Sep 12, 2022
The Benefits of Multi-Token Pools
Balancer Multi-Token Pools offer Liquidity Providers a greater degree of control compared to traditional 50/50 Pools
Liquidity Pools have revolutionized the world of cryptocurrency trading, allowing investors to earn yields from idle funds and traders to instantly swap one asset for another. As with any new paradigm, however, first-generation Liquidity Pools and Automated Market Makers (AMMs) aren’t perfect. Ask any DeFi users, and they’ll likely admit that they have had to deal with high gas fees, limited trading pairs, or the looming risk of impermanent loss.
Luckily, there’s a solution in sight — multi-asset Pools offer Liquidity Providers greater control over their assets while potentially reducing trading costs. Here’s everything you need to know about Balancer Multi-Token Pools and how they benefit both sides of the liquidity equation.
What Are Multi-Token Pools?
Most traditional AMMs like Uniswap v2 create 50/50 liquidity pools. In this scenario, two tokens can be traded against each other and are given equal weightage or importance. If demand for either one of these two tokens rises, the AMM ensures that its price increases correspondingly, too.
Liquidity providers that add tokens to these pools earn fees for every trade, making AMMs a highly lucrative source of passive income; however, these 50/50 pools are quite inflexible in reality — most users rarely ever want to own exactly the same amount of two tokens. A risk-averse investor, for example, may only want to own a small percentage of volatile assets.
That’s where Balancer Protocol comes into play — it’s an AMM network that’s specifically designed to handle many tokens in a single Pool. Even better, it allows liquidity providers to set up their own Pools with custom token splits and weights. This level of customization helps providers have full control over their portfolios and plan to reduce their exposure to risky assets. It also enables low-fee swaps for traders, as we’ll discuss in the next section.
Balancer’s ability to create a Pool with multiple tokens also allows it to function as an index fund, where you have the ability to create custom portfolios or baskets of tokens depending on your investment philosophy. Instead of manually rebalancing your portfolio to maintain the right proportion of tokens, the Pool automatically adjusts prices as traders swap between various tokens.
What Are the Benefits of a Multi-Token Pool?
So, what does a multi-token Pool look like? With Balancer, that’s completely customizable — you could create an 80/20 pool consisting of WETH and WBTC or an 8-asset Pool with an equal 12.5% allocation for each token.
Traders looking to swap between lesser-known assets benefit from a multi-token Pool too. In traditional AMMs, if a direct trading pair doesn’t exist, you’d have to first convert your token into a more liquid token like ETH or stablecoin before proceeding to your final swap. With multi-asset Pools, however, the number of possible trading pairs increases severalfold.
While legacy two-token Pools only yield a single trading pair, a four-token Balancer Pool results in the creation of six distinct pairs. This not only provides traders with a simpler swapping experience, but also increases potential revenue sources for the liquidity providers participating in that Pool.
Multi-Token Pools with custom weights also address one of the biggest problems with traditional liquidity Pools: impermanent loss. In a nutshell, impermanent loss refers to the scenario where liquidity providers lose money to market volatility while their tokens remain locked up in a Pool. Liquidity providers typically steer clear of volatile tokens that could deviate in value significantly from the other asset in the Pool. While this strategy does help avoid impermanent loss, it’s an imperfect compromise.
The ability to create liquidity Pools of different weights helps limit exposure to volatile assets that may experience price swings. In other words, a liquidity provider would expose themselves to lower risk by participating in an uneven Pool. This is because the volatile component can be as little as 5 or 20%, compared to a flat 50%.
In fact, Balancer’s customizable Pool feature helps other DeFi projects control and mitigate risk as well. Aave, for instance, uses an 80/20 liquidity Pool to maintain a reserve of tokens for its Safety Module. According to Aave, “Holding AAVE/ETH liquidity with uneven weights is very close to simply holding AAVE, with the benefits of earning trading fees on top of it.”
How Multi-Token Pools Save Traders Money
In a previous section, we discussed how multi-token Pools yield more trading pairs than traditional two-token pools. If you have a pool with 8 tokens in it, you would need 28 two-token pools to provide the equivalent number of direct trading pairs!
However, there are also some other advantages worth noting. More specifically, traders can swap between tokens for lower fees, since multi-asset Pools contain many more potential trading pairs.
Moreover, Balancer’s unique Smart Order Router ensures that traders always get the best price, even if it means traversing through multiple Pools. Balancer can intelligently calculate which route gives the highest number of output tokens, depending on the liquidity available in each Pool. The feature also takes gas fees into account, ensuring that the additional Pool hops make economic sense.
With Balancer V2, the Smart Order Router becomes even more efficient since assets across all Pools are held in a single Vault. This means that a multi-hop swap can be processed internally, without creating expensive on-chain transactions for every single hop. This concept is similar to Layer 2 scaling networks, which consolidate multiple transactions into a single on-chain record.
For a real-world example of how much a trader can save with Balancer V2, check out our dedicated post on Smart Order Routing.
Closing Thoughts
All in all, multi-token Pools provide flexibility to both, liquidity providers and cryptocurrency traders. And that’s not all — the Balancer Protocol’s unique feature set is bringing DeFi to the next billion investors through a combination of lower fees and unprecedented simplicity.
Communications from Balancer are intended solely for informational purposes, and should not be construed as investment or trading advice and are not meant to be a solicitation or recommendation to buy, sell, or hold any digital assets mentioned. All figures are estimated and unaudited unless otherwise noted. Past performance is not necessarily indicative of future results. Transactions on blockchains are speculative. Carefully consider and accept all risks including risk of loss of all funds and extreme volatility of token prices and liquidity before taking action.
