What are liquidity pools on PancakeSwap ?
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The previous weeks I am investing in DeFi projects that are built on the Binance Smart Chain (BSC). I know how to use the tools, I know how to swap, I know hot to connect my MetaMask wallet, I know how to provide liquidity to the liquidity pools, but I also have questions.
What is exactly a liquidity pool?
How does a liquidity pool work?
What is AMM?
How is the price set within a liquidity pool?
What is impermanent loss?
So I did some research on the internet, read some articles, watched video’s and tried to figure this out. This article is a summary of this research and a practice for me, to see if I was able to explain the questions to you.
I will take PancakeSwap as an example, as this is the most famous DeFi project on the BSC.
PancakeSwap
PancakeSwap is the most known protocol to swap tokens on the Binance Smart Chain (just like UNISwap for the Ethereum blockchain). It has an automated market maker (AMM).
Launched on September 20, 2020 PancakeSwap is a DEX on the BSC using permissionless liquidity pools that are automated and run completely by algorithms. This use of algorithms to run the pools makes PancakeSwap an automated market maker. An AMM is an exchange that allow users to trade digital assets against liquidity pools and collect yields. In the AMM a user loans their digital assets to liquidity pools and in return they receive liquidity tokens that they can then stake to earn more digital assets.
What is a liquidity pool?
These are the pools where Liquidity Pool (LP) tokens are marketed. This is automated and differs from a normal exchange where the price is simply determined by demand and the use of an order book. You have a buyer that wants to buy a token against a certain price and you have a seller that wants to sell the token against a price. When the prices come together you have a deal. For example on the Binance exchange there is a XRP/BNB market where you can trade XRP/BNB pairs.
A liquidity pool is a new type of digital market where two tokens are marketed.
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