Anyone Can Create Their Own ETF and Get Paid for It; This Wasn't Possible Before

Hello Defiers! This week’s interview is with Fernando Martinelli, co-founder and CEO of Balancer Labs, a second-generation Automated Market Maker. So first let’s briefly talk about AMMs: Bancor and Uniswap popularized the concept of a decentralized exchange, where tokens get deposited in smart contracts, together with a more liquid asset to facilitate trades between any two assets, no matter how illiquid they are. Those who deposit tokens in the protocol, or liquidity providers, get fees in return. These “pools” of tokens mean that traders don’t need to wait for a counterpart and trades can happen automatically. They eliminated the need for order books and complicated interfaces, and allowed for an automatic, seamless experience, which was many times better than clunky decentralized exchanges of the past.

Balancer Labs is an AMM with a twist. Instead of liquidity providers having to deposit tokens in a pool at a pre-determined ratio together with a more liquid token (usually ETH), Balancer enables users to create token pools that have any ratio they want between their tokens. They can use any combination of tokens, and can even exclude ETH. The pools automatically rebalance when tokens’ price change, so that the same ratio is maintained. This way, liquidity providers are effectively creating something like a tokenized index fund, or ETF, in which anyone can invest. On the other side of the protocols are the liquidity takers, or traders, who can exchange tokens from these pools, or “ETFs.”

Traders pay a small fee, determined by liquidity providers, which means that unlike in traditional finance, where you have to pay ETF providers to trade index funds, you can create your own fund and get paid for it.

Fernando explains how Balancer works, and gives the scoop on what’s coming up next, which includes, an interface for non-technical users to create their own token pools, a Balancer token to be launched in V2, liquidity provider rewards using this new protocol token, and plans for decentralized governance. He also talks about Balancer’s business model, the steps it took to ensure the protocol is safe and the level of control the team has over the protocol —which he says is basically zero.

Now let’s get into it!

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Fernando Martinelli: I started going down the rabbit hole of crypto in early 2013 when Ethereum didn't exist. I was very excited with Ethereum and paid very close attention to the early projects in the space. One that really caught my attention was MakerDAO and I got involved with the team, Rune and Nikolai. I did some collaboration on the control of the target rate feedback mechanism.

I slowly moved to a full-time crypto job with Balancer as a project at Block Science. Block Science is a research company that does works with complex systems. It does a lot of cool projects in crypto. We started Balancer as a project in early 2018 and realized that it had a very big potential so we spun it off as its own company, which is Balancer Labs. Nikolai was very excited about the project as a user. He was pre-seed investor and helped write the code which is something he's brilliant at and did a great job. He was the main person to write our first version Balancer.

Liquidity on Your Own Terms

Camila Russo: And then in 2018, what was it that made you want to spin off Balancer as a separate company? What were the origins of Balancer that excited you so much?

FM: I actually also was looking for something like Balancer as a user, as someone who wants to provide liquidity and have my portfolio composed of a few different tokens. Uniswap wasn't even a thing. It hadn't been launched back then. The idea that you can provide liquidity on your own terms, so you can say I want to put 20% of ZRX and 80% of BAT, that wasn't possible back then. So that's how the idea of Balancer was born. We did a lot of research and a lot of simulations to make sure that it worked and all the mathematical frameworks made sense.

CR: If you could describe Balancer for a non-crypto person, what's the analogy or description you would use for the traditional finance world?

FM: It's great that you asked that because it's really easy to explain Balancer to non-crypto people. It's simply an ETF that you create. The fact that Balancer keeps continuously rebalancing your pool or your liquidity means that it's practically an index fund. So you say, I want to have 20% of my dollar value in ZRX and 80% in BAT and it will always keep that way, 20/80, even if the prices of those two tokens vary relative to each other.

Image source: Balancer Labs token pools dashboard

The best thing is that actually when you have like an index fund or an ETF in the real world, you're usually paying fees for others to rebalance for you, because they have to do that actively. They have to go out and sell stocks and buy stocks. Balancer inverts that idea and lets people buy when it wants to sell and sell when it wants to buy and charges a fee for trading [and pays liquidity providers who are creating index funds.]

Then there's the idea of impermanent loss. I don't get into that detail for people outside of crypto, but it explains more or less why if prices fluctuate, you end up making money from the trading fees because Balancer charges a fee for the liquidity provider instead of the liquidity provider having to pay a fee to have their portfolio rebalanced.

ETF Maker

CR: Let's kind of break it down even more. So you're saying Balancer is like an ETF, but would it be more like an ETF maker? Does it allow people to construct their own ETFs and invest in other people's ETFs that they have also made?

FM: Exactly. So you can either create your own pool or use your liquidity and add that liquidity to other existing pools.

CR: Okay. And then the difference between fees in traditional ETFs and in Balancer, what you were saying is that for traditional ETFs, you have to pay to provide liquidity, right? You have to pay when you want to buy an ETF, you have to pay fees for the portfolio managers, the ETF provider, BlackRock, whatever you're buying from. And in this case you receive fees to provide liquidity?

FM: Yes.

CR: Okay. And who is paying those fees?

FM: Traders that use the liquidity in Balancer to exchange a token for another one pay fees. So yeah, let's say you, Camila, want to sell ZRX for BAT and I have a pool with those two tokens, you can just go to my pool and say, I want to exchange one BAT for one ZRX and then you pay a very tiny fee that goes to the liquidity provider. And if someone else wants to do the opposite trade, then you're both meeting on my liquidity pool. You could have used an order book exchange but by having a liquidity pool, you can always trade with that liquidity pool. You don't need to wait for another order to exist for people to meet. So that's kind of a main advantage of AMMS [automated market makers].

CR: So that gets to the other piece of Balancer, right? Which is, it's also an exchange. Because you have the ETF side of it and then the other side is, these pools of tokens which create the ability for traders to just come and trade their tokens.

FM: That's correct.

CR: And for traders to use this liquidity, for example, if I go on with your example with ZRX, say they want to trade for ETH, for a trader to come and buy ZRX, does it have to be with the same pair of that same ETF or can you just take tokens from one ETF and another ETF and combine?

Multi-Hub Trades

FM: Yes, you can. That's something we are building right now. That's multi-hub trade. So if you want to sell A for B and there's no pool with A and B, you can sell A for C and then C for B. So you're trading A for B.

But right now, imagine you have a pool with five different tokens, A,B,C,D and E. You can trade within that pool across any pair of those five tokens. So A to B, A to C, A to D, which is actually great because you're not fragmenting liquidity across many pools just because you are limited to having two tokens per pool.

I’ll use a practical example here: RealT. I don't know if you know David Hoffman's project. So they are putting tokenized shares of properties on the Ethereum network. They have to make sure that those tokens are liquid, so they have them in Uniswap pools. But yeah, you would have to have ETH and property A in one pool, ETH and property B in another pool and so on and so forth.

Balancer allows you to have property A, property B, property C; all of those in one pool and you don't need to have ETH there as well. Any combination of ERC20 tokens is enough. So you don't have that much impermanent loss which happens when you have ETH and another token that varies a lot. So yeah, that's just to show you that you can have one pool with many tokens and you can trade across any pair of those tokens in that pool.

CR: Okay, so you can trade within pairs in in one pool, but in the future you're building so that you can trade between pairs across different pools.

FM; Right. So if you want a pair that's not present in any pool, then you need to do a multi-hop trade, which is where you use an intermediary token for that trade, from A to B, you pass through C and then go back to B.

Flexible Fees

CR: How do those fees compare with traditional ETF fees? How much in fees should a liquidity provider expect to gain?

FM: That's something that shows our flexibility. That's totally configurable. The creator of the pool chooses what swap fee or trading fee they will charge for traders that will use their pool. You can not only choose what tokens you want to have in your pool, what percentages or weights you want to have for each of those tokens, but you can also say people will trade for 1% in my pool.

And then the market adjusts it. If there's another pool —and there can be any number of pools because we're totally permissionless and trustless so people can create pools as they want— there can be other pools with a lower fee and traders will probably trade with them more than with mine. But on the other hand, if you have zero fees, then the liquidity providers are not going to be attracted to put their liquidity in that pool because it doesn't generate any returns for them. So there is a sweet spot where it's really up to the market. We say we're a market enablers, so we are not setting up that fee. We just let anyone choose whatever fee they want and let the market decide what pools are most successful.

If You Build it Liquidity Will Come

CR: I think like the great innovation that you're doing is allowing these different weights of tokens within these pools, like these different percentages. I think that's the biggest difference with other AMMS.

So how are you able to make this work? Because I imagine the reason why in the past, other protocols like Bancor and Uniswap, the reason why they need a specific weight is to secure some level of liquidity between token pairs. I see how this can work for the ETF side, but how do you make it work well for the Dex side?

Fernando Martinelli: That's a great question. Our focus is mainly on the liquidity side. Our belief is that if there is a lot of liquidity, then there will be trading, there will be traders coming to our liquidity pools because they offer very good rates or very low slippage and low fees. Since you have lots of different pools with the same pair, some will be better for you to buy, others will be better for you to sell.

So we focus on the liquidity provisioning side and the trades are a byproduct of that. Of course, if you're not integrated and connected to DeFi then people will not see our liquidity pools and they will not trade with them. So we need to be integrated so that there are trades, so that there are trading fees being paid and the pools are profitable otherwise liquidity providers will go elsewhere.

[ … ]

Paid subscribers have access to the full interview, including sections on:

• Liquidity integrations
• Activity stats
• Smart pools
• User-friendly interface
• Balancer’s business model including protocol fees
• Plan to introduce a token and token-based rewards
• Team’s lack of admin keys
• Long-term vision

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About the author: I’m Camila Russo, a financial journalist writing a book on Ethereum with Harper Collins. (Pre-order The Infinite Machine here). I was previously at Bloomberg News in New York, Madrid and Buenos Aires covering markets. I’ve extensively covered crypto and finance, and now I’m diving into DeFi, the intersection of the two.