The Critical Balance Between Low Swapping Fees and High Liquidity Provider Reward in DeFi

The Critical Balance Between Low Swapping Fees and High Liquidity Provider Reward in DeFi
Photo by Christophe Hautier / Unsplash

DeFi is liberating. Instead of relying on centralized entities for better yields, this emerging sub-sector in finance does away with intermediaries. They anchor their operations on mainly audited smart contracts for security and the burgeoning DeFi community to extract maximum value.

The Age of DeFi in Binance Smart Chain (BSC) and Ethereum

Trackers show that different DeFi protocols manage over $23 billion worth of value in the Binance Smart Chain (BSC). The figure is even higher in Ethereum, where it stands at over $55 billion.

DeFi is an umbrella term describing various open finance activities ranging from ordinary trustless swapping, lending and borrowing, derivatives trading, insurance, and so much more.

As vast as it may be, DeFi is known for facilitating trustless trading. Some of the largest DeFi protocols, therefore, revolve around offering DEX-related solutions.

In the BSC ecosystem, PancakeSwap is the largest and one of the earliest to launch. Nonetheless, new entrants like OrionSwap promise to improve on flaws picked out in PancakeSwap without binning the all-important Automated Market Maker (AMM) system.

OrionSwap, like PancakeSwap and Uniswap in Ethereum, depends on the community to perform efficiently. For users to quickly and cheaply swap tokens, the underlying must be scalable and ideally interoperable. Blockchains like the BSC ensure these conditions are met.

AMM Protocols and Liquidity Providers

What remains for AMM protocols, after that, is to build a strong force of liquidity providers. These are drawn from the community and are primarily keen on offering, first and foremost, offering liquidity with the expectation of getting a share of transaction fees.

On the surface, that's what liquidity provision is all about.

A level lower, it can get complicated.

Aforementioned, a liquidity provider, could  deposit capital to the CAKE/BNB pool, but must first be comfortable with the protocol’s overall security. Besides, a liquidity provider must also be guaranteed consistent passive income streams at rates displayed by the protocol when marketing.

This is because all liquidity providers, once they deposit their funds, are considered trade facilitators. As a result, the swapping protocol is automatically obliged to dispense a percentage of transaction fees in all pairs they enable.

Depending on the dApp, a liquidity provider is required to fund a pool with two different assets. For example, in the CAKE/BAKE pool, a liquidity provider supplies both CAKE and BAKE tokens in equal proportions.

The amount of income—the revenue stream—earned, on level ground, directly depends on the capital staked. The higher it is relative to the size of the pool, the higher the revenue drawn. This is why it is critical for would-be liquidity providers to critically analyze an AMM's code to determine, from the protocol level, whether they walk the talk.

Why Lower Transaction Fees and Higher Liquidity Provider Rewards Matter

The OrionSwap development team painstakingly dissected the PancakeSwap code and found flaws causing a deviation of what's advertised and what the liquidity provider does earn. PancakeSwap typically charges 0.20 percent as transaction fees in any pool.

Out of this, the liquidity provider ought to receive 0.17 percent, and the rest distributed to the pool's creators. However, because of foundational errors in the code base, PancakeSwap liquidity providers receive 0.15 percent and the protocol 0.05 percent.

Transparency is crucial. As they adopt, OrionSwap developers are now correcting this flaw. The OrionSwap DEX will be charging 0.18 percent as transaction fees but have added another line of code for assurance in transaction fee distribution to liquidity providers.

Accordingly, regardless of the liquidity status of supported pools, a liquidity provider will constantly receive 0.165 percent while the rest 0.015 percent is channeled to the OrionSwap treasury. In this mode, the portion of transaction fees set aside for liquidity providers in OrionSwap will be notably consistently higher than those offered by competitors like PancakeSwap.

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