Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.
Decentralized finance (DeFi) broke out in a big way in 2020. The term refers to a slew of decentralized financial products, such as decentralized exchanges, automated market makers, and non-custodial lending protocols. The small economy blew up in 2020, starting the year at $1 billion and, as of March 2021, hitting $43 billion.
One of the hot new DeFi apps is called Balancer. The platform, a kind of index fund for crypto with exchange-like functionalities, launched in March 2020. One year later, Balancer has a market cap in excess of $300 million and a platform that’s locked in at $1.89 billion worth of liquidity.
But, like all decentralized finance protocols, Balaner is complex. Understanding it requires some guidance and patience. This guide explains what Balancer does, how it works, and how people make money from it.Buy and Sell Bitcoin, Ethereum, and over a dozen other cryptocurrencies with Wealthsimple. Sign up and Trade here.
What is Balancer?
Balancer is an automated market maker. Investors pledge lots of different types of cryptocurrency into big funds called liquidity pools, and then Balancer makes it possible to trade cryptocurrencies from those liquidity pools. For example, if a user holds Ether, they can earn money by depositing their funds into a liquidity pool on Balancer. And then another user, should they wish, can tap that liquidity pool to trade some cryptocurrency.
The platform, like many other blockchain projects, is built using Ethereum, which is a platform for developing apps on a blockchain.
Balancer can be compared to an index fund. Index funds are collections of different stocks; for example, the S&P 500 can be bought as an index fund. This index fund would then track the performance of every company as an aggregate, ensuring a balanced portfolio with reduced risk. Similarly, users of Balancer can effectively create their own index funds, composed of cryptocurrencies that they own. These funds, called liquidity pools, can comprise up to eight different cryptocurrencies, offering a balanced product, similar to an index fund.
These cryptocurrency funds are called Balancer pools, and users can provide liquidity to them by depositing their cryptocurrency into one of them. These could be already existing pools, but users also have the option to create their own. Tokens in the pools are limited to ERC20 tokens—those that are based on the Ethereum blockchain. Once deposits have been made, users rake in trading fees, since the network charges people who want to trade cryptocurrencies in the funds. Liquidity providers are paid in Balancer’s native token, the BAL.
The value of a pool is determined by the tokens that make it up and their relative percentages within the pool. For example, a token that makes up 50% of the pool will have a much greater influence on a pool’s value when compared to one that makes up 5%. This weighting is determined at pool creation, and it’s maintained through “balancing.” Hence, the name.
A Balancer pool may be made up of 50% ETH and 50% BAL. If the value of ETH doubles while BAL stays the same, then the pool’s value will now be made up more by ETH than by BAL. Balancer has an automated protocol to address this. When these imbalances occur, the pool reduces the quantity of the cryptocurrency that has gone up to maintain the proportions that were put in place when the pool was first set up.
What happens to the ETH? It becomes available for traders to buy, hence the term liquidity pools. These pools of cryptocurrencies sell off some of the currency to maintain balance, and as a result offer a seller to traders who want to buy. When this rebalancing happens, users with money in pools make some money through trading fees. This is in contrast to traditional index funds, which usually charge for rebalancing services.
Automated and paid rebalancing could be especially useful for portfolio managers who want to maintain exposure to cryptocurrencies without having to manually rebalance their funds. Manual rebalancing could even incur fees, as a trader would have to buy and sell the cryptocurrency on their own on the open market. Balancer is also useful for everyday investors who may have cryptocurrency lying around and want to put that money to work.
Traders can also benefit from Balancer’s systems. The range of pools on offer opens up a variety of different trading opportunities. Balancer identifies three main types of trader who may have some usage for the platform. The first of these are classic “retail” traders. These are traders simply looking for a way to trade with low slippage (slippage is the difference between the expected value of a trade and its value when executed. A second are arbitrageurs, who profit from taking advantage in price variation between centralized and decentralized exchanges. Finally, Ethereum smart contracts that require liquidity to trade on behalf of users can also use the Balancer protocol.
Balancer pools come in two flavours, public and private. Public ones are the ones described above, open to any user who wants to provide liquidity. They are popular among smaller scale users, who can benefit from contributing to the most liquid pools. In contrast, private pools are restricted to the pool creator who adds and subtracts assets. The various factors that make up the pool, such as fees, weightings, and asset types, are entirely up to the pool creator.
There is also a subtype of private pool called a smart pool. These pools are governed by smart contracts. These contracts can automate weight changes for a private pool. One such application of these smart pools is in real estate. The real estate investment company RealT uses these smart pools to rebalance its property portfolios and enable tokenized investment in property.
Balancer is also a fully permissionless platform. Once a contract is on the blockchain, there is no way for Balancer Labs (the company behind Balancer) to change it. The platform can’t ban traders and public pools can’t be edited or upgraded. This entails a limitation: Balancer cannot control the coins within the pools, so if a centralized token, such as the Coinbase and Circle run USDC stablecoin, were to shut down for whatever reason, it would also shut down in the Balancer pools.
Balancer has grown rapidly since breaking out in 2020, and could become an even bigger player when it comes to cryptocurrency trading. Its success is tied to the success of blockchain as a whole and Ethereum in particular however, so without any demand for trades it loses its primary use case.
How is Balancer different from Bitcoin?
Balancer’s purpose is completely different than Bitcoin, which is a peer-to-peer payments network, intended for transactions between buyers and sellers. It is also used as an investment or as a store of value, due to the proof-of-work protocol that sees new Bitcoin minted by computers solving mathematically complex puzzles.
In contrast, Balancer is a network for decentralized trading and generating liquidity. While BAL can be used to buy things, similar to most cryptocurrencies, this is dependent on vendor approval and is not the primary use case for the token. Instead, it is meant as a reward for offering liquidity by pooling cryptocurrencies.
Another difference: Balancer is built on the Ethereum blockchain, which is why it’s limited to ERC20 tokens. Bitcoin was the first cryptocurrency and predates Ethereum by about six years. This means the two systems are on completely different blockchains.
Bitcoin, which has a market cap of $1.1 trillion, is also far larger than Balancer. Bitcoin’s dominance varies, but it generally represents at least 60% of all value in the cryptocurrency economy. Balancer is comparatively tiny, despite having its own market cap in excess of $300 million.
Bitcoin is a significantly different investment to Balancer. Balancer depends upon the success of the cryptocurrency market as a whole, as it needs a supply of desirable coins to be useful. Without this supply, there would be no trading and hence no need for Balancer. While Bitcoin is often taken as an indicator for the general health of the cryptocurrency space, it dwarfs all other projects in size and stands alone in terms of success, as it is totally independent of other cryptocurrencies.
How to buy and earn Balancer
BAL can be purchased on a traditional cryptocurrency exchange, such as Kraken or Binance. Buying on these exchanges may require a wallet, and will usually require you to register an account as well. If you want to trade BAL against other cryptocurrencies or the US Dollar, then it makes sense to buy it on an exchange. From there, you can sweep your BAL into a hardware or software wallet.
The primary way to earn Balancer is through providing liquidity to pools. Balancer pays out its earnings every Tuesday. This is called liquidity mining. The more a user contributes to the pools, the greater their reward in BAL.
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