Liquidity Bootstrapping Pools: Balancer’s ICO Solution

In TradFi, asset exchanges often involve a third party like a bank, broker, or exchange. Market players add their orders to an order book, and if there's a match under specified conditions, the trade happens. But what if there's no matching party?

This gap is filled by market makers who provide liquidity (the ease of converting an asset to cash) and ensure trades are executed as planned. While this method offers several benefits, its centralized nature limits its full integration with blockchain systems.

The functioning of market makers. Source: bitpanda.com

An alternative to traditional market makers are Liquidity Pools (LP), ensuring continuous trading. These pools are typically composed of two assets. For example, an LP that allows buying ETH with USDC is known as the ETH/USDC pool.

One of the applications of Liquidity Pools (LP) is the AMM (Automated Market Maker) protocol. These systems set token prices based on their relative amounts within the pool. While AMMs suit trading well-established assets, they're less ideal for Initial Coin Offerings (ICOs) due to several reasons:

• AMMs require a significant amount of liquidity. For instance, to back the value of a token X using AMM, a considerable quantity of a collateral token, such as ETH, needs to be locked in. This high liquidity requirement is often beyond the reach of many projects.
• They necessitate an initial purchase price. The outcome of an ICO can be adversely affected if the starting price of the asset is either over or under its fair value.
• AMMs pose a risk of market monopolization. Large players can potentially acquire all tokens from the pool risk-free and later sell them at a higher price to other market participants.

There's no one-size-fits-all solution to these issues. However, Liquidity Bootstrapping Pools (LBPs), developed by Balancer, have emerged as one of the more effective approaches. 

What are Liquidity Bootstrapping Pools?

LBPs are a type of liquidity pool designed to assist token creators in equitably distributing their tokens among investors. LBPs are typically utilized to conduct Dutch auctions, a model for selling tokens via ICOs.

LBPs differ from standard liquidity pools in their asset ratio. For example, in an AMM, the ratio might need to be 50/50, whereas in LBPs, this ratio shifts over time. This flexibility helps stabilize token prices, especially in scenarios where a large player might artificially inflate demand.

Setting up an LBP requires specific details:

• The initial and target token ratios.
• The timeframe for adjusting the token weights (their proportion in the total asset value of the liquidity pool).
• The duration of the LBP's operation.

For instance, if you aim to launch a token X with ETH as the collateral asset, your Liquidity Bootstrapping Pool would be labeled as X/ETH. Suppose you decide on a starting asset ratio of 10/90, shifting to 50/50 eventually. In this setup, the weight of the token X will decrease until it either equals ETH or the LBP period concludes. 

Like traditional liquidity pools, token values in LBPs are determined by their relative quantities. An oversupply of an asset in the pool implies low demand, causing the price to drop, and vice versa. Developers predetermine these ratios to align with the initial price requirements. 

LBPs play a critical role in establishing a token's fair market value. The price reduces until the market begins to purchase the asset, thereby lessening its proportion in the pool. This mechanism ensures a balance: the price drops due to increased supply, and it remains stable due to a reduction in tokens in the pool.

The token's price trajectory relative to time post-LBP launch. Source: reddit.com

It's crucial for LBP creators to accurately gauge the initial token price. If set too low, the asset might be bought out quickly after trading begins; if too high, the price might not reach its fair value promptly.

The green line in the graph represents a scenario where a major player acquires a substantial portion of the tokens. However, if the broader market is unwilling to follow suit, the price lacks support and continues to decline.

Advantages of Liquidity Bootstrapping Pools

Countering Bots. One of the critical objectives of Initial Coin Offerings (ICOs) is to ensure equitable sales for all market participants. However, large investors often deploy special bots to quickly purchase assets and distribute them across various wallets.

In the Liquidity Bootstrapping Pool (LBP) scenario, bots become less effective. As the asset price reduces over time, early buying by bots incurs the risk of not finding later buyers at a higher price, deterring such practices. 

Establishing Fair Asset Value. In LBPs, trading begins at a level deemed fair by the users. This mechanism significantly challenges setting an excessively high initial asset price, as market forces naturally drive it toward a fair valuation.

Accessibility. To engage in an ICO utilizing LBPs, participants need only have capital and a cryptocurrency wallet. This approach bypasses the need for registration on centralized exchanges, KYC procedures, and specific residency requirements.

Case Study: Perpetual Protocol’s Use of LBP

In September 2020, Balancer's LBP was utilized for the first time to distribute 7.5 million PERP tokens. This event saw the participation of 1355 users, with 1221 becoming final holders of the asset.

In this LBP, participants purchased PERP using USDC. The initial asset ratio was 90/10, shifting eventually to 30/70. To set the starting token price at $1.6, the team pooled 7.5 million PERP and 1.33 million USDC. The asset weight adjustment was linear for three days, calculated in blocks (20,080 in total).

PERP/USDC Weight Change. Source: medium.com

This PERP token sale successfully demonstrated how LBPs can establish a fair market value for assets. When the LBP was launched, many market players hesitated to participate, believing the price to be inflated or expecting it to drop further.

PERP Price Chart on LBP. Source: medium.com

As a result, the trading volume for PERP was minimal initially. But as the price stabilized around $1, a significant uptick in demand occurred, driven by FOMO among participants who then purchased the token above its initial offering price. 

The peak price of PERP during the LBP reached $2.3, with an average value of $1.63.

Final Words

LBPs offer a novel approach to conducting ICOs, with the key advantage of adjusting the token ratio in the pool at the beginning and end of the sale. This strategy mitigates the risk of immediate large-scale purchases and aids in finding a fair price for the asset.

Notable examples of successful LBP implementation include Perpetual Protocol, Nsure.Network, and HydraDX. Whether other projects will continue to embrace LBP for ICOs or find alternative methods remains to be seen.