Dissecting How the 'Balancer' Protocol Operates


9 min read
Dissecting How the 'Balancer' Protocol Operates

We're not going to dive too deep into the functionality of the 'Balancer Protocol' here, but we are going to take a look at the technical documentation + whitepaper(s) published publicly by Balancer and its affiliates to see if we can't make this protocol a bit less confusing.

Main Goal? Walk away from this with a conversational knowledge of Balancer (i.e., you'd be able to get through a 7th grade class presentation on it).

We'll be using Balancer's own documentation for reference: https://docs.balancer.finance/getting-started/faq

Brief Overview of How Balancer Works

The most relevant statement from the excerpt above is the following:

"There are two categories of users who can benefit from Balancer Protocol: liquidity providers ‒ who own Balancer Pools or participate in shared pools ‒ and traders ‒ who use pools to trade."

Also, this idea that those that decide to create a liquidity pool on Balancer are typically doing so because their "story" / situation / motivations match one of the two detailed scenarios in the documentation:

"1. Portfolio managers who want to have controlled exposure to different assets without having to deal with complicated and/or expensive rebalancing procedures."
"2. Investors who have ERC20 tokens sitting idly in a wallet and would like to put them to work so they can effortlessly earn fees"

From That Alone - its Obvious Why Ethereum Was Withdrawn From the Protocol in Haste

Unless a user is looking to hedge against Ethereum (i.e., go 'short'), then there is no reason for them to create a liquidity pool on 'Balancer'.

"Why would they need to be going short?"

Because, as the documentation suggested, the creation of a liquidity pool is typically done by those that simply want to gain exposure to other assets / pools / project types.

However, if Ethereum is rocketing through the skies like it is today and outperforming the rest of the market, then there is absolutely zero incentive for anyone to create a liquidity pool because they will invariably be exposed to less profitable assets (by virtue of simple process of elimination + outright outperforming their price action).

Balancer Protocol's Resulting Price

Disclaimer (Important Note!): This was originally written back on July 23rd, 2020 ; so the dates / prices will not be accurate to the time of publishing - this is still a helpful breakdown though! Just keep that in mind so you don't get confused below

Contrary to other DeFi projects in the market (like Synthetix / Kyber Network / etc.), Balancer Protocol's governance token has experienced super gains (see below):

Approximately +12% and counting at the time of writing (6 p.m. UTC on July 23rd, 2020).

We Know No More Than We Did Before

Its great that we were able to isolate the fact that there was a major decline in the amount of Ethereum being "locked" to create liquidity pools on Balancer (that's a no-brainer based on the metrics we saw).

But what we still don't know is:

  1. Whether that was a catalyst of some sort for the bullish price action we've seen from the $BAL token (governance token).
  2. Whether Ethereum's price action / exodus from the protocol over the past 24-48 hours are either both or, separately, correlated with the massive increase in valuation for the $BAL token in concert with Ethereum's momumental gains (at +14% and counting at the time of writing)

Examining How the $BAL Governance Token Works

Documentation from the team on the $BAL governance token can be found here: https://docs.balancer.finance/protocol/bal-balancer-governance-token

(this is fluff above - moving on)

Quick Summary

In the excerpt above, Balancer essentially states that they need users to create pools for liquidity (otherwise the protocol / ecosystem will come to a crashing halt).

The concept is simple - no liquidity, no trades. No trades, no "DEX" (decentralized exchange).
On top of that, there aren't any super strong incentives that immediately reward users for choosing to provide liquidity for the platform either.

Specifically, the documentation lists the following potential setbacks / negatives associated with creating liquidity pools (first starting out):

  1. Early liquidity providers take on more risks and opportunity costs
  2. Contract Risk
  3. Low initial pool profitability

Thus, Balancer Came Up With a Plan to Provide Incentive For Users to Create Liquidity Pools

Specifically, the documentation states that, in response to the situation outlined above, the protocol was designed to ensure that:

"Protocol users should get to participate early on in deciding how the protocol evolves."

According to the documentation, the Balancer Protocol was designed to provide this assurance by:

"[Proposing and implementing] the concept of liquidity mining."

Specifically

"Balancer governance tokens (BALs) are distributed to liquidity providers."

Summary and Translation

Essentially, in exchange for providing liquidity on the platform, users are rewarded with $BAL governance token.

Details Regarding the Supply of the $BAL Governance Token

Summarizing quickly here, there are only 100 million $BAL tokens that will ever exist in circulation (unless those that possess the proper governance authority on the protocol decide otherwise).

However, these tokens are not all minted yet.

Instead, they are minted through the creation and maintenance of liquidity pools by users (i.e., liquidity mining).

What This Means

The rewards (in $BAL governance token) that users receive in exchange for creating liquidity on the platform is not taken from an already existing circulating supply, but rather minted, then distributed to the liquidity creators in accordance with the protocol's specifications.

According to the documentation:

"Every week 145,000 BALs, or approximately 7.5M per year, are distributed to liquidity providers."
"This means in the first year of BAL's existence there would be 30% supply inflation off the initially allocated supply of 25M tokens (here we are not considering the two funds since they are not allocated to anyone yet)."

Providing an Explanation For the High Initial Rate of Inflation

Per the docs:

"The high rate of supply inflation is meant to kickstart the distribution of governance rights of the protocol out to those who earn it."
"At the current rate of 145,000 BAL per week, it would take 8.666 years to distribute the whole 65M BAL remaining until the 100M cap is reached."

Formula For the Division of $BAL Governance Tokens Among All Liquidity Pool Providers

Fast Forwarding Through the Review of Balancer Protocol For a Second

There are an infinite number of links that outline the unnecessarily extensive mathematical documentation accompanied with the proposed distribution of $BAL governance token (plus the reallocation / rebalancing of pool portfolios).

We won't dig into the details - but there are certain aspects of the protocol's functionality that we need to look at.

source: https://balancer.finance/whitepaper/#constant-value-distribution-proof

Constant Value Distribution

The 'constant value distribution' is the most relevant part of the protocol that we need to isolate here:

Translating the Above into English

Essentially, balancer pools are "baskets" (of various tokens in varying ratios)

Since users cannot buy the entire basket at once, the protocol leverages an algorithm that automatically reapportions the 'balance' of a given pool's portfolio to ensure that no one asset is 'overbalanced'.

Example:

There's a balancer pool that contains 30% ETH / 20% BAT / 50% OMG. Recently, there was a major price spike for $OMG. In response, the protocol funnels additional buy orders for BAT & ETH (the remaining 50%) versus $OMG in order to ensure the consistency of the spot price.

Spot Price Consistency

This concept is touched on in the whitepaper as well, but we're going to conservatively assume that no one reading this report is a mathematician (since it appears that one would need to possess a comparable level of knowledge to parse out the validity of the equations / proofs provided by 'balancer protocol', which ultimately aren't relevant or necessary to understand how the protocol functions).

The explanation for Balancer's insistence on maintaining a consistent spot price:

Relevance of Balancer Pool's Consistent Spot Price

After doing some research via the community directly (in the balancer Discord), the lead we were looking for to explain balancer's accompanying price action surfaced.

The response that we received to our query in the screenshot above actually hits the nail on the head.

Breaking This Down Into Parts: Part One

(This wans't included in the user's ansewr, but this supplementary part helps) - a few weeks ago, there was a governance decision made on the balancer protocol that capped the total liquidity pools could have count toward their total contribution on the protocol (for certain tokens). Additionally, the liquidity factor for $BAL was increased to 1.5 (versus just 1.0) - incentivizing its inclusion in pools.

source: https://defirate.com/balancer-governance-polls/

The link to the actual governance proposal (approved on July 18th/19th, 2020), can be found here [and is pictured below]: https://vote.balancer.finance/balancer/proposal/QmSXpyHBrkjzjmGpdYxKvYoRAMvdJNp7rrnyvJqTdtpayZ

Breaking This Down Into Parts: Part Two

As a result, pools that contain baskets of Ethereum and balancer (the token), result in explosive buy volume / orders that target balancer's governance token ($BAL) to compensate for the price appreciation of Ethereum.

source: https://defimarketcap.io/protocol/balancer

Where Does the Value for Balancer's Governance Token Stem From?

Short answer? Nothing. At all.

And by 'nothing', that's not being stated in a philosophical, opinionated way - but in a factual, almost mathematical, literal deductive sense.

Apart from being given to users as a reward on the protocol, there is no other mechanism in the protocol's architecture / design that is designed to create organic, persistent demand for the governance token (beyond the incentive to want to acquire some of the token for a "voice" / 'vote' on the protocol on certain proposals).

But, even in that case, we're right back at square one again - because, the only reward that one could reasonably glean from having a greater say in the 'governance' of the protocol is a chance to influence decisions in a manner that allows that user to gain greater rewards.

What are those rewards?

The $BAL token.

The rationality behind the token's value can't even be considered to be 'circular', because there isn't even a viable starting point here.

Yield Farming

The convoluted scheme that we outlined above is indicative of this new 'craze' in the decentralized finance space - called "yield farming".

We've touched on this topic peripherally in the past before, but we're going to take a closer look in this next section below.

To start off with - here is a great report that outlines the 'ins and outs' of "yield farming": https://defipulse.com/blog/the-yield-farming-frenzy-and-its-impact-on-defi/

What Yield Farming is in a Nutshell

We're going to start off with the definition given by the article (defipulse is a really reliable platform), then we're going to come full circle to show the relevance of this concept with Balancer Protocol (and, on a larger level, Ethereum).

The excerpt above states:

"Yield farming is the act of leveraging different DeFi protocols and products to earn a yield or a return on their assets, in some cases obtaining profits well over 100% APY through a combination of lending interest and token incentives."
"The recent yield farming frenzy made total value Locked (TVL) on DeFi skyrocket to new all-time highs, zooming far past $2B."

Yield Farming in a Smaller Nutshell

This concept simply refers to the idea of liquidity pool providers (liquidity providers for a DEX) receiving a benefit (in the form of whatever the protocol's native / governance asset is) as a reward, in proportion with the total amount being provided to the protocol for match making, order creations, etc. (just like what we outlined above with the balancer token).

Conclusion

In covering the 'balancer protocol', we have also shelled out Synthetix (to a large extent), as well.

However, the reason why balancer is experiencing such a boost in delta (ROI) today versus Synthetix is because the former was designed with a portfolio re-allocating mechanism that maintains the "balance" among asset pool (baskets), by funneling demand toward lower priced assets whenever there is an imbalance in the price appreciation of any sole, constituent asset.

In this case, Ethereum's price gain forced the balancer protocol to create overwhelming demand for balancer ($BAL, governance token), algorithmically driving up demand for $BAL with the goal of increasing the price to maintain "price stablility"(i.e., selling off $ETH for the balancer per the documentation + funneling buy orders for the pool's basket)

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