Balancer is one of the hottest new DeFi projects in the space today, as evidenced by its recent spike following the release of its governance token BAL.
The Balancer Protocol consists of a decentralized exchange and liquidity mining platform that allows users to earn interest as they provide liquidity to the exchange.
In this guide, we shall explore how Balancer works, what services the platform offers, and most importantly, how to generate income from its liquidity mining scheme.
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Balancer was an incubation project by engineering company BlockScience. It was co-founded by security engineer Mike McDonald and Fernando Martinelli as they officially announced the project in September 2019, before officially becoming Balancer Labs.
Balancer Labs held a seed round on March 20, which led them to raise $3 million from well-known venture capital firms like Placeholder and Accomplice. Additionally, their protocol was fully audited by Trail of Bits and went live on mainnet on the 31st of that same month.
What is Balancer?
Balancer is an automated market maker protocol that allows users to provide liquidity and earn from the trading fees generated, on top of the BAL rewards given weekly. In that sense, it is very similar to Uniswap except with Uniswap, users are required to deposit 50% ETH and 50% of their desired crypto asset.
With Balancer, there are no restrictions or requirements for the trading pair, as long as the tokens you want to contribute are supported. It allows pools of up to eight tokens with customizable allocations. For instance, you can have 49% WBTC, 49% cBAT, and 2% COMP.
Balancer pools enable the Bancor protocol to function as a decentralized marketplace with users providing liquidity for their own profit. The protocol itself ensures that the value percentage of the tokens in a pool will remain as close to the weight even with varying market prices.
You could think of the Balancer pool as a self-balancing index fund, only better since a traditional index fund requires investors to pay a rebalancing fee. In the Bancor pool, the liquidity providers are rewarded for supplying liquidity to the platform instead.
There are two benefits for liquidity providers: earning fees and having their index funds continuously rebalanced for them.
Types of Balancer Pools
There are two types of Balancer pools. One is shared or finalized and the other is private or controlled.
Shared pools have fixed parameters, meaning they cannot be modified by the pool creator. These types of pools are more suitable to be shared with the general public, allowing anyone to provide liquidity and make profits as they see fit.
Private pools are very flexible, meaning tokens can easily be added or removed, weights can be altered, etc. Obviously, the creator of this pool could easily abuse the system for his/her own gain at the cost of other liquidity providers. Therefore, only the creator is allowed to provide liquidity for this type of pool.
This type of pool is better suited for large index funds that manage holdings from third-party clients, for instance.
Users also have the option to create their own Balancer pool, although the steps required can be a little technical for most average users since the interface is not user-friendly. For now, most users are better off becoming a liquidity provider for existing Balancer pools.
Potential Use Cases
Diversification may be a basic principle for investing, but most crypto investors usually have uneven distributions in their holdings. In fact, they usually have one or two vastly dominant assets. For instance, a typical investor’s crypto portfolio distribution might look something like this:
With those holdings, an investor could simply hodl and wait for the assets to appreciate, or put them to work so they can earn while hodling. However, this requires creating your own pool. The Balancer protocol has a unique way of allowing anyone to provide liquidity with full flexibility even to the most uneven pools.
Another use case is for Liquidity Bootstrapping Pools (LBP). Basically, new projects that want to make their native asset liquid and also distribute tokens in a sale can use the so-called ‘smart pool’. Smart pools are essentially private pools that are owned by smart contracts, which can be used as portals for external users to add liquidity to pools under certain conditions.
LBP does two things: provide liquidity for a project’s token at the same time exchange it for ETH or DAI to fund their development.
BAL is the governance token of the Balancer Protocol, which allows holders to vote on decisions concerning the protocol, as well as changes to system parameters. Unlike other governance tokens like MKR and KNC, Balancer currently has no economic value besides having influence over the protocol governance.
MKR tokens are regularly destroyed as part of the MakerDAO operational procedure, which helps create scarcity for the token and increases its value. The Balancer Protocol does not follow the same framework.
The Balancer team is exploring how governance tokens should be properly valued when there are no economic rewards in place. The community, however, believes that in the future as new base layers and blockchain networks launch, we may witness many governance tokens to naturally evolve into money-generating assets as they become increasingly important.
The total supply of BAL is capped at 100 million tokens, 25 million of which is allocated to the founding members, core developers, advisers, and investors. The rest are being distributed to the community through liquidity mining. The total supply of BAL at the time of writing is currently at 35,435,000.
Liquidity Mining (Making Money through Balancer)
Liquidity mining is essentially the process in which Balancer rewards liquidity providers so they would provide liquidity to the pools. It is probably the hottest feature of the Balancer Protocol at the moment since it is the easiest way to make money from the platform.
There are two reward schemes for adding liquidity to the protocol: reward from trading fees and BAL.
How to Add Liquidity to Balancer Pools
In order to add assets to a pool, first you need to go to go over to Balancer Pools and connect your Metamask or another wallet.
You will be able to view the different pools available. Choose which one you’d like to add liquidity to. In our example, we shall pick the 75% WETH, 25% MKR pool.
The next step is to click “Add Liquidity” and Unlock both MKR + WETH. Note that this will incur a small gas fee. Be sure that you have the right ratio of tokens required to enter your chosen pool. For this example, we will be adding 0.0865 MKR.
Since this pool is 75%/25% MKR/WETH, we need to match our tokens with 0.0503 WETH tokens. Please note that WETH tokens are not ETH tokens. If you have ETH, you’re gonna need to wrap it into WETH first.
Once everything is in place, confirm the transaction on your Metamask or whatever wallet you’ve used.
Congratulations, you will now be earning passive income through trading fees. But that’s not all.
Now that you have provided liquidity to the platform, you are entitled to receive BAL per week proportional to how much you have contributed compared to everybody else. The purpose of this reward scheme is not only to further incentivize users to add liquidity to the platform, but also to properly decentralized the Balancer Protocol.
Basically, 145,000 BAL will be distributed to liquidity miners every week. The protocol allocates these tokens proportionally to the amount of liquidity a user contributes relative to the total liquidity on Balancer.
The pools also have an uncommon feeFactor design which incentivizes pool creators to charge the lowest possible fees, and here’s why. The lower the fees they impose, the more BAL the pool receives, and vice versa.
Therefore, this creates a rather wonderful dilemma as pool creators, as well as liquidity providers, will have to consider their priorities. Will they focus on long-term benefits by minimizing trading fees to maximize their BAL rewards or will they go short-term by focusing on earning as much from trading fees as possible?
How to Trade in Balancer
With all the hype being centered around liquidity mining, a lot of people tend to forget that Balancer is also a non-custodial crypto exchange. The purpose of the liquidity providers is ultimately to maintain the operation of this marketplace in a decentralized manner.
Balancer’s interface is one of the simplest among DEXes and requires no signups or KYC. Here’s how you can trade in the exchange.
First, you need to visit the exchange portal and connect your Metamask or another wallet the same way you did when adding liquidity to the Balancer pool. You will see a pair dropdown list of available assets from ‘Token to Sell’ and ‘Token to Buy’. Choose accordingly.
Balancer will automatically filter through the most suitable pool for your chosen pair, as well as the most efficient allocation ratio in order to provide the best price. Remember that the bigger the swap trade the more liquidity required, which results in higher prices for the token you are buying due to slippage.
There is an option to set an additional limit which can be seen after finalizing your input amount.
After everything is set up to your liking, click ‘Swap’ and approve the transaction in your Metamask.
The BAL token is actually very new. It launched on June 24 on the Ethereum mainnet, and went from $6.65 to nearly $22, technically tripling in price in just one day.
Unfortunately, it appears that the Balancer Protocol was also hacked last June 29 through an exploit that allowed the culprit to trick the protocol into giving $500,000 worth of tokens. According to CTO Mike McDonald, the attacker had borrowed around $23 million worth of WETH in a dYdX flash loan.
Then they traded with Statera (STA), an investment token that utilizes a transfer fee model that destroys 1% of its original value every trade, against themselves. The cybercriminal traded between WETH and STA 24 times and drained the STA liquidity pool. And since the protocol thought it had the same amount of STA, it released WETH that was equal to the original balance, rewarding the hacker a larger margin for every trade.
It appears that the DeFi segment of the crypto space is getting more innovative at the same time more cut-throat. Balancer may be one of the new additions, but it has gone up to the rankings pretty fast thanks to its ingenious liquidity incentive schemes and protocol design.
Although there have been security breaches, it’s not an uncommon occurrence in DeFi. In time, these systems will evolve to become more secure and resilient to cyber attacks.
Since BAL is only a few days old from the time of writing, we have yet to see the full effects of its token distribution. It will be exciting to see just how its fee dynamics will play out in the coming months. Will users be more inclined to accumulate BAL and maintain or push up its value? Or will they opt to liquidate as soon as they receive their weekly rewards?