OpenFi: Balancer
This week, I’ll be evaluating Balancer, an automated market maker for any ERC-20 token, under the OpenFi framework.
Disclaimer: The following piece is simply a summary of my opinions and should not be construed as investment advice.
O: Opportunity - How large is the Total Addressable Market? Does the project disrupt an existing market, or does it create a new market?
SCORE: 3.5/5
Like other AMM’s out there, the Balancer protocol allows users to swap tokens and provide liquidity to pools. Balancer operates in the $12 billion DeFi space and currently holds the #11 spot in DeFi Pulse among DEX’s with $400 million locked in its liquidity pools.
Liquidity providers can add assets to existing shared pools or create their own private pools. The portfolio of assets in each pool is automatically rebalanced based on predetermined rulesets around the relative dollar weight of each asset, i.e. programmatically rebalanced as the prices of assets change. Balancer spins the index fund model on its head - rather than paying someone (or a computer) to adjust your portfolio, Balancer pays you for providing liquidity and does the rest for you.
While many projects and companies in the cryptocurrency space have struggled with product-market fit, exchanges have been a clear exception. Many have a large user base and are extremely profitable. Although there are fundamental limitations to AMMs, they are in fact disrupting a large market.
P: Product - How innovative and differentiated is the product? Is there product-market fit? How easy is it to use the product (i.e. good user interface and experience)?
SCORE: 4/5
On the surface, Balancer seems similar to other AMM’s out there: you earn fees by contributing to liquidity pools though there are some key distinctions from competitors in the market. Unlike Uniswap, which consists entirely of 50/50 split pools, users are currently able to add up to 8 different tokens to Balancer pools, each with a unique weighting. Such a model allows the creation of more markets but also requires higher fees because Balancer smart contracts need to make more calculations when swaps occur. By my own estimates, trades between different tokens cost 30-70% more on Balancer than on Uniswap.
So what makes Balancer compelling? To really understand the value Balancer brings to DeFi, we have to take a closer look at the private pools users are able to create. Unlike shared pools, private pools let users implement their own “index funds” with unmatched flexibility. This includes removing/adding tokens, adjusting weights, changing fee structures – offering complete control over the fund by the creator.
We are beginning to see smart pools being created with smart contracts as owners optimize for specific use cases. For example, RealT’s potential partnership with Balancer intends to produce pools of digitized real estate assets. It’s a natural application of Balancer pools as the value of real estate assets can fluctuate constantly because of market trends and property management. For example, if a building undergoes renovation, the value of the asset in the portfolio can be adjusted along with its weight relative to other assets. Rather than having multiple pairs on Uniswap, all tokenized properties are aggregated into one pool, effectively creating a real estate trust vehicle.
As mentioned earlier, Balancer currently only supports 8 different assets in each pool. As of now, the only way to get around this would be to create pools of Balancer pools. This is far from ideal. The index funds that Balancer intends to implement offer baskets of hundreds, if not thousands of underlying assets. I’ll be watching closely as new developments are rolling out to allow pools to scale to the “N-th” dimension.
E: Experience - Does the team have any previous experience building software and technology? Is the team well-versed in blockchain? What previous experience does the team have to ensure success?
SCORE: 4/5
Fernando Martinelli is the CEO & Co-Founder of Balancer. He has experience in both engineering and business-focused roles at companies such as Airbus and Bain Consulting, and founded two companies prior to Balancer. Balancer’s Head of Growth, Jeremy Misighi, was also a serial entrepreneur with two successful exits and was most recently Chief Investment Officer of Immutable Capital, an LA-based crypto VC fund. The rest of the team is rounded out with engineering talent with experience at companies in both crypto and traditional industries.
Depending on which direction the project intends to take, it’ll be great to see more team members with relevant experience in traditional industries being brought on board. Financial services products, especially index funds, are often complex and require specialized skill sets to offer at scale.
N: Network Effects - Will more people in the network benefit when others join? Are there high switching costs and stickiness in using the platform?
SCORE: 2.5/5
DEX’s by default thrive as more users provide liquidity. That is not to say DEX’s are naturally sticky in terms of user retention. We’ve seen the case of SushiSwap draining billions from Uniswap seemingly overnight by adding in a few community retention elements to what was essentially an identical product.
Balancer has first-mover advantage by being the only decentralized protocol to offer customizable pools of multiple assets. The project has a strong social media presence with over 30,000 Twitter followers and releases regular updates on pools and grant rewards. However, should a new platform be released with improved features, given the decentralized nature of the product offering, it would be difficult for Balancer to retain liquidity. This is especially evident when I look at the 50% drop in assets locked from almost $800M in September to the $400M now.
As more options for liquidity mining and staking rewards become available, providers will vote with their investment dollars for applications with more features and more importantly, higher yield.
F: Fundamentals: Do the underlying unit economics make sense within the current network? How quickly are users growing? How much value has been transacted or locked up?
SCORE: 3/5
Since launching in March 2020, Balancer has carved out a $400 million slice of the DeFi pie. At a fundamental level, Balancer uses the traditional AMM model pioneered by Uniswap and Curve for share pools. Users swap tokens for a variable fee payable to liquidity providers and the network itself.
What really makes Balancer compelling for advanced traders is the ability to create customized portfolios of ERC-20 tokens. Uniswap only allows for 50:50 pools while Curve specializes in stablecoins. Balancer’s flexibility when it comes to custom index funds give the protocol huge potential if they are able to break into traditional finance. To scale up to the size of traditional index funds, however, would require significant effort and institutional buy-in. For comparison, traditional financial services funds, like the Vanguard 500 index fund, have market caps in the hundred of millions of dollars each.
Liquidity providers in Balancer, like many other AMMs, are still exposed to the risk of impermanent loss.
Impermanent loss is loosely defined as the amount of value lost (opportunity cost) for liquidity providers that stems from relative price changes in the underlying assets. Liquidity providers need to optimize their earnings from fees and incentives to offset or minimize the risk of impermanent loss. This is a large part of why orderbook-based exchanges are still superior to AMMs, since they allow professional market makers to avoid making bad trades. For the average cryptocurrency user who is a bit more risk-seeking and values opportunities differently, absorbing some impermanent loss might not be an issue. Furthermore, generalized AMMs like Balancer allow tokens with idiosyncratic properties like Ampleforth (AMPL) to reduce impermanent loss. It will be interesting to see what new innovations Balancer will bring.
I: Incentives - Are there proper cryptoeconomic incentives in place for network stakeholders and users to support blitzscaling?
SCORE: 5/5
Balancer released its liquidity mining program in May 2020. Since then, mining rewards have spiked to an estimated $736,000 on an annualized basis. The rewards program incentivizes liquidity providers to offer pools and lower trading fees for more mining rewards.
This past August, the Balancer community voted to adjust the liquidity mining program to favor BAL-based pools. The balFactor initiative gave BAL-based pools 1.5x higher return than other pools. This program was intended to incentivize liquidity for key BAL pairs and accelerate decentralization of the protocol. Since the change, users saw a marked increase in liquidity rewards. Some BAL-based pools peaked at around 300% APY. These rates have since settled down to a lower, but still very impressive, 90%+ APY.
The holders of Balancer tokens are also able to vote on various improvements to the protocol and how grants are allocated. Token holders appear to be engaged with protocol governance and are voting on proposals regularly.
Overall Score: 22/30
Balancer’s AMM platform currently provides some of the best liquidity mining rewards available within DeFi today. But more importantly, the protocol gives users the flexibility to create custom pools that could become the foundation of DeFi’s version of index funds and investment trust vehicles. Of course, there will be a lot of work to be done to get to that point. Overall, current capabilities and level of user adoption signals to me that the project is moving in a positive trajectory towards that grand vision.
