Ethereum’s gas fees skyrocketed during the first NFT wave in 2021. Ethereum’s network grew saturated as more people entered the world of DeFi (again). As a result, dealers were required to spend more money on each transaction.
Fortunately, a Binance Smart Chain (BSC) alternative was ready to take advantage of Ethereum’s traffic spike. PancakeSwap, BSC’s most popular decentralized exchange (DEX), is one of the major beneficiaries, comparable to Ethereum’s Uniswap.
What is PancakeSwap, and can it be used to generate passive income?
What Distinguishes a DEX From a CEX?
There was no such thing as a decentralized exchange, or DEX, until a few years ago. To exchange stocks, commodities, or cryptocurrency, one needed to contact a centralized exchange or CEX. CEXes, which are regulated and have large wallets, supply the market with the liquidity it requires to function.
For example, if you wanted to purchase a Tesla (TSLA) stock, the market would need a seller. However, what happens if there is no vendor available at that time? This is where market makers—whether they be on the NYSE, Nasdaq, or Citadel Securities—come into play. These exchanges add liquidity to the market by acting as a buyer or seller anytime a deal is initiated.
CEXes maintain optimal market flow by covering asks (sale orders) and bids (purchase orders). In turn, they earn money by charging a small fee for the asset being exchanged—whether sold or purchased. The challenge, therefore, becomes how DEXes might perform the same function—market liquidity—without relying on a centralized operation with sufficient funds to cover all ask/bid spreads.
Revolutionary Blockchain Invention—AMMs
As you’re probably aware, not all blockchains are made equal. Dogecoin (DOGE) and other cryptocurrencies operate on a blockchain that exists solely to facilitate transactions. Both Ethereum and Binance Smart Chain, on the other hand, are generalist blockchains.
Due to the incorporated smart contracts in each data block, these blockchains are capable of digitizing and automating any action that can be lawfully formed. Trading is one such activity, which is governed by smart contracts known as Automated Market Makers, or AMMs.
By providing market liquidity, AMMs ensure that DEXes function similarly to CEXes. Liquidity pools and liquidity providers are two critical components in making this happen. Consider PancakeSwap to see how that would work in practice. More importantly, how this method may be used to generate revenue.
Slippage and AMMs
Before we dig into the inner workings of PancakeSwap, there is one critical point to grasp. On a traditional controlled exchange, such as Binance, traders rely on the firm to cover token asks and bids. As is the case with stocks and commodities, it is critical that an initiated trade is completed immediately.
Otherwise, you will experience slippage—a change in the sell/buy price between the time the market order is placed and the time it is executed. Slippage Tolerance refers to this pricing disparity, which is typically around 0.5 percent on DEXes. The more liquidity providers on a DEX, the lower the Slippage Tolerance.
The most frequently used method of avoiding slippage is through the use of limit orders. A limit order enables traders to specify a maximum buy or sell limit. In other words, until certain requirements are met, the market order will not execute. This gets us to the operation of PancakeSwap and other DEXes.
PancakeSwap’s Yield Farming
As previously stated, AMMs are composed of liquidity pools and liquidity suppliers. Liquidity pools are smart contracts that hold a specified quantity of coins in pairs. As a result, if a trader wants to exchange tokens, he or she must do it through a liquidity pool.
For instance, in a liquidity pool, the BUSD/WBNB token pair is used to exchange stablecoin BUSD for wrapped BNB tokens and vice versa. WBNB is used for altcoin trading, whereas BNB is the Ethereum equivalent of ETH. In other words, a decentralized application created on Binance Smart Chain would be able to utilize WBNB—a BEP-20 token—while BNB is the native coin of BSC.
To make these decentralized token exchanges work, liquidity providers must be compensated. After all, it is they that bet their cryptocurrency holdings in liquidity pools. The liquidity pools on PancakeSwap are called Syrup Pools, and the payout is in the form of CAKE tokens.
You earn CAKE whenever another trader dips into your Syrup Pool, according to the amount of crypto you have locked in. At the moment, one CAKE is worth $24.6 in BSC’s stablecoin, BUSD.
You can build a Syrup Pool using the token pairs CAKE/BUSD or CAKE/BNB. As you can see, this is what yield farming is all about—when you give liquidity to the crypto market, you become a yield farmer.
Due to the Federal Reserve’s (and other central banks’) massive money production, commercial banks provide almost 0% annual percentage yields (annual percentage yield). For instance, Chase Savings bank accounts offer an annual percentage yield of 0.01 percent
Providing liquidity via PancakeSwap, on the other hand, is light years ahead.
The annual percentage yield (APY) on your locked-in cryptos is around 175 percent when staking in the CAKE Syrup Pool. This is why PancakeSwap skyrocketed in popularity, coming in second place in terms of trade volume to Ethereum’s Uniswap.
As such, PancakeSwap is a tempting investment prospect in comparison to traditional banking, with one caveat—permanent loss. You risk losing money if the price of your staked tokens changes after you lock them into a Syrup Pool. Trading costs, on the other hand, can compensate for this if the price shift is not too substantial.
Finally, PancakeSwap offers a lottery. Users can win a substantial amount of CAKE by exchanging a lottery ticket for a CAKE token. To win 40% of the prize pool, the winner’s ticket must match six numbers, with each ticket having a 1 in 10 chance of matching the first number.
As one could expect, only the most disciplined users employing a compounded ticket approach would distinguish themselves from the losers. Naturally, becoming a regular yield farmer entails significantly less danger.