The Balancer protocol is taking DeFi to the next level. It may seem just an AMM protocol like any other, but here's why this platform isn't just a plain old DEX.
Updated Jun 22, 2022
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There's nothing closer to being your own bank in the crypto world than being a liquidity provider because without liquidity providers, half of DeFi wouldn't function. Every decentralized exchange (DEX) needs liquidity providers in order to fund the pools that traders use to swap cryptos, but most DEXs don't give them a lot of say in how their deposited assets are used.
Balancer has filled that gap by being the first to make liquidity pools more customizable than ever before. Here's how it works.
Originally launched on Ethereum, Balancer is a DeFi protocol for creating custom liquidity pools. Balancer offers liquidity providers more flexibility when compared to other DEXs like Uniswap or Curve Finance because Balancer liquidity pools can be comprised of a greater number of assets and at custom proportions. This makes Balancer not just a DEX, but also an automated crypto portfolio manager that investors can also treat as a build-it-yourself crypto index fund.
Assets deposited into liquidity pools deployed on the Balancer platform are weighted in order to customize the proportions. When comparing Balencer to Uniswap or Curve, this is one feature that makes it unique. Both Uniswap and Curve require liquidity pool assets be equally distributed according to their dollar value. Balancer, on the other hand, enables liquidity pools to change these value proportions to contain different dollar amounts of each crypto by default.
Additionally, Balancer V2 enabled the creation of weighted pools of up to 16 assets, which is double that of V1. This does away with the limitation of only being able to deposit two or three different assets per liquidity pool, so it offers more customizability than other DEXs. For instance, assets in Uniswap pools must be at a 50:50 value ratio. Tripools on Curve raised the limit to three but kept value proportions equal to one-third of each asset.
Balancer weighted pools can contain more than three cryptos and keep them all at different dollar-value ratios. For example, the top liquidity pool containing the BAL and wETH tokens are at a respective 80:20 ratio, so the pool contains a value of BAL four times greater than that of wETH at any given moment. Hypothetically, one could deploy a weighted pool with five assets set to remain at a 5:10:20:25:50 ratio, or make it 10:10:10:10:60, or a pool with eight assets with 12.5% of each—the possibilities go on.
Balancer wants to be the main destination for swapping cryptos, including stablecoins. That's why Balancer took notes from Curve Finance's 3pool and enabled the deployment of stable pools and metastable pools. Stable pools are liquidity pools created specifically for pegged assets, such as stablecoins like USDT and USDC. They use the same formula as Curve tripools to enable the swapping of like-kind stablecoins for low fees and with low slippage.
Balancer created Metastable pools in a similar vein to stable pools, but rather than being designed for assets pegged to the same value, like stablecoins, they are designed for non-pegged assets with high price correlation. Metapools are perfect for assets that tend to stay near the same value, such as a pool containing ETH and a corresponding liquid staking token like stETH.
Another variation of stable pools is boosted pools, which are stablecoin pools that maximize capital efficiency by allowing the assets to be utilized by crypto lending protocols in addition to providing liquidity for traders. This gives liquidity providers the best of both worlds because they simultaneously profit from both trading fees and the interest being earned from lending out stablecoins from the pool to protocols like AAVE.
One way Balancer goes beyond other DEXs is managed pools, which are just like weighted pools but with more features. Managed pools are permissioned (private) liquidity pools that can contain up to 50 assets at once. That's right, you can deposit a custom ratio of up to 50 crypto assets into a managed pool, and you can even choose who's allowed to provide liquidity. This makes them sort of like private crypto index funds that one can actively manage by adjusting the distribution of the pool's tokens.
What makes managed pools better than an index fund is that neither pool managers nor liquidity providers have to pay any fees. Instead, those who contribute liquidity to a managed pool actually earn fees paid by traders for using it to swap cryptos. This is also great because it eliminates the need to pay fund managers. Instead, trading activity organically balances assets within the pool according to the pool proportions and the market forces of supply and demand.
While managed pools are basically automated crypto portfolio managers, the catch is that they're harder to create because you either have to deposit all the assets yourself or find liquidity providers who will deposit their assets into the pool. Nevertheless, managed pools are an innovative way to create a self-balancing crypto portfolio that leverages the power of Balancer's AMM formula.
Another type of liquidity pool invented by Balancer is the liquidity bootstrapping pool, which basically uses the factor of time to adjust the proportion of assets in the pool. This means that the weight of each asset shifts gradually over time until the pool reaches are target weight at which it will remain. Liquidity bootstrapping pools are great for introducing new cryptos into the market by gradually increasing the liquidity relative to a more liquid asset.
Liquidity providers are incentivized to deposit their assets into Balancer pools for two reasons. One incentive is the fees they can earn from traders who use their liquidity to swap cryptos. The other incentive is the BAL token, the governance token of the Balancer protocol. BAL tokens are awarded to those actively providing liquidity in pools on the Balancer protocol.
Although BAL is the governance token, a new governance update has made it so that BAL holders can no longer use it to vote on proposed changes to the Balancer protocol. Rather, if you want to participate in Balancer protocol governance, you must hold veBAL. To get veBAL, you have to first deposit both BAL and ETH into the BAL/ETH 80:20 liquidity pool, and then you stake the subsequent liquidity pool token (LP) in the veBAL contract. This new governance system helps incentivize long-term participation in the protocol while maximizing BAL's liquidity, similar to superfluid staking implemented on the Osmosis DEX.