Instead of paying fees to a fund manager like an index, Balancer crypto exchange trading fees are paid directly to liquidity providers, who also receive multi-purpose Balancer (BAL) tokens on a weekly basis. These tokens effectively represent an ownership stake in the platform and voting rights in community governance decisions.
By realigning incentives and removing intermediaries from top to bottom, the Balancer crypto platform has taken a cornerstone of traditional finance — index funds — and automated, democratized, and decentralized the concept into a wholly novel apparatus that creates remarkable value for its stakeholders. In this way, Balancer is an excellent example of DeFi in both theory and practice.
How Balancer Works
The most essential feature of the Balancer crypto protocol is its set of algorithms that manage and incentivize interactions between liquidity providers, liquidity pools, and traders according to two objectives: rebalancing pools and finding the best price across pools.
Here’s an example of how rebalancing works on Balancer: Let’s say a Balancer crypto pool is set to maintain 80% of its value in wETH, and 20% of its value in wBTC. If slippage occurs, the protocol will adjust token prices to maintain the 80/20 ratio. Over on the Balancer DEX, when a trader wants to buy wBTC for wETH, the protocol will scan its thousands of pools for the best price. By design, the pools with the best wBTC per wETH prices will also be the pools that most need to be rebalanced. The liquidity pool and the trading platform are locked in a perpetual algorithmic dance for equilibrium that makes every other aspect of Balancer possible.
Like any investors, liquidity providers want the best return on their assets when they deposit into AMMs. Instead of only allowing tightly controlled asset pairs, Balancer allows liquidity providers to execute their own strategies, even as it balances ratios across its network.
For example, if you believe a ratio of 80% ETH to 20% BTC is optimal, Balancer allows you to enter a liquidity pool with your preferred strategy. If you are a liquidity provider looking to participate in an existing 80/20 ETH/BTC pool on Balancer and have 10 BTC to spend, the steps would be roughly as follows:
You provide 10 BTC to the pool
2 BTC is deposited to the pool
8 BTC is converted to the equivalent value in ETH
8 BTC worth of ETH is deposited to the pool
You receive Balancer pool tokens representing your share of the pool
Balancer now has more BTC than ETH compared to before you entered the pool
By providing only BTC to a pool containing BTC and ETH, you have increased the amount of BTC relative to ETH. By increasing the relative quantity of BTC, the relative price of BTC must decrease in order to maintain the constant value ratio of Balancer’s liquidity pools.
There are two main types of Balancer pools: native and smart pools. However, native pools themselves come in two forms: a controlled or ‘private’ form, meaning the pool owner is the only actor who can manage the pool’s parameters and add or remove liquidity. Centralized, private pools are dynamic where the weights, ratios, fees, and even the tokens themselves can be altered by the pool creator. Private pools are like actively managed index funds, where you have to trust the creator to continue making good decisions.
However, a core pool can be finalized or made ‘public’ or ‘shared’, meaning that its parameters are set in stone, but anyone is able to add liquidity and trade. A finalized Balancer core pool with 80% ETH, 20% BTC, and a 0.1% fee will always remain that way, ensured by a permanently fixed smart contract code on Ethereum. Public pools are better suited as passive investment strategies that you can set and forget, and anyone can join in on the strategy at any time.
Smart pools are private pools controlled by automated smart contracts that function as a gateway for anyone to provide liquidity. Therefore smart pools can be seen as a hybrid of private and shared pools, a combination of the best of both worlds. Smart pools can execute features like dynamic fees, liquidity caps, LP whitelist Ing, trading pauses and so on. Balancing a flexible basket of tokens, it can theoretically be programmed to execute any strategy imaginable, for example dictated by a DAO-based alignment mechanism.
The Balancer crypto platform has two faces: An exchange for traders, and an investment fund for liquidity providers. Liquidity providers want to own a share of a Balancer crypto pool because they believe the weighted balance and fees from holding assets in the pool will be more profitable than holding their assets outside of Balancer. Traders are simply looking for the best prices to exchange tokens.
Most traders — be they individuals or bots with pre-programmed strategies — are just looking to exchange one token for another at the best rate possible. Regardless of their intention, traders who find the lower-priced BTC on Balancer will likely enter the pool and buy BTC by selling ETH to Balancer. Because Balancer is made up of thousands of liquidity pools with different tokens in different ratios, some liquidity pools will have greater price discrepancies than others. For example, our 80/20 ETH/BTC pool may have a different price for BTC than another pool with 70% of its value in ETH, 15% of its value in BTC, and 15% of its value in DAI.
Balancer looks across all the different liquidity pools on the platform for the best BTC per ETH price. Liquidity pools with the largest discrepancies in price and token distribution relative to other liquidity pools on Balancer are where trades happen first. When a trader wants to buy BTC and sell ETH on Balancer, the protocol will automatically select the pool with the best price for that trade. Since pricing on AMMs like Balancer are dictated by a constant trading formula, the pool with the lowest priced BTC will also be the pool with the most amount of BTC relative to ETH.
When trades are executed, liquidity pools with the most divergent prices are brought closer to the prices of other pools on Balancer. This is an example of aligned incentives achieved via automation, as the trader benefits from getting the best priced BTC on Balancer, and liquidity providers benefit by having their pool rebalanced — it is all done automatically by the Balancer crypto protocol.
Balancer (BAL) Tokens
Like many DeFi projects, the Balancer crypto protocol has integrated governance mechanisms into its native Balancer (BAL) token. The Balancer community governs the protocol and is responsible for proposing updates or changes. Holders of the Balancer token are then able to approve or decline the proposals by voting with their Balancer tokens. Since decisions are made by BAL holders, the Balancer token essentially represents ownership of Balancer. A potential future outcome of the governance process is for BAL holders to vote to implement a protocol-level trading fee on Balancer which could accrue value back to the Balancer token.
In addition to being available to buy on open market exchanges, Balancer tokens are distributed to liquidity providers on a weekly basis. The more liquidity, tokens, and value you provide to a Balancer pool, the more Balancer tokens you earn. Like many DeFi governance tokens, the material value of BAL is far more than nominal, reaching an all time high of $37.01 in August 2020.
Decentralized applications (dApps) in DeFi are trending towards governance, management, profit, and ownership models that are accountable to community stakeholders. Awarding liquidity providers with Balancer tokens distributes ownership of Balancer to users of the protocol, and is creating a decentralized governing community while seeing remarkable market growth in this early period.
Through automated markets and collectivized ownership models, DeFi projects like Balancer are incorporating the ideas of decentralization into their platforms from top to bottom in reimagining finance. The result thus far has been an explosion of growth and innovation in the still-nascent DeFi space, and Balancer has earned its name by aligning incentives, algorithms, and decentralization.
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