The ICON DeFi Guide: Part 2— Stable Coins, Borrowing, and the Balanced Network
(Note: This chapter focuses on the Balanced Network. Most of the content is derived from the Balanced whitepaper. While this chapter works to educate readers on the basics of Balanced, there are some more advanced features that users may benefit from as well. If interested, I encourage you to read the whitepaper in it’s entirety.)
As I mentioned in the introduction to this guide, the most critical element of any financial system is money — in the form of currency — to facilitate the exchange and store of value.
On the Ethereum network, the most obvious choice to serve as currency is ETH, which is essentially the blood of Ethereum. When it comes to ICON, ICX serves that role.
But there’s a problem with ETH and ICX. Both are volatile. They could be worth 10% more tomorrow (or 10% less!) then they are today. It’s hard to transact when it’s unclear whether or not what you’ve sold something for will be worth far less just a day later.
Fairly quickly, the blockchain ecosystem recognized this as a problem and went about creating stablecoins. If you’ve ever traded cryptocurrency on an exchange, you’re likely familiar with USD-based tokens such as USDT (Tether) or USDC (USD Coin).
Now, as you may be aware, there’s some debate around just how well Tether is actually backed by assets. Tether was created by Bitfinex, which has stated that they have adequate fiat USD to back each printed Tether at a 1:1 ratio. But there are many who are concerned that may not be the case.
Meanwhile, USD Coin (USDC), which was created as part of a joint venture between Coinbase and Circle, and is also backed by US dollars.
Both of these stablecoins are fairly straightforward. The companies issuing them have backed them with US dollars, meaning you should hypothetically be able to exchange one USDT or USDC for one U.S. dollar. The two tokens fulfill the mission of being able to quickly facilitate the transfer of stable value on the blockchain.
However, in 2015 a new project was started, which would ultimately launch without an ICO at the start of 2018: MakerDAO.
At its most basic level, MakerDAO is a project dedicated to creating another stablecoin that trades at $1, just like USDT and USDC.
However, what makes MakerDAO different is the fact that it’s backed not by a 3rd party claiming to have collateral in the form of fiat USD, but rather by Ether (ETH). MakerDAO’s stable coin, DAI, is always worth $1.
How does it work?
First, an individual deposits ETH into the MakerDAO smart contract. In this example, let’s assume the price of ETH is $150. In order to protect against the volatility in the price of ETH, MakerDAO will allow the individual to take up to 100 DAI out of the DAO in the form of a loan (the minimum collaterlization rate is 150%).
Now, you have 100 DAI, serving as stable dollars which can be moved around the Ethereum network just like ETH would. Meanwhile, you’ll always be able to pay back the 100 DAI and receive your 1 ETH, regardless of what happens to the price of ETH. This provides a lot more trust in this stablecoin compared to one that is backed by USD, as the MakerDAO smart contract and balances can be viewed publicly on the blockchain.
Wait, but what happens if the price of ETH drops? Remember how the minimum collateral ratio was 150%?
Let’s say you still have the 100 DAI you borrowed with your $150 in ETH. Now let’s say ETH drops to $149. You’re now under 150%, meaning your collateral gets automatically liquidated (sold) on the open market. You’ll get to keep your DAI, but you’ll only receive whatever is left after the $100 you borrowed is accounted for through the liquidation, minus a liquidation fee, which is around 13%.
You’d ultimately walk away with about $136 in total value after the liquidation and the fee (the $100 in DAI you still have, plus the $36 remaining after your ETH is sold and you pay the liquidation fee).
Obviously, this isn’t ideal. You don’t lose everything, but it’s never fun to walk away with less money than you started. Fortunately, 150% is only the minimum — you can provide as much collateral as you wish. If you had deposited $400 worth of ETH but took out only $100, you’d have a 400% collateralization ratio, meaning the price of ETH would have to drop by a lot before you had any chance of liquidation.
To get a better understanding of how MakerDAO works, I encourage you to watch this brief video from DeFi Weekly by Kerman Kohli:
There is a dual benefit to MakerDAO model. On one hand, it’s a mechanism for generating a stable coin backed by assets in a transparent manner. On the other, it’s also a way to extend credit via loans to those who wish to take advantage of that opportunity.
What is Balanced?
Now that you know how MakerDAO works, we can move onto breaking down Balanced.
Balanced is modeled after MakerDAO, but offers some more advanced tools and options for those utilizing the protocol.
The most significant impact of Balanced, as is with the case of MakerDAO, is the creation of a stablecoin. Balanced is responsible for creating ICON Dollars (ICD), which will be the first stablecoin on the ICON network.
At the most fundamental level, the presence of a stablecoin running directly on ICON provides immense benefit, as any number of DApps being built on the network now have the ability to utilize a stable asset without having to ever leave the ICON chain. Meanwhile, ICONists can now trade out their ICX for ICD (perhaps hoping to buy more after an anticipated price drop) on one of the decentralized exchanges operating on ICON, meaning they never have to move their ICX to a centralized exchange.
We’ll go into more of the benefits of having a stablecoin on ICON later on, but first lets take a look at a couple ways Balanced works differently than MakerDAO.
First, is the fact that the minimum collateral ratio to take out a loan in ICD is 400%, rather than the 150% of MakerDAO. However, if the price of ICX drops and you fall below a 400% ratio, rather than getting liquidated, you instead are prohibited from getting your collateral back unless you deposit an adequate amount of ICX to get back above the 400% minimum.
In some cases, the user might not need the funds right away, or they have a belief that the ICX price will quickly bounce back. In which case they don’t have to do anything.
There is still a liquidation threshold though: 150%. If your collateral ratio falls below that number, your position will be liquidated, just as it would have been on MakerDAO.
This is essentially a two-tiered approach. Falling below 400% is sort of a “warning zone” prior to liquidation at 150%. It’s possible over time that this 400% number could change, but that’s what it will begin at.
The other difference is derived from the fact that holding ICX provides an opportunity to receive staking rewards. Accordingly, doing anything with your ICX other than staking means you’re potentially leaving a ~12% annual yield on the table.
Fortunately, Balanced has a way to solve this. When you deposit your collateral into Balanced, it first goes into a “staking pool” and is converted to sICX (for “staked ICX”). The sICX is then actually used as the collateral. On the front end, the user doesn’t really notice this process.
What’s important is that behind the scenes, the ICX in the staking pool will earn rewards like any other ICX could. When it comes time to claim your collateral, you’ll receive your initial amount, plus any staking rewards it has accrued since you deposited it.
The Balance Token
In order to incentivize certain behaviors on the Balanced protocol, the creators have created the Balance Token (BALN), which users can mine by either providing liquidity on the decentralized exchange (more on that below), or if they meet following borrowing qualifications:
- Deposit collateral into Balanced
- Borrow pegged assets from Balanced
- Be at or above the Target Collateralization Ratio of 500%
In order to incentivize people to add collateral to the pool (because without any collateral backing a stablecoin, there can be no stablecoin), the protocol will reward “miners” with BALN. The more collateral you have deposited, the more BALN you will earn.
Meanwhile, you can also earn BALN by providing liquidity on the decentralized exchange that operates on the Balanced protocol. At launch, several pairs will be available: the sICX/ICX pair, the BALN / ICD pair, and the ICX/ ICD pair. Providing liquidity to any of these liquidity pools will earn you BALN.
Why incentivize trading? Well, without people buying and selling, the decentralized exchange is fairly useless. You wouldn’t go to buy something if you didn’t think anyone was selling it.
Similar to mining via borrowing, the more liquidity you provide to the DEX, the more BAL you earn.
So what is the value of the Balance token?
Most prominent in the eyes of many will be the fact that Balance token holders are entitled to a portion of the fees that the protocol generates, to be split pro-rata amongst qualified Balance Token stakers and paid on a weekly basis. Balanced will also use a portion of the fees to be set aside into a DAO fund managed by BALN holders.
Here are all the fees that Balanced will generate from it’s launch:
- 0.00% Transfer Fee — Charged each time a pegged asset minted on Balanced is transferred from one wallet to another. The initial transfer fee will be set at 0%.
- 0.3% Decentralized Exchange Maker Fee — Charged when executing a trade on the Decentralized Exchange.
- 1% Origination Fee — Charged each time a borrower mints new pegged assets.
- 0.50% Redemption Fee — Charged each time a non-borrower claims collateral in exchange for retiring a pegged asset.
As you can imagine, if Balanced becomes a popular resource for borrowing and trading, it could generate a good amount of fees for Balance token holders.
An important caveat to point out is that simply holding the Balance token doesn’t entitle you to fees. If you own Balance tokens, you must hold them in a wallet that also has debt in the Balanced network. In other words, only users of the Balanced protocol will be able to receive the benefits of the Balance token.
But the share of fees aren’t the only benefit of the Balance token. In addition, holding Balance tokens give holders governance rights over the platform. These powers include (but are not limited to):
- Adjusting fees
- Adjusting interest rates
- Adjusting inflation rates
- Adjusting inflation allocations
- Adjusting the Balance Token unstaking period
- Adjusting Loan to Value (collateral ratio) requirements
- Adjusting the Balanced governance process
- Transferring Balance Worker Tokens (BWT)
- Spending the Balance Tokens held in the DAO fund
- Adding new pegged assets
In addition, Balance token holders have the ability to determine which P-Reps to delegate a portion of the staking pool toward (in other words, which P-Reps should receive votes with the ICX in the pool), also based on a pro-rata share. So if you hold 10% of the Balance tokens, you can delegate 10% of the staking pool to the P-Rep(s) of your choice.
It’s important to note that DeFi is full of potential risk, just as our traditional finance system is. However, if you know the risks associated with a given protocol, you can manage them or avoid them entirely.
When it comes to Balanced, there are two primary risks:
First, when using the protocol you are essentially sending your ICX to a smart contract. It’s impossible to know if a smart contract is 100% invulnerable, meaning there is always a small risk it can be hacked or attacked. Fortunately, the team working behind Balanced is more than qualified, and the smart contract has been through a rigorous auditing process. So while the risk is still present, it’s very very unlikely the smart contract has any issues. It’s important to note that this smart contract risk is present on any DeFi platform, so be sure to keep this in mind.
Second, is the risk you face from liquidation. As covered above, if you the value of ICX falls low enough to where you are collateralized at a ratio below 150%, your position will be closed. While you won’t lose all of your funds, you will lose some. However, as long as you are able to keep your ratio well above 150%, this shouldn’t be much of an issue.
Thanks to Balanced, we now have two important tools for the ICON DeFi ecosystem: a stable coin, and a mechanism to borrow money by leveraging our existing capital (the ICX you hold).
In the next chapter, we’ll learn how you can further leverage your ICX capital, either earning more by lending it out, or using it as collateral to borrow an asset on the ICON network.
As mentioned at the very beginning of this article, I encourage you to read the whitepaper if you want a full understanding of how the Balanced protocol works.
If you’d like to ask questions about DeFi, discuss strategies, or just have a general discussion, please join us in the ICON DeFi Discussion group I’ve created on Telegram to supplement this guide and build a vibrant DeFi community around ICON.