Balancer 101: Intro to DeFi

Balancer is an investment platform that is destined to shake up the financial realm. By using a series of smart contracts, Balancer has created a powerful combination of financial tools that allow you to manage your investment portfolio, create your own index funds, and earn a passive income. In this series of articles, we’re going to take a deep dive into what makes Balancer work. If terms such as “smart contracts”, “automated market making”, “liquidity providing”,
“decentralization”, etc., are unfamiliar to you, you are in the right place. We’ll take it one step at a time, and make sure you are equipped with the knowledge you need to get started.

Part 1: What is Decentralization?

One of the cornerstones of Balancer’s platform — and cryptocurrencies in general — is the concept of decentralization. This concept goes to the very core of cryptocurrency, dating back to its inception with the creation of Bitcoin back in 2009. While blockchain enthusiasts debate amongst themselves and speculate over the purpose that Bitcoin was created, many believe that it was intended to be a hedge against fiscally irresponsible governments. Recall that in 2008, the global economy went into a recession — spurred by irresponsible risk-taking by banks which led to the bursting of the United States housing market bubble. In an effort to curb economic losses, Central Banks around the world issued bail outs to these banks, which they deemed “too big to fail.”

Bitcoin was created as a response to this centralized control of world currencies. It operates using what we call a decentralized network, meaning that it is not located in any one place, or controlled by any one entity. Unlike the Federal Reserve — located in America and controlled by the U.S. Government — Bitcoin is a global phenomenon and is controlled by hundreds of thousands of mining nodes spread all over the world.

An example of a decentralized network that we interact with everyday is the Internet itself. No one owns the Internet, and as much as some governments may try to limit access to the Internet — it is impossible to fully restrict. If you were to lose access to the Internet, or if an Internet Service Provider were to experience an outage — the Internet would still be alive and well. Such is the nature of Bitcoin — and other cryptocurrencies. They are open-source, censorship-resistant, decentralized networks.

Let’s continue with our example of the Internet. Were the Internet decentralized the way that we process and share information, cryptocurrency will decentralize the way we handle our money. Decentralized cryptocurrency networks enable us to send any amount of money, anywhere in the world, with a fraction of the fee charged by a bank for a similar service.

Part 2: What are Smart Contracts?

Blockchain technology is what enables cryptocurrency to operate in a decentralized manner. It’s what provides the network security that makes sure your funds are safe in the network. Blockchains themselves are just a way to store data. Each “block” is just a chunk of data, which after the “block” is formed, cannot be changed. All of the network participants agree on what data should be stored in the block — confirming it — and moving on to the next block. Blockchains can be used to store all kinds of data, but for cryptocurrency this is transaction data (who sent funds, and the quantity of funds sent).

But what if blockchain technology was used to store the terms of a contract between two parties? Furthermore, what if the terms of the contract were automated to execute, given certain conditions? In essence, this is exactly what a “smart” contract is designed to do.

Smart contracts are simply blockchain-based applications, with computer code stored in the blockchain designed to execute if a certain event occurs. This allows a whole host of industries to rethink the way they do business. Almost every industry uses contracts of some sort, all of which would require a third party or intermediary to carry out the terms of the contract. Smart contracts remove the middleman from the equation, simplifying and streamlining processes to make them far more efficient in terms of both time and money.

Part 3: What is DeFi?

DeFi is the popular concatenation for the phrase “Decentralized Finance.” Quite literally, this term refers to the very broad concept of finance in a decentralized setting. This could apply to currencies themselves, financial investment platforms, protocols, and the decentralized governance structures that manage them. But in the context of cryptocurrency, DeFi refers to a segment of the crypto market that utilizes blockchain technology to perform finance-related tasks — in particular, using smart contracts.

Oftentimes, smart contracts are used in combinations and paired with a UI to form what we call a dApp (Decentralized Application). These are the applications that investors can use to interact with smart contracts, and actually use the blockchain technology. These applications can be built on a number of different platforms, but the most popular one by far is the Ethereum Network. In fact, when someone in the industry refers to DeFi, they are most likely referring to an application built on Ethereum. Remember, Ethereum is both a token and a blockchain network, and anytime someone wants to interact with the Ethereum blockchain they are required to pay a fee. This fee is paid exclusively in Ether tokens.

Part 4: What is Market Making?

The term liquidity is defined as the available assets to a market or company. You have probably heard before that, “carbon is the building block for life.” In the same vein, liquidity is the foundation upon which markets are built. Without sufficient liquidity, a market is nothing but an empty ledger and is only as useful as the amount of healthy liquidity available. This applies both to traditional and non-traditional financial markets.

Market makers are those who provide liquidity to markets of all types by placing both buy and sell orders for a given financial product, to profit off of the spread between their orders. As the saying goes, “buy low, sell high.” This is essentially the same thing that a merchant does, buying or creating their goods and selling them for a profit — with the main difference being that financial products are the “goods”. Securities exchanges have specified market makers who have been designated as “official” market makers for each security listed on their platforms. These market makers receive special trading privileges that everyday investors do not.

Enter: Smart Contracts, the disruptor to traditional finance.

The invention of Smart Contracts (contracts executed by code located on the blockchain) was a complete game changer to the financial realm, enabling tech-savvy entrepreneurs to automate the market-making process. Automated Market Makers (AMMs) are hard-coded trading algorithms that use smart contracts to take the work out of trading, while also creating long-lasting market liquidity. What’s more, smart-contract-powered AMMs allow investors to retain control of their funds while the trade algorithms are running. No more need to place your hard-earned money into someone else’s hands to make a profit!

Part 5: Liquidity Pools

Perhaps the most prevalent form of AMM available in all of DeFi is the liquidity pool. The concept — first pioneered by Gnosis’ Alan Lu and made famous by Uniswap, takes the balance of two tokens and weighs them against each other in a 50:50 ratio to determine the price. Liquidity pools help to address many problems faced by the crypto industry, namely, a lack of sufficient liquidity, bootstrapping funds for new projects, and wild price fluctuations. Arguably, the biggest “knock” on cryptocurrencies by outsiders is that the assets are just too volatile. By taking a large pool of funds and placing them in these algorithmic smart contracts, liquidity pools serve to dampen price movements in either direction.

The conventional method of providing liquidity on an exchange (both in traditional finance and cryptocurrency) is by placing orders on an order book. On exchanges that use order books, a trader would enter a price and amount of an asset to buy or sell, and place the trade in the order book. This trade would not execute until that order was matched with a party looking to buy/sell at that same price.

In the case of liquidity pools, a smart contract automatically acts as the counterparty to the trade, automatically matching orders at a given price. This results in a constant liquidity available for both buyers and sellers, and has a “smoothing” effect on price fluctuations.

Part 6 — Balancer

Balancer is not the first AMM to come to Decentralized Finance, but it is the most flexible one, giving it powerful abilities that other AMMs do not have. Using Balancer, anyone is able to create their own liquidity pool and set its parameters, including what the trading fee is to interact with the pool, and what assets are included in the pool. In fact, with Balancer a pool is able to contain up to 8 tokens — all with customizable proportions — effectively becoming a self-rebalancing index fund of cryptos!

Traders use Balancer to exchange one cryptocurrency for another, including any ERC-20 token.

When traders interact with Balancer’s liquidity pools, a trading fee (set by the pool creator) is taken and added to the balance of the pool, providing an APY for the pool on top of the gains realized by rebalancing.

Balancer also incentivizes investors to deposit their crypto into its liquidity pools by enabling them to earn the BAL token in proportion to the amount of capital they provide — a process called liquidity mining. Whenever an investor deposits funds into a Balancer liquidity pool, they automatically begin to accrue BAL tokens that can be claimed from the Balancer claim page. BAL incentives vary from pool to pool, and depend on factors such as: which tokens are in the pool, token weights, the liquidity provider’s participation in decentralized governance, and more.

Recap

Balancer plays a key role in the development of decentralized finance, serving as an exchange, AMM, and self-contained index fund that allows users to take greater control of their finances. All of these features are completely blockchain-based, and powered by smart contracts. In the following series of articles, we will continue to explore Balancer’s unique features in-depth, but now you’ve got the basics!

For more information on Balancer, please check out their documentation and join the community on Discord and the Balancer forum.