Balancer Protocol is one of DeFi’s largest liquidity providers. Learn all about how Balancer Protocol works.
Balancer Protocol is an open-source protocol, automated portfolio manager, and liquidity provider. Built on the Ethereum blockchain, Balancer offers new solutions to the problems present on traditional and centralized exchanges. Designed for user accessibility, Balancer Protocol allows for trustless and permissionless trading of ERC-20 tokens.
Balancer Protocol allows users to trade tokens, create liquidity pools, and invest in existing pools while earning yields from trades. The ultimate goal is to become the leading platform for programmable liquidity.
With around 25,000 liquidity providers, over three billion dollars locked in liquidity, and thousands earned in trading fees daily, Balancer Protocol offers users several ways to optimize their crypto experience.
How Balancer Protocol Works
Balancer Protocol targets three prominent use cases. Liquidity Providers who can create and contribute to existing pools, traders and arbitragers looking for liquidity sources, and developers building on top of the Protocol.
Let’s look at the different possibilities.
Balancer Pools are smart contracts that define how traders can swap between tokens on Balancer. What makes Balancer Pools unique from those of other protocols is their limitless flexibility. Balancer Pools with high token counts are similar to traditional index funds, allowing users to have broad exposure to the crypto market. Where Balancer differs from traditional index funds, however, is in the fees.
Instead of paying fees to have a broker rebalance the Pool, Balancer Pools distribute fees as they are continuously rebalanced by traders making swaps.
Balancer Protocol also operates as a decentralized exchange. Users can swap their assets or provide liquidity without relying on centralized intermediaries.
Balancer Pools enable users to earn income simply by depositing their tokens into the pool. Liquidity providers (LPs) earn fees whenever swaps are conducted through Pools they provide liquidity to. In addition to trading fees they collect, Liquidity Providers can earn BAL tokens — the governance token used to cast votes on Balancer improvement proposals. To attract further liquidity, Balancer has a flexible Liquidity Mining Program that targets high-priority pools and can respond quickly to changing market conditions.
Any user who identifies a price difference in two Balancer Pools can execute a Flash Swap. The arbitrageur who makes a flash swap does not need to hold any of the input tokens required to make a trade. The arbitrage opportunity arises as the trader identifies the price imbalance, tells the Vault to make the swap, and receives the profit.
Flash Loans are uncollateralized loans that must be repaid in the same transaction as borrowed. Two of the most common flash loan use cases are arbitrage trades and collateral swaps.
Setting swap fees is a tricky situation between optimizing LP returns, maximizing trader utilities, and ensuring that prices are competitive enough for on-chain trading. While swap fees empower decentralized market-making since LPs earn a return on the capital they provide, they also create a barrier to entry for traders and drive fee revenues to zero. The solution? Balancer Protocol’s V2 weighted pools have dynamically managed swap fees that increase LP returns, boost volumes, and maximize capital efficiency.
Balancer’s native BAL token is known as a governance token. BAL holders vote on proposals relevant to the Protocol, such as new features and directions of where the Balancer Protocol should go. These proposals range from Protocol fees to how BAL tokens themselves are distributed, notably, the allocation of BAL tokens towards the Balancer Liquidity Mining program.
Aligning with their vision of being the primary source for DeFi liquidity, Balancer Protocol released V2 last Spring. The core blocks of Balancer V2 are security, flexibility, capital efficiency, and gas efficiency. The main component of V2 is the transition to a single Vault architecture that holds and manages all the assets added by all Balancer Pools. Because Pools are contracts external to the Vault, they can implement any arbitrary, customized AMM logic. The Vault architecture separates token accounting and management from the pool logic and simplifies pool contracts since they no longer need to actively manage their assets.
Additional V2 features include:
- Protocol Vault for all Balancer Pool assets
- Improved gas efficiency to reduce trading costs
- Permissionless, customizable AMM logic
- Capital efficiency through Asset Managers
- Low gas cost and resilient oracles
- Community-governed protocol fees
Balancer Pools are smart contracts that define how traders can swap between tokens on Balancer Protocol. What makes Balancer Pools unique from those of other protocols is their limitless flexibility. Balancer Protocol’s architecture allows anyone to create their own Pool type, opening the door for further customization. Let’s take a look at the different Pools Balancer Protocol can accommodate:
- Weighted Pools — Weighted Pools are highly versatile and configurable pools. They are ideal for general cases and enable users to build pools with different token counts and weightings, such as pools with 80/20 or 60/20/20 weightings.
- Stable Pools — Stable Pools are optimal for assets expected to consistently trade at near parity, such as different varieties of stablecoins or synthetics.
- MetaStable Pools — An extension of Stable Pools, MetaStable Pools contain tokens with known exchange rates. A notable use case is Balancer’s recent launch with DAO-based staking platform Lido.
- Liquidity Bootstrapping Pools — Liquidity Bootstrapping Pools (LBPs) are pools that can dynamically change token weighting. LBPs create sell pressure and fair market advantages.
- Managed Pools — Designed for increased flexibility, Managed Pools allow users to have pools of up to 50 tokens. These pools provide a framework for fund managers and can be used to track a wider crypto sector.
Building on Balancer Protocol
Balancer Protocol’s success comes not only from the Balancer Labs team and members of the Balancer Community but from the projects building on top of it. The Balancer Grants program provides support and funding to projects committed to bringing Balancer Protocol a step closer to achieving its mission of becoming the leading platform for programmable liquidity. Developers leverage Balancer Protocol as a permissionless building block to create new treasury management systems. The BAL Grants program recently concluded its first wave of grants with $462k allocated to 11 projects building on Balancer Protocol.
The Bottom Line
Balancer Protocol aims to be the leading platform for programmable liquidity. Balancer V2 reduces Ethereum gas fees through vault architecture and allows users to trade between Balancer Pools at a fraction of the cost of trading on other platforms. Through customized pool logic, much more can be achieved beyond index fund-like pools. Balancer Protocol is more than an Automated Market Maker; it’s a building block for the entire DeFi ecosystem.