Smart Liquidity Mining

VeradiVerdict - Issue #111

BITCOIN HITS ALL-TIME HIGH

First of all, congratulations to Bitcoin for reaching its highest market cap ever of $338 Billion earlier today, hitting its highest price of the year at over $18,000, and currently sitting at $17,800. It’s definitely the early beginnings of a bull run!


Last week, it was announced that Pantera Capital and Alameda Research, the company behind the FTX exchange, recently invested into the Series A of Balancer, a decentralized platform for liquidity. I wrote about Balancer and liquidity mining in this blog post earlier this year but wanted to update everyone on their new features of smart pools:

  • Balancer is an automated market maker (AMM) designed for liquidity mining. An AMM is essentially a pool of assets that can be algorithmically traded; traders submit trades to a pool and pay a small swap fee to exchange a certain kind of asset for another kind of asset. Each of Balancer’s liquidity pools can support up to 8 kinds of ERC20 tokens and earns return for its liquidity with each trade. As of writing, the protocol has nearly $420M locked in value.

  • Previously, Balancer liquidity pools were either public (all parameters, like token weights, are fixed at creation, and anyone can provide liquidity to the pool) or private (all parameters can be edited, but only the address that created the pool is authorized to provide liquidity). Given the need for custom-designed liquidity pools for specific trading strategies, Balancer launched “Smart Pools” –– a mix of the two.

  • Users can create a Balancer smart pool and customize the following variables:

    • the set of tokens that are included in the pool

    • the weight of each token in the pool

    • the swap fee

    • the ETH addresses allowed to supply liquidity

    • the maximum capitalization the pool is allowed to achieve

    • A Smart Pool can be controlled by a smart contract, rather than an individual user, allowing the controller to react to real-time data anywhere on the Ethereum blockchain and dynamically adjust the pools’ parameters accordingly. This enables a diversity of applications, where traders want variables like token weight, swap fees, and maximum capitalization to trade in response to live-trading data. One potential use case is setting higher swap fees during times of high-trading volume, similar to Uber’s Surge Pricing model during periods of high ride-requesting demand. 

    • Ultimately, Smart Pools present a powerful primitive for more complex DeFi applications that rely on liquidity pools that follow custom-engineered behavior. More broadly, Smart Pools also represent a huge step forward in terms of customization and open-sourcing strategies within DeFi. Traditional finance has seen an explosion of customization and shared strategies through services like Quantopian, Robinhood, etc. Smart Pools show how developers can leverage the infrastructure of existing protocols like Balancer and fine-tune them to specific use cases, broadening the scope of what’s possible in DeFi. 

What is Balancer?

Balancer is an automated market making protocol for programmable liquidity. An automated market maker (AMM) is a liquidity pool of ERC20 tokens that can be algorithmically traded, rather than trading via a classic order book; this allows smart contracts to programmatically trade, leveraging Balancer pools as liquidity sources for a diversity of assets. In this system, the pool can dynamically re-adjust the price and ratio of its underlying assets. In Balancer’s “liquidity pools”, users can supply up to 8 kinds of tokens, which Balancer algorithmically rebalances and reprices in response to market fluctuations. In exchange for providing tokens as liquidity to traders, users can earn their proportional share of a trade fee that Balancer charges whenever a trade attempts to use its liquidity pools. This essentially provides a hands-free mechanism for users to deposit assets, algorithmically adjust the balance of their portfolio, and earn money by supplying liquidity to traders. 

Balancer’s key advantage over other AMMs, like Uniswap, has been that it can support up to 8 kinds of tokens in a liquidity pool while most AMMs can only support 2. Its largest pool as of writing is split evenly between WBTC and WETH, with a market cap of $61.8M. Its largest pool with more than two types of tokens has 8 tokens (wPE, STR, LIFT, NFTS, PIXEL, YFU, IMPACT, GIFT) with a market cap of nearly $8M, indicating that there’s a sizable need for broader, more diverse liquidity pools for modern DeFi. Its governance token, BAL, is trading at $12.81 and has a market cap of roughly $89M. As a whole, the protocol has $420M locked into its liquidity pools.

What are Balancer Smart Pools?

Previously, Balancer allowed two kinds of pools: public and private. Public Balancer pools are the classic pools that one thinks of when one thinks “Balancer”; though they can be created by users, they have fixed attributes governing how the pool operates to ensure that anyone who publicly trades with or deposits liquidity into the pool understands the expected behavior. Specifically, once created, users cannot edit a public pool’s supported assets, token weights, or swap fee percentage. 

Inevitably, this fixed model introduces several roadblocks for algorithmic traders that aim to optimize every last bit of their trading procedures. Having variable, flexible pools has key advantages for many trading use cases. Thus, Balancer offers “private pools,” which allow only a single user (the “controller”) to directly provide liquidity, and give this user control over all pool parameters. Since the risk of liquidity is limited to just one user, and that one user is responsible for the pool, Balancer is able to offer further flexibility for specific trading use cases.

However, with the recent explosion of DeFi, more and more folks are looking for a middle-of-the-road solution, that enables pool creators to have more control over a pool, but also allows any user to supply liquidity with transparent assurances regarding how their capital will be utilized. This is the motivation behind Balancer’s “smart pools” –– a mix between its previous public and private pools that offers more complexity and flexibility to the community. 

Smart pools have five main variables that can be dynamically changed by the pool’s controller (or whoever created the pool):

  • Approve Token: This controls which tokens can be held in a pool during its lifetime.

  • Set Weights: This controls the weights of the various assets in the pool, meaning the percentages of total pool value to be held in each asset.

  • Swap Fee: This configures the swap fee (or trade fee) for a particular pool, which also affects the returns that liquidity suppliers earn from a particular pool.

  • Limit LPs: This parameter allows pool controllers to whitelist Ethereum addresses that will be allowed to add liquidity to a pool, essentially permissioned. Balancer also allows Smart Pools to be public as well, meaning anyone can supply liquidity.

  • Pool Cap: This parameter sets the maximum for the value deposited into the pool.

Externally, users can build a network of smart contracts that interprets live trading data and adjusts the parameters of the pool to meet their needs. This essentially allows users to use the underlying infrastructure of Balancer’s liquidity pools, while having nearly full control over how that pool operates, especially in terms of executing trades. Instead of algorithmically controlling the pool parameters, controllers can manually alter the parameters as well, if they wish to manually manage the pool over the course of trading.

How do you make a Balancer Smart Pool?

Despite the complexity that goes into designing a liquidity pool and its swap behavior, creating a Smart Pool on Balancer is remarkably easy. The feature is currently in Beta, but users can initiate the creation of a new pool here.

Once selecting the “Smart” pool type at the top, users can then configure the custom parameters for their pool, including the assets in the pool, the swap fee, the LPs who can supply liquidity, and more.

Creating a new Balancer Smart Pool (source)

Users can also fine-tune the rate at which Balancer updates the quoted price of the pool’s assets, by changing the “Minimal graduate update duration (in blocks)” parameter that surfaces when the “Can change weights” option is checked. This essentially marks after how many Ethereum blocks mined the Balancer will change its weights.

Why is this useful?

Balancer Smart Pools present an interesting model for what user-designed DeFi could look like in the future. The vast majority of DeFi protocols simply involve users lending, borrowing, and moving around assets; this space has gained massive popularity, despite the relatively limited functionality. Smart Pools are a step towards open-sourced trading agents, user-configured liquidity mining schemes, and more. Traditional finance open-sources strategies with tools like Quantopian, Robo-Advisors, etc. Balancer Smart Pools are a step in that direction for crypto: giving communities full customizability over the functionality of the underlying protocol.

Smart Pools can also solve several concrete use cases within consumer finance today. One popular concept is the trading analog of “Surge Pricing”, often used by ride-sharing apps to raise ride fees during times of high-demand. Smart Pools can implement a similar form of surge pricing, where the swap fee changes in relation to the trading volume and price volatility; in times of high trading demand, the swap fee can algorithmically increase to account for the higher demand, ensuring that the pool is able to continuously supply liquidity. This demonstrates just one example of how Balancer Smart Pools can leverage real-time data, such as trading volume, to adjust the dynamics of various liquidity pools.

Final Thoughts

With the recent explosion of interest in DeFi, it’s more key than ever that protocols offer versatile, highly customizable platforms to its users. Balancer’s Smart Pools builds off the incredibly powerful primitive of Balancer’s liquidity pools and extends its use cases and functionality to account for liquidity pools that follow custom, dynamic, user-tuned behavior. This opens a variety of applications within trading, and DeFi more broadly, where users can design their own liquidity pools and open it up for public use, building off of the protocol’s pooled assets infrastructure.

Smart Pools also present a promising vision for what custom DeFi, generally, might look like. Though Smart Pools are specifically designed for swap-style trades, the product provides an interesting model of using an existing protocol’s infrastructure, but custom-tweaking its behavior to fit various use cases; the same idea could be applied in crypto robo-advisors, lending protocols, etc. As DeFi continues to explode over the coming months, we hope to see more variants of this idea –– where developers build off of existing innovation in crypto and find new and exciting ways to return power and functionality to the user.

- Paul V

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ABOUT ME

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.