Liquidity Bootstrapping Pools (LBPs)— Explained
The ICO boom of 2017 taught some important lessons, crowdfunding being one. A centralized exchange listing was expensive and the smaller exchanges mostly lacked security. The crypto world transgressed from ETH to stablecoins and centralized exchanges to decentralized exchanges learning along the way. It, however, did not solve the underlying problems of huge upfront capital and price manipulation by the bots. Whales would ape in using the bots, skyrocket the price and then dump it on retail investors. There is no perfect solution for these problems but one that has proven to be quite effective is the LBP or Liquidity Bootstrapping Pools. These pools were introduced by Balancer on Ethereum.
Liquidity Bootstrapping Pools
Understanding LBPs requires an understanding of the swap pool architecture that most AMMs are built upon.
An essential component of the DeFi ecosystem, AMMs use liquidity pools to permit the trade of digital assets in a permissionless and automatic way. AMMs eliminate the traditional way of matching buying to sellers and ensure liquidity 24/7.
Users supply liquidity pools with their assets, the price of which is determined by a mathematical formula. One such formula is the constant product formula popularized by Uniswap and Bancor,
K= x * y
This formula requires the pool to stay in constant balance which is represented by the constant, K. Reserves of two types of tokens represented by x and y, need to stay at equal total values (in a 50:50 ratio). Since the relative value of tokens is fixed, the formula automatically determines the price based on both tokens’ supply. If you want a detailed understanding of AMMs and Liquidity pools, watch this video by Whiteboard Crypto.
Constant product pools are widely used owing to their simple and versatile structure. Moreover, these pools are easy to create and incentivize. Studies show these pools do well despite their simplistic nature however there is a major problem associated with their use for token generation events. Let me describe this for you-
When it comes to creating a market for a new token, constant product pools put users in a rather unique position wherein they must choose the pricing level at which they wish to provide their initial liquidity. There are two scenarios-
- When the price is too high- a large amount of capital needs to be provided to the pool accompanied by the risk of having lesser buyers as well as low token float.
- When the price is too low- unfair market manipulation and network congestion are common as early traders, bots, and crypto whales tend to have an upper hand.
Bots are notorious for their infiltration. They operate at speeds that are much higher than real investors and these are capable of making purchases at the lowest price and then dumping on the actual supporters. The constant monitoring enables these to make truckloads of money at the expense of the community you’re actually targeting.
This is where Liquidity Bootstrapping Pools come into the picture eliminating the concern over unfair token distribution towards the bots.
The solution to a recurring problem- Liquidity Bootstrapping Pools
How LBPs work?
LBPs increase trust in the token launch by eliminating bot manipulation and creating a fair launch for everyone regardless of their portfolio size. They’re designed to safeguard the reputation of new projects, gain a competitive edge over bots and prevent whales to profit through rug pulls or other manipulation techniques. The operating mechanism of LBPs entails adjusting the weight of the two tokens in the pool. In other liquidity pools, tokens are required to maintain a set ratio of 50:50. A weighted pool proves advantageous as it allows for a high initial price with minimal up-front capital. LBP controller needs to provide the new tokens and a small portion of a second asset (mostly a stablecoin) to start the pool and initiate distribution. The programmatic adjusting of weight over time facilitates lowering of the price slowly thereby elongating the price discovery period enabling participants to wait for the price they think is fair to buy at.
Let’s break it down — — — — — —
The Liquidity Bootstrapping Pool as mentioned operates by changing the pool weight in order to maintain downward pressure on the market successfully overcoming the problem of unfair and unequal token distribution. The natural downward selling pressure created by downward and gradual shifts in pool weight is offset by the inflow of the second asset. This movement in weight and price discourages price spikes due to early speculation. Moreover, in this setup participants are motivated to wait until the price falls to levels acceptable to them since the market determines the ultimate price of the launched token by starting at a high initial price that declines gradually.
Creating capital-efficient pools is at the core of LBPs and is achieved by establishing a two-token pool composed of the token being launched and a collateral token. At first, the weight of the pool is in favor of the project’s token. Eventually over time, the balance shifts, and by the end of the token sale, the collateral token is preferred.
Let’s say a Project utilizing LBPs commences operations with greater weight distribution in favor of its token (say 80 percent), thereby minimizing the capital required upfront. Now the collateral token is assigned a smaller weight of 20 percent. The weights eventually rebalance to enable the sale of the project token and to facilitate efficient determination of its price in relation to the collateral token.
A unique feature of LBPs is the controller’s ability to halt swapping. This option can be exercised for several reasons including but not restricted to maintaining a relatively constant price in case of unexpected demand raising the token price or in case of individuals opting to sell back to the pool for profit. The gradual release of project tokens with varying weights in the pool compels whales to break down their transactions as the motivation to benefit from a rug pull is eliminated. Also, this mechanism makes the price discovery relatively more flexible and enables individuals to enter the sale in a fair manner.
Let’s try to understand this through an example. Project X launches its X token against DAI through an LBP. For the sake of example, the initial weighted ratio is 95:5 which means 95 percent of X against 5 percent of DAI. That translates to a low upfront capital requirement of DAI for the project. The final weight ratio is 5:95 which means the price of X token keeps reducing at a given ratio at the end of 70 hrs.
As can be seen from the graph,
- The price is constantly reducing over the course of 70 hrs with the prices reducing much sharply at the start.
- At any point in this curve, if the buying pressure is stronger than the downward weight pressure, the curve will move up.
- If the buying pressure balances the downward weight pressure, the curve will be flat and the price will oscillate around the market price.
- If the buying pressure is high towards the end, it will result in the graph growing up at the end.
First and foremost LBPs are designed to launch new tokens with relatively low-capital-requirement. In addition to that, they provide the ability for broad token distribution as well as fair price discovery as explained above.
Buyers need to take note that the token is listed at a maximum auction price and this price declines gradually over a defined period of time until the pool balances of both tokens are of equal value. This mechanism helps evade the malicious actions of the bots/whales that try to corner everyone else to eventually dump their tokens for hefty gains.
LBP comes as a savior providing a fair opportunity to the entire community. A project’s success depends on both institutional and retail investors. LBPs help all users achieve exposure to the token launch at a fair price minus the price swings and other associated concerns.
LBPs serve as brilliant alternatives for projects looking to distribute their tokens to a broad user base without being constrained by a fast-growing price curve in a fair and capital-efficient manner.
LBPs allow for tailor-made token distribution mechanics that give the project control as well as flexibility over their token launch. It is no doubt that experimentation is key and definitely necessary around this particular mechanism to achieve better results and maximize efficiency in the future. Thus, LBPs can be pegged as the future for fundraising especially when it comes to new projects that are looking at minimum capital investment.
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