The following explains how liquidity pools work when using a decentralized crypto exchange. For our step-by-step instructions we use PancakeSwap.
We are discussing:
- What is a Decentralized Exchange (DEX)?
- What are liquidity pools and why are they important?
- How can users interact with liquidity pools?
- What are the risks associated with liquidity pools?
Decentralized Exchanges (DEX)
In simple terms, a decentralized exchange is self-executing code on a blockchain that performs trades for users.
As such, DEXs do not have a centralization point like a corporation or centralized exchange, meaning they have no ability to seize, confiscate, or freeze your assets.
What is a liquidity pool?
A liquidity pool can be thought of as a “cryptocurrency reservoir”. For example, when a user wants to exchange their Bitcoin for Toncoin, the DEX protocol takes Toncoin tokens from the liquidity pool, transfers them to the trader, and deposits the Bitcoin into another pool.
This ensures a seamless and lightning fast trading experience on DEXs.
Admittedly, we’re simplifying the process, but DEXs don’t “take” anything – the code handles all of these transactions automatically.
DEX’s code is open source, meaning anyone can read it and spot potential security vulnerabilities, for example.
Where is the liquidity coming from for these pool pairs?
Liquidity providers deposit token pairs in pools, creating liquidity for other users.
Why should people deposit their cryptocurrencies into a liquidity pool?
Without liquidity pools, DEXs could not function properly.
For this reason, DEXs offer financial incentives to liquidity providers. By providing liquidity, users receive a percentage of transaction fees within liquidity pools.
In a way, it is a form of passive income.
“I have 10 toncoins. Can I become a liquidity provider and earn rewards?”
The short answer is no. In fact, there is no such thing as a “single pot of cryptocurrencies” with a wide variety of tokens coming in and going out.
A liquidity pool always consists of a trading pair.
For example, there could be Toncoin/Bitcoin, Bitcoin/Ether, or Toncoin/USDT pools. Each of these pairs is an individual pool.
To become a liquidity provider for the Toncoin/Bitcoin pool, you need to deposit both Toncoin and Bitcoin. Different DEX protocols have different pairing ratios that users must meet before depositing their crypto into a pool.
After depositing your crypto into the Toncoin/Bitcoin liquidity pool, you will receive a fraction of each transaction fee within that special pool.
If someone wants to exchange Toncoin for Ether then it will be done in a completely different pool and you will not get any transaction fees since your tokens are in the Toncoin/Bitcoin liquidity pool.
How to use liquidity pools
Now we will explain you step by step how to become a liquidity provider on the PancakeSwap DEX for the Toncoin/USDT pair. You can choose any other pair you want to provide liquidity on, but the Toncoin/USDT pool is one of the most liquid.
Instructions:
- You need a cryptocurrency wallet compatible with DEX. We recommend using MetaMask as it is one of the most popular and secure crypto wallets in the world.
You can download MetaMask here.
2. Before doing anything, you need to buy a Binance Coin (BNB) as it is the native currency of the Binance Smart Chain and is required for transaction fees. About $1 should be enough.
Buying cryptocurrencies is easy on the Binance crypto exchange.3. Once you’ve bought BNB, go to PancakeSwap and connect your wallet by clicking “Connect Wallet” on the top right of the page.
4. Connect your wallet. For this tutorial we use MetaMask.
5. Click “Act Now” to begin.
6. Now you need to add Toncoin to your list of supported cryptocurrencies. Copy Toncoin smart contract address from official website.
7. Go back to PancakeSwap and click in the To field:
8. Paste the copied smart contract address into this field:
9. Click on “Import”. Toncoin appears in the list of cryptocurrencies available for trading:
10. Exchange your BNB for Toncoin:
11. Now you are ready to deposit your Toncoin into a liquidity pool, but remember you can only add them as a pair. In our example, we use USDT as the second token of the pair. So make sure you have some in your crypto wallet too. To join a pool you must need the same amount of both tokens in dollars. For example, if you have $10 worth of Toncoin, you must have at least $10 worth of USDT to proceed.
Go to the “Liquidity” section and click “+ Add Liquidity”:
12. Select the Toncoin/USDT token pair and click Deliver. You must give the smart contract permission to issue or use your assets within the liquidity pool. (This is done in 3 transactions.)
13. Click on “Confirm delivery”:
14. Confirm the transaction in MetaMask.
15. This is it! Your tokens are now in the Toncoin/USDT pair’s liquidity pool and you will receive a commission from the pool’s transaction fees.
Risks related to the provision of liquidity
There are two main risks:
- Ephemeral Loss
- The possibility of smart contract exploits
Ephemeral Loss
This is common with liquidity pools as crypto markets are volatile. However, we will spare you the confusing technical details.
However, that does not mean that you should ignore this problem. If you are interested in becoming a liquidity provider, you should read this article.
Let’s take a look at what fleeting loss means in simple terms:
A temporary loss is when the value ratio of your initial pair of tokens fluctuates.
The volatility of the crypto market is notorious and can cause serious stress for even the most experienced investors. While it sounds tempting to earn commissions from transactions in liquidity pools, simply hodling your cryptocurrencies can sometimes yield better returns than providing liquidity.
The possibility of smart contract exploits
In the world of DEXs, there is always a chance that your liquidity pool’s smart contract could be exploited by hackers from whom no one is safe or secure.
In 2020 alone, DeFi users lost a total of $100 million to smart contract exploits and hacks.
Diploma
Liquidity pools are an interesting but important part of DeFi ecosystems across all blockchains, offering potentially lucrative financial incentives.
As always, be aware of the risks when investing in cryptocurrencies and do your own research.
This guide does not constitute financial advice.
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