Understanding how Balancer works?
Demystifying a revolutionary decentralized exchange!
Table of Contents-
A brief explanation of prerequisite topics
How exchanges work
Market Makers & why we need them
Types of exchanges & brief explanation
What's Balancer and how it works
Terms glossary
What's liquidity and why we need liquidity providers
Use cases of Balancer
How to use Balancer to earn passive income
Understanding the maths of Balancer protocol
Before we dive into Balancer, let's get a primer on basic topics like how exchanges work, the types of exchanges, what are market makers and why do we need them etc
How do exchanges work?
An exchange matches people who want to buy and sell something for something else. Buyers say what price, they are willing to buy any particular asset, by placing a ‘buy order’. If there is a ‘sell order’ at the same price, then the exchange matches these two orders, a trade happens and the assets get exchanged. The price at which the trade got executed becomes the "Last Traded Price" and this is the price that we see on the Exchange.
When the next person places an order, the Exchange again checks if there is a matching order on the other ‘side’ (buy or sell), and so the "Last Traded Price" changes with each successive trade. A quick note, if there isn’t any order at the same or better price (higher is better on the buy-side and lower is better on the sell side, by common sense), then this order stays ‘open’, until a future order matches against it (or is canceled by the person who placed it). But imagine a situation where there is no one to ‘buy’ a particular sell order or even vice versa for a long time? There should be someone always ready to buy or sell any assets. That's when we need Market Makers!
Who are Market Makers and why do we even need them?
Whenever an asset is bought or sold, there must be someone on the other end of the transaction. If you want to buy 10 ETH, you must find someone who wants to sell 10 ETH. However, it's unlikely that you will immediately find someone who wants to sell the exact number of ETH you want to buy. This is where market makers come in.
Market Makers are always ready to buy or sell! When we place an order to sell o1ur 10 ETH, a market maker is always ready to purchase it from you, even if it doesn't have a seller lined up. Without market makers, it would take a considerably longer time for buyers and sellers to be matched with one another. This would reduce liquidity, making it more difficult to enter or exit positions and adding to the costs and risks of trading.
Key Takeaways:
Market makers provide liquidity by being always ready to buy or sell assets at any time.
Without market makers, far fewer trades would happen and companies would have more limited access to capital.
Market makers profit from the difference between the bid and ask prices on their trades.
Types of Exchanges:
Centralized Exchanges
Decentralized Exchanges
Centralized Exchanges:
Centralized exchanges are just like traditional stock exchanges where people buy and sell assets. It maintains an order book(It's just a list of the currently open buy and sell orders for an asset, organized by price) to execute trades for participants of the exchange.
On a centralized exchange, buyers and sellers offer up different prices for an asset. When other users find a listed price to be acceptable, they execute a trade and that price becomes the asset’s market price.
In a Centralized Exchange, our funds remain in their custody. But it's for a good reason because an individual can lose hundreds or thousands of dollars of crypto holdings simply by forgetting the key to a wallet. A centralized exchange will not allow this to happen, as it safeguards the holdings in place of the individual trader. So one downside to CEX is we don't have custody of our own wallet as the private key of our wallet is never exposed to us. Some popular Centralized Exchanges include companies like Binance, Coinbase, WazirX, etc.
Decentralized Exchanges:
On the other hand, Decentralized Exchanges are totally revolutionary as it allows buyers or sellers to trade without having to give up control over their funds to any intermediary or custodian. This type of infrastructure is entirely different from centralized exchanges where users hand over their crypto assets to the exchange, which acts as a custodian!
But unlike Centralized Exchanges, the match-making system in DEXes doesn't maintain Order Books to execute trades! Instead, it has some mathematical formulas that determine the price of any crypto asset. These mathematical formulas are known as Automated Market Makers.
Some popular Decentralized Exchanges are projects like Uniswap, Balancer, PancakeSwap, etc.
Huh! That's a lot of things to digest but is very crucial in order to understand how Balancer works. Let's now get into Balancer and how it works!
Terms glossary
Let's get some of the terms defined before we get moving forward!
Spot price: It's the current market price of any asset! Spot prices change according to supply and demand!
Token: It just represents any cryptocurrency.
Balancer pool: It's just a pool that holds the tokens. It can contain up to 8 different tokens, each with its own arbitrary weights.
Weight: The weights represent the percentage of value that the pool should be holding in each token at any time. That percentage of value the pool holds in each token is expected to be always very close to the pool weight.
What is Balancer?
Balancer is a decentralized finance protocol running on Ethereum blockchain! It enables users to seamlessly exchange Ethereum-based assets in a decentralized manner. We will understand how it's much more than a traditional exchange as we move forward.
Using Balancer users create funds based on the cryptocurrencies in their portfolios. These funds are known as Balancer pools, and any user wishing to provide liquidity (a major of the ease in which assets can be exchanged) to a pool can do so by simply depositing an asset in them.
Users who provide liquidity to a Balancer pool, earn a portion of the trading fee paid to the network for the use of their funds and are rewarded with a custom cryptocurrency called BAL.
These deposits are essential to the network, providing the liquidity needed for users to buy and sell cryptocurrencies on the platform.
For example, a Balancer pool might start off with 50% ETH, 25% USDC, and 25% COMP. If at some point, the price of COMP doubles, the pool automatically reduces the amount of COMP it holds so that it can retain 25% of the pool’s value. So, where does the COMP go? Balancer’s smart contracts make them available to traders looking to buy COMP as prices go up.
Understanding the mathematics behind Balancer
Let's start with the Balancer pool’s value and how it is determined! When we create a Balancer pool, we define the percentages and the weights of each token within it! The value of each pool is defined solely by the balance and weights of each token.
The value function is defined by:
The formula Balancer uses to find the Spot Price is defined by:
SP = (Bi / Wi) ÷ ( Bo / Wo)
But before trying to understand the proof, let's first understand how it works by taking an example:
Let's assume we have 2 tokens, A & B And the value of 1 A = $2000 & 1 B = $1
If we provide 1 A / 500 B to the pool
The values on each side become $2000/$500, which has an 80/20 weighing!
If we would have provided 1A / 2000 B to the pool, that would have been a normal 50/50 pool! And in a normal 50/50 pool, SP = Balance_A/Balance_B because the weights are the same. But if we have an 80/20 pool, Balance_A/Balance_B doesn't really make as much sense. So we divide each balance by its weight [Balance_A/80]/[Balance_B/20]
Spot price of A = [Balance_B/Weight_B]/[Balance_A/Weight_A] = [500/20]/[1/80] = 2000
Spot price of B = [Balance_A/Weight_A]/[Balance_B/Weight_B] = (1/80)/(500/20) = 0.0005
This means we need 0.0005 of A to get 1B.