Liquidity Is King

VeradiVerdict - Issue #91

  • Liquidity mining is one of the most popular topics in DeFi in recent history. Liquidity mining is essentially when users provide liquidity in various assets to different DeFi protocols, and they earn rewards for supplying that liquidity. 

  • Balancer offers an n-dimensional automated market maker for liquidity mining. Users can supply up to 8 tokens to a Balancer “liquidity pool” and they can set the relative weights of each of the 8 tokens in the pool. Balancer will automatically rebalance the user’s portfolio for the user in response to fluctuations in price. Moreover, Balancer generally executes rebalancing by supplying tokens as liquidity to traders; in exchange, they can charge a trade fee which they then redistribute to the user. It’s a clean way for users to earn money by supplying liquidity in various pools.

  • Balancer’s largest pool at the moment comprises of USDT, BAT, and COMP and contains $11 million in liquidity; for context, BAL’s best competitor’s (Uniswap) largest pool has $3.3 million in liquidity. The protocol has also reached $100 million in AUM.

  • Balancer differentiates itself from its competitors in two key ways:

    • Most competitors (including Uniswap) only support two tokens in a liquidity pool, whereas Balancer supports 8. Balancer adjusts the dynamic math in order to allow users to balance 8 assets simultaneously, which allows for better customizability and more automated management. 

    • Balancer is governed by a governance token called BAL, which is now being distributed to users in exchange for liquidity. BAL isn’t explicitly priced yet, but investors speculate it will have a cash-flow component in the future and are currently valuing all BAL at $1.4 billion. With BAL rewards, investors generally earn nearly 7 times more on Balancer than they would with Uniswap.

  • With the huge returns of liquidity mining also come sizable risks. Attackers have taken advantage of a vulnerability of pools containing non-standard, deflationary ERC20 tokens in Balancer’s protocol, draining about 0.36% of the total liquidity on Balancer.  Also an actor took advantage of very broad and inclusive rules on the kinds of tokens that can get BAL for liquidity mining in order to try to get big amounts of the weekly distribution of BAL. They ended up not being successful as the community reacted fast and only ~2,000 BAL out of the total of 145,000 in the week was mined by the attacker. As more and more people become interested in liquidity mining, it’s critical that protocols like Balancer communicate better the limitations on types of tokens that can be securely held in pools to build trust in the space.

  • Ultimately, Balancer presents one of the most technologically advanced and generalizable tools for liquidity mining and automated portfolio management that the DeFi space has ever seen. With the huge returns that users are earning from engaging with Balancer, the protocol is likely to rise in popularity in the coming weeks, spurring more interest in liquidity mining, tokenized models of governance, and automated portfolio management. 

The Liquidity Mining Boom

Liquidity mining has become one of the most popular topics of conversation in the space of decentralized finance (DeFi) in recent weeks. At its core, liquidity mining is essentially when users supply liquidity of assets to a DeFi protocol in exchange for some kind of reward. That reward may be various tokens, including governance tokens of the underlying DeFi protocol (which may end up having monetary value – like COMP). It basically offers a way for users to earn money on assets that they hold.

With the recent public distribution of COMP tokens, and similar changes executed by other protocols, liquidity mining is increasingly being seen as an easy way to make quick money in the DeFi space. Certain tools, like InstaDapp, have even set up specific automations to generate 5-6x returns on user assets, using liquidity mining. As a result, there’s been much more industry interest in the space. One of the most notable protocols for liquidity mining is Balancer

What is Balancer?

In fancy terms, the Balancer Protocol is an n-dimensional automatic market maker, which comprises of an automated portfolio manager, a liquidity provider, and a price sensor. At a high level, the key goal of the protocol is to automatically rebalance users’ portfolios (based on fluctuations in price) using various arbitrage opportunities, generating high returns on investment.

Fundamental to the design of Balancer is the idea of “pools.” With the complicated re-balancing math and buzzwords, it’s easy to get lost in understanding what exactly a pool is. In reality, a pool is simply a group of several digital assets –– like a collection of different tokens. Pools are often called “liquidity pools” because they can often represent units or quantities of liquidity; for example, if I had a pool consisting of 3 USDC and 4 USDT, I could liquidate them (by trading them) for roughly 7 USD. Any pool-owner can similarly liquidate their pool (or portions of it) to use in other places.

What exactly is an n-dimensional automatic market maker? An automatic market maker (AMM) is a well-studied topic in algorithmic finance. It’s basically a set of algorithms that follows rules designed for various trades, to allow for automatic execution. A very classic example is a pool with 2 tokens. Suppose your “rule” for managing this pool of value is that the balances of the 2 tokens must maintain a constant product. That means, if X is the balance of the first token at some timestep, and Y is the balance of the second token at the same timestep, then we want to ensure X*Y = K, where K is constant across all timesteps. Seems simple right? What happens if the price of token 1 goes down? Since the quantity you possess of token 1 remains the same, but the price (unit value) of the token decreases, we see that the balance X also decreases, moving the product of X*Y below the desired threshold of K. In this case, an AMM might trade quantities of token 1 for token 2, until the values of X and Y change enough to again hit the desired ratio.

Balancer takes this idea and generalizes it, making it n-dimensional. Pools can have more than 2 assets, and Balancer uses the formula V=∏ BtWt to measure balance in a given pool. In English, the equation basically means the product of the balances of all of the tokens in the pool, with each balance raised to the power of its proportional weight in the pool. 

That’s cool and all, but why does this matter?

Liquidity is one of the most important components of crypto trading, and it’s something that’s very often in high demand. Balancer gives end-users the advantage of automatically managing portfolios to ensure that they can stay balanced. In exchange, Balancer now has access to the users’ assets, and traders can trade against their portfolios, using the pools for underlying liquidity. For instance, if Balancer had to rebalance a portfolio to reduce the quantity of Dai, traders now have somewhere to source Dai from; they can trade against the Balancer portfolio.

But why would a trader work with a Balancer pool instead of making a trade with an exchange, like usual? Balancer does not use an external price oracle, meaning that the prices of the assets in the pool don’t necessarily correlate to the prices of those same assets in the real-world. In fact, one of the mechanisms by which Balancer re-adjusts the balance in various pools is by adjusting the price of various assets, within that pool specifically. This presents a significant arbitrage opportunity for traders, because they can often find incredibly competitive and advantageous prices in the asset pools. Trading against Balancer portfolios is advantageous for Balancer as well, because they can earn trade fees on the different arbitrage opportunities made with their pools. These trade fees can be redistributed to the individual liquidity contributors, providing a real value-add for those users. 

There are two kinds of pools: private and shared. Private pools are owned by one address only, and users (who own that address) have total control over swap fees, weights, amount of value, etc. Shared pools are distributed across several addresses but contributing users cannot change the parameters (swap fee, weights, etc.). They can only contribute liquidity to the protocol. In a private pool, the pool owner receives all of the trade fees earned by trading with that pool. In a shared pool, each contributor receives a proportion of the trade fees earned by trading with that pool, proportional to their share of the liquidity in the pool.

Which pools are doing the best right now?

Right now, in terms of total liquidity, the top pools are:

  1. 2% COMP, 49% cBAT, 49% cUSDT - $11.4M in liquidity

  2. 90% RPL, 10% WETH - $11.2M in liquidity

  3. 80% BAL, 20% WETH - $9.9M in liquidity

Even within just the top 3 examples, we can see incredibly profitable uses of Balancer. The first pool provides liquidity for those trying to do liquidity mining with the COMP token, which began its public distribution recently and has sparked a huge DeFi craze around liquidity mining. The fact that it has significant value ($11M in liquidity) and is the largest pool on the protocol reflects the very real value that Balancer presents to users; real-world changes in crypto are being reflected in how users want to manage their assets to maximize profits. For context, the largest liquidity pool in BAL’s main competitor Uniswap is $3.3M, likely because it can only support 2 tokens in any given pool. The Balancer protocol has also reached $100 million in AUM.

How does Balancer differentiate from other tools like it?

Balancer’s value-add to the end user is that it can provide returns in exchange for liquidity on various assets, much like a decentralized exchange (DEX). Its primary competitor in that category is Uniswap, which also helps manage pools of liquidities, but can handle only 2 assets in any given pool (think back to the X*Y = K example from earlier). Balancer uses the updated average rule (which can be thought of as a “rolling average”) and can generalize pools to handle up to 8 assets, giving users significantly more flexibility. Prior to Balancer, users may have had to manage several Uniswap pools consisting of pairs of assets, just to get the same general balance that Balancer can automate for end-users. Particularly in the world of liquidity mining, which may involve governance tokens AND several stablecoins, being able to support a diversity of assets is critical and presents a huge value add. There’s tons of other DEXes or protocols similar to Uniswap, that allow for the exchange of tokens for balancing –– Curve.Fi is another key example. Yet, the recurrent issue with these protocols is that they can only support swapping between two tokens in a pool, limiting the use cases. 

That said, the legacy of protocols like Uniswap definitely give it considerable advantages in the liquidity mining space. One particularly strong example of this is Ampleforth’s recent partnership with Uniswap to launch AMPL liquidity incentives. Without getting into the deep complexities of it, Ampleforth provides a synthetic commodity that adjusts its supply and demand based on price fluctuations, rather than simply pegging it against a “real-world” asset (commonly the US dollar). To boost growth, Ampleforth wants to increase the liquidity in the AMPL/ETH pool on Uniswap, which would help support more uses of AMPL moving forward. Thus, Ampleforth is offering AMPL rewards (currently at 103% APR) to those who supply liquidity to that pool, through a system called Geyser. That means users that provide liquidity doubly earn rewards from (1) trade fees and (2) AMPL rewards. Users loved it. In fact, in just 3 days, the AMPL pool became the 8th largest Uniswap pool (ahead of COMP – which is impressive considering the hype around it) with upwards of $900k in Geyser and $1 million in Uniswap. Ampleforth is not the first protocol to provide incentives for liquidity on Uniswap, nor will it be the last. With the liquidity mining craze, we expect to see several similar launches in the coming months. We may now, however, see a shift towards generalizable protocols like Balancer which may bring more value and customizability back to the end-user, creating a simpler and more profitable liquidity mining experience. 

How is Balancer governed?

Like many other DeFi protocols, Balancer has moved towards a decentralization-first mindset around governance. In June, the Balancer team launched the BAL token on the Balancer mainnet, which is essentially Balancer’s governance token. Like many other governance token models, ownership of BAL gives users voting privileges and proposal privileges to help adjust various parameters and regulations on the protocol. The founding team and engineering team main very little control over the governance; it is now up to the community (which still consists of the founding & engineering teams, but also several other end-users).

The protocol will distribute a maximum supply of 100M BAL tokens, of which 25M has already been distributed to the founding team, stock options, shareholders, etc., 5M has been distributed to Balancer’s Ecosystem Fund, 5M has been distributed to Balancer’s Fundraising Fund, and ~0.4M has been distributed to liquidity providers within the first 3 weeks of the launch. That leaves 65M BAL tokens to be distributed to liquidity providers over the life of the protocol. 

Currently, the protocol is set to distribute 145K BAL each week, which means it will take roughly 8.5 years until the maximum supply is distributed. The amount of BAL that each user earns is proportional to the ratio total liquidity they contribute (in USD) across all their pools to the total liquidity of the Balancer protocol. The exact distribution parameters for different pools depend on the asset weights, total liquidity, pool type, and the tokens included in the pool. One rule of thumb is that lower-fee pools earn more BAL than higher-fee pools. Nonetheless, the enthusiasm surrounding BAL distribution has certainly spurred more activity on the Balancer Protocol; the number of new pools created per day shot up 8300% between mid-May and mid-June.

As of right now, the BAL token isn’t explicitly priced, but enthusiasts speculate that it will be listed in the future (much like COMP for Compound). This change will only come when BAL owners vote to charge a fee for the token, creating a cash-flow component. Given the speculation of the cash-flow component in the future, investors are currently valuing all BAL at $1.5 billion. With this high-valuation, BAL has become another natural target for liquidity mining. Users are incentivized to offer liquidity to the Balancer protocol to earn BAL. With BAL, they can either vote on various referenda or hopefully trade it in the future for profit. BAL rewards also help differentiate BAL from its competitors. Without BAL distribution, users would earn more by providing liquidity to Uniswap, since they’ll earn higher fees. BAL distribution makes providing liquidity to Balancer nearly 7 times more profitable than providing liquidity to Uniswap, which helps convert users from Uniswap to Balancer. 

The Risks of Liquidity Mining

With Balancer, Compound, Uniswap, and so many other protocols, it’s become hard to not get caught up in the craze of liquidity mining. It’s one of the most tangible examples of DeFi bringing value back to users (in exchange for liquidity). That said, the concept of liquidity mining isn’t totally riskless. Here’s some ways that they’ve gone wrong in the past. 

Fundamentally, the incentive structure of making “providing liquidity” profitable inherently means that when users “capitalize” by moving money around, it may compromise the underlying liquidity in various pools. 

In one recent case, the exchange FTX added two obscure tokens (USDTBEAR and USDTHEDGE) to Balancer and supplied $100 million in liquidity to a pool consisting of those 2 tokens. This presents no value for anyone else; no trader wants the tokens USDTBEAR and USDTHEDGE. FTX only created the pool with such a substantial amount of liquidity, so they could capture >50% of the BAL tokens being distributed daily. This obviously seems like a huge waste of BAL distribution and liquidity. In response, Balancer Labs got together with certain stakeholders on Discord and created a whitelist of tokens that could be mined on Balancer (excluding obscure ones like USDTBEAR/USDTHEDGE) to circumvent this problem. However, several users are critical about how the whitelist decision was made via Discord and not an official vote, possibly compromising the integrity of BAL governance (and thus, the underlying value of the asset).

In another case, an attacker developed a smart contract that automated a series of transactions that trained $500k from several token pools on Balancer. The exact mechanics of the smart contract are pretty complex, but in a high-level, the attacker used flash loans and several particularities with how transfer fees were handled to execute the steal. Balancer Labs announced on Twitter that it would reimburse liquidity providers who lost funds in the attack. 

In yet another super recent case, an attacker was able to extract roughly $2300 in ETH from a Balancer pool by using flash loans and fooling the protocol into thinking the attacker owned more of the COMP liquidity than they actually did. 

With any automated protocol, particularly in its early stages, there will inevitably be technical and architectural vulnerabilities that can compromise the security of the protocol. In a space with incredibly high rewards, like liquidity mining, the desire to execute these kinds of attacks is even higher. It’s important that the community develops strong security and trust guarantees to avoid these problems to ensure that liquidity mining can continue to be profitable.

Final Thoughts

Liquidity mining has become so popular that it may very well be the face of DeFi in 2020. With more and more users just realizing how they can generate insane returns for simply supplying liquidity, there’s a demand for more customizable protocols and new token distribution structures to help propel this space forward. Balancer takes the existing idea of balanced portfolio management and generalizes it to a new level. Now, users no longer have mine liquidity by repeatedly swapping pairs of assets; users can literally deploy up to 8 tokens in a Balancer pool, and sit back as the rewards come flowing in. Balancer is able to provide two kinds of rewards to users: (1) trade fees generated from traders interacting with liquidity pools and (2) BAL tokens, which will hopefully have a cash-flow component one day. It’s a perfect example of the various forms that liquidity mining can take in a real DeFi protocol and demonstrates how users can reach incredible returns just by temporarily supplying assets. That said, liquidity mining is not without its risks; multiple recent incidents demonstrate that these automated protocols are not immune to attacks, and such attacks can result in devastating losses or corruption of protocols. With all the recent interest around liquidity mining, it’s important that protocols beef up their protections to keep the space moving in its current direction. Nonetheless, the recent interest in liquidity mining and Balancer demonstrates the tangible value that users are receiving from this space. Liquidity mining will be an integral part of DeFi for months to come. 

- Paul V



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Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. The firm invests in equity, pre-auction ICOs, and cryptocurrencies on the secondary markets. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.