Balancer is one of the most popular automated market makers (AMMs) in the burgeoning DeFi market. An understanding of what Balancer is and how it works can help you decide if you want to use it to dip your toe in the DeFi liquidity pool to earn investment income.
What Is Balancer?
Balancer is an automated market maker protocol that enables users to seamlessly exchange Ethereum-based assets in a decentralized manner.
In many ways, it functions in a similar way as Uniswap. However, Balancer’s prime differentiating factor is that it supports as many as eight assets for each market.
Also, the creator of the pool is allowed to set custom trading fees for transactions.
How Does Balancer Work?
A market maker in a traditional market acts as a liquidity provider. They buy and sell financial instruments, buying from sellers and selling to buyers.
When they buy an asset, they mark up the price and then sell it to a buyer. Market makers make their money off this mark-up, which is called the bid-ask spread.
An automated market maker like Balancer accomplishes the same purpose but through the use of algorithms; they set the rules for trading.
A user creates a balancer pool and then adds liquidity to the protocol by depositing digital assets. This is where the Balancer process gets different because instead of limiting users to the normal 50/50 split between the pair of tokens, Balancer allows as many as eight tokens to be included at once. Also, users can decide how much of each token makes up the pool.
For example, you could choose four tokens: MKR, DAI, USDC, and LINK. You could then set your own percentages for each token. For instance, you could spread it out like this:
- MKR: 20%
- DAI: 30%
- USDC: 35%
- LINK: 15%
To route trades to the pools in a way that provides the best rate possible, Balancer makes use of smart order routing (SOR).
How to Use Balancer to Earn Investment Income
As an investor, you can earn with Balancer by depositing tokens into a liquidity pool to receive a portion of the trading fees. In addition to earning trading fees, liquidity providers are also rewarded with BAL tokens, the protocol’s governance token, that is minted to incentivize users to provide liquidity.
Earning governance tokens as a reward for providing liquidity is typically referring to as liquidity mining or yield farming.
To start earning on Balancer:
- Go to the Balancer site, and select Exchange
- Select Add Liquidity
- Connect your wallet
- Choose from either the Shared Pools or Private Pools and designate the amount you’d like.
In addition to trading fees, liquidity providers are rewarding with BAL tokens, which is why Balancer has become so popular among yield farmers.
Factors Affecting BAL Yield Farming Returns
Balancer makes it easy to yield farm BAL tokens. When you become a liquidity provider on Balancer, you automatically receive get BAL tokens in addition to the pool’s trading fees.
To maximize how much BAL you earn, you may want to take into account the various factors that affect your yield.
- feeFactor. The feeFactor gives you higher BAL rewards if the pool has a lower swap fee. Conversely, you get lower BAL rewards if the pool has higher fees.
- ratioFactor. The rationFactor gives more or less rewards based on how balanced or imbalanced the pool is. The more a pool’s ratio skews towards an asset, the higher that pool’s ratioFactor. The higher the ratioFactor, the lower the BAL rewards. For example, assuming all other variables are equal, a liquidity pool with a weight of 70/30 would yield fewer BAL than one with a weight of 55/45.
- wrapFactor. Pools containing pegged token pairs have a wrapFactor. Pools with hard-pegged assets have lower wrapFactors, and those with soft-pegged assets have higher wrapFactors. The wrapFactor, a value less than 1, such as 0.1 or 0.7, reduces the BAL reward you get because the reward is multiplied by the wrap factor. A wrapFactor of 0.1, for example, results in you earning only 10% of the BAL you would have with a pool containing a normal pair.
- balFactor. The balFactor rewards users for selecting pools with BAL. Liquidity providers using these pools have their BAL rewards multiplied by a factor of 1.5.
How the Balancer Token (BAL) Works
The governance token of Balancer is called BAL. The Balancer team is hoping users adopt the token in order to help support the Balancer movement. They “believe alignment between token holders and protocol stakeholders is crucial for successful decentralized governance.” The team sees BAL tokens as “the vehicle to drive alignment and participation in the protocol.”
The team projects that several changes will have to be made going forward and, therefore, add, “BAL tokens are not an investment; BAL token holders should be people that interface with the protocol in some way, are committed to its future development, and want a seat at the governance table.”
Before taking a seat at the governance table, you may want to understand more about how the token works.
Here’s a basic breakdown.
Balancer has planned a cap of 100 million coins. As of the time of writing, there are around 37 million coins that have been minted. The coins are distributed in accordance with the Balancer team’s mission. 25 million of the coins are for stakeholders within Balancer Labs. This includes the founding team, advisors, investors, and those who will own stock options. Ten percent of the 25 million (2.5 million) are designated to be issued as stock options.
Another five million tokens are part of the Balancer Ecosystem Fund. This is designed to help Balancer draw more partners to further develop Balancer as a player in the DeFi arena. An additional five million tokens are allocated for the Fundraising Fund. In addition to Balancer’s initial pre-seed and seed rounds, this fund will be invested in the growth and development of Balancer.
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