DeFi New Favorite | Understanding Balancer's "liquidity mining" governance token distribution mechanism in one minute

Since its launch at the end of March, the popularity of the non-custodial automatic market maker protocol Balancer has been steadily increasing. Recently, the introduction of the "liquidity mining" token mechanism has sparked attention and discussion in the DeFi market. Starting from June 1st, 145,000 tokens (valued at approximately $87,000) will be allocated weekly to Balancer's liquidity providers.

By: Sunday

"Automated Market Maker (AMM)" has become the hottest track in the current DeFi field. More and more on-chain trading platforms or decentralized exchanges (DEX) are starting to integrate AMM as a bottoming liquidity guarantee. Previously, the decentralized trading platform Uniswap garnered attention, and Balancer, which just launched two months ago, is also rapidly gaining popularity.

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Balancer is a non-custodial general automatic market maker (AMM) protocol. ChainNews has previously analyzed the project in detail.

In simple terms, Balancer is a "more advanced version of Uniswap." It can not only be a trading tool but also expand into a popular "index fund investment tool," with the potential for investment returns to surpass professional investors, bringing more imagination to the AMM tools.

In mid-May, Balancer proposed the introduction of the community governance token BAL (Balancer Governance Tokens), and on June 1st, it announced the official implementation of the "liquidity mining" token mechanism, aiming to provide economic incentives for early adopters of the Balancer protocol through the injection of its token BAL to encourage more liquidity providers to join and participate in community governance.

When the Balancer protocol was initially launched, there was no native token. However, Balancer Labs believed that in order to maintain decentralization, a decentralized community governance model needed to be introduced. The introduction of the community governance token BAL marked the beginning of the transition to a community governance model, where BAL holders have the power to decide the future of the Balancer protocol.

BAL is used for community governance within the Balancer protocol, allowing decisions to be made on significant events within the community, such as adding new features, deploying smart contracts on blockchains other than Ethereum, Layer2 scaling solutions, and introducing protocol fees.

The total supply of BAL is 100 million tokens, with 25 million allocated to founders, core developers, advisors, and investors, all of which have set vesting periods. The remaining 75 million tokens are planned to be distributed to users providing liquidity for Balancer pools, a process known as "liquidity mining."

According to an official announcement by Balancer Labs, starting from June 1st at 00:00 UTC, a total of 145,000 BAL tokens will be distributed weekly to liquidity providers in Balancer pools, approximately 7.5 million BAL per year. Subsequent distributions may be determined by governance. The seed round token price is $0.6, and based on this price estimate, Balancer will distribute tokens worth approximately $87,000 weekly.

Considering that early liquidity providers often bear more risks and opportunity costs (such as contract risks, lower initial Balancer pool profitability, etc.), Balancer introduced the "liquidity mining" token mechanism to create a truly strong incentive for early adopters of Balancer, encouraging them to actively increase liquidity and participate in community governance.

Previously, decentralized lending protocol Compound announced the introduction of a governance token and stated that its users would begin receiving COMP tokens in mid-June. Of the total 10 million COMP tokens, 4.23 million will be distributed for free to Compound users through smart contracts, under the condition that users engage in lending transactions using the Compound protocol. The more they borrow or lend, the more COMP they receive. Therefore, the distribution mechanism of COMP is also known as "borrowing is mining."

The "borrowing is mining" mechanism of Compound and the "liquidity mining" mechanism of Balancer are fundamentally similar, as both deeply integrate community governance tokens with their own business logic. This alignment of token holders and overall ecosystem interests is more conducive to the development of the entire DeFi product ecosystem. The increasing prevalence of such mechanisms indicates the continuous evolution of token models in the DeFi space.

Liquidity is crucial for the growth of DeFi products like Balancer and is a decisive factor in their ability to achieve cold starts.

In the Balancer protocol, any Ethereum user can create a Balancer pool and add liquidity to the protocol. Liquidity attracts traders, and trading generates transaction fees, ultimately attracting more liquidity to the entire pool, creating a kind of "flywheel effect."

Therefore, Balancer Labs believes that liquidity providers are the most important stakeholders in their ecosystem.

Given the critical role of liquidity in the Balancer protocol, the distribution of BAL tokens is designed to be proportional to the liquidity on Balancer. BAL tokens are distributed based on the proportion of liquidity each address contributes to the total liquidity on Balancer.

Due to the diverse tokens in liquidity calculations, the community decided to unify liquidity measurement in dollars. All liquidity providers receive BAL tokens as long as their pool contains at least two tokens, and those tokens have their dollar prices available on CoinGecko (tokens without a dollar price on CoinGecko are ineligible for liquidity).

Specifically, Balancer Labs calculates and distributes BAL tokens weekly according to the following steps:

• Determine the "start block" and "end block" for the week. The standard is to select the nearest blocks based on a fixed time, for example, Sunday at 1 PM UTC. For example, if the start block for the week is #10,100,000 and the end block is #10,140,000.
• Determine all "snapshot blocks." Every 64 blocks (every 15 minutes), calculate backward from the "end block" until reaching the "start block." Following the example above, the "snapshot blocks" are #10,140,000, #10,139,936, #10,139,872, and so on.
• Calculate the dollar liquidity in each Balancer pool. Each "snapshot block" and the various tokens in each Balancer pool are priced in dollars (extracted from CoinGecko).

One of the cool aspects of Balancer's liquidity mining is that it aims to incentivize pools with lower transaction fees.

The BAL token earnings for each pool are calculated based on the dollar value of each token in the pool multiplied by a "fee factor," calculated as follows:

As a result, the Fee Factor exhibits a bell-shaped curve (as shown below). The higher the transaction fee, the lower the Fee Factor, and the fewer BAL tokens the liquidity providers of the pool receive weekly. For example, a Balancer pool with a fee of 0.5% has a Fee Factor of 0.94, while a pool with a 1% fee has a Fee Factor of 0.78.

The underlying design logic is that pools with lower transaction fees will attract more users willing to trade using the Balancer protocol. These pools contribute more liquidity to the overall Balancer ecosystem, and as a result, liquidity providers should receive larger rewards.

As mentioned above, Balancer's "liquidity mining" mechanism, designed based on its community governance token, is a way for DeFi products to achieve a cold start. Balancer introduces the feeFactor factor in its design to attempt to stimulate liquidity growth while implementing lower transaction fees.

However, this mining model may lead to more arbitrageurs chasing after it. For lesser-known tokens, simply adding them to a Balancer pool and maintaining lower fees can earn a certain amount of governance token BAL, even without engaging in many trades. This liquidity may not hold much value for the entire Balancer system.

Additionally, although the "liquidity mining" mechanism is proposed as a new token distribution mechanism in the DeFi space, similar incentive mechanisms have long existed in China.

Yang Mindao, the founder of decentralized finance platform dForce, believes that Balancer's "liquidity mining" is similar to the "trading mining" model previously implemented by the FCoin exchange, and using such a mechanism alone may be lacking in consideration.

FCoin once used this strategy to stimulate its trading volume growth, surpassing Huobi and Binance at one point. Traders and arbitrageurs flocked to the FCoin exchange to "provide liquidity" in exchange for tokens, then quickly sold them for profit. This created a cycle where no one wanted to hold the tokens, leading to a collapse in the token price as the pace of the FCoin price collapse exceeded the arbitrage profits, causing active users to stop providing liquidity, and ultimately resulting in the collapse of FCoin due to depleted liquidity.

In Yang Mindao's view, for the "liquidity mining" mechanism to work effectively, several conditions must be met: the DeFi protocol must be useful (without tokens), the incentivized behavior must generate lock-up effects, locking additional liquidity into the protocol, and most importantly, stimulating an increase in demand for the protocol's tokens.

However, in reality, most governance tokens only propose a distribution plan without considering how to maintain the value of their tokens amidst continuous issuance (inflation), which is crucial for the viability of incentives. In DeFi, governance utility and cash flow alone do not create holding power, which is necessary to maintain the value of the token and incentivize continued participation. Once the token value is difficult to sustain, the entire incentive mechanism becomes unfeasible.

Unlike the FCoin trading mining mechanism, Balancer's BAL token distribution is a constant amount each week, setting a certain "cap" for incentivizing liquidity, which may to some extent avoid concentrating long-term development dividends in the short term, preventing wash trading and arbitrage teams from becoming the main force on the platform, worsening the entire ecosystem, and falling into a negative feedback loop and collapse risk.

This article is authorized and reproduced with the permission of ChainNews. Original source: ChainNews (ID: chainnewscom)