TL;DR (SUMMARY)
Liquidity pool tokens (sometimes called liquidity provider tokens) are issued to users who contribute liquidity to these types of pools. These tokens act as a receipt that allows you to claim the portion you originally staked and the interest earned.
You can also use LP tokens for compound interest in yield farming, take out crypto loans, or transfer ownership of liquidity in staking. However, it is important to understand that once you give up custody of your LP tokens, you no longer truly own the liquidity associated with those tokens.
Introduction
While most DeFi users are aware of liquidity pools, LP tokens are often seen as secondary. However, these cryptoassets have their own use cases aside from unlocking the liquidity you provided. While there are risks to using your LP tokens in other applications, there are viable strategies to get more value from these unique assets.
What does it mean to provide liquidity?
In its most basic form, liquidity is the ability to trade an asset easily without generating significant price changes. A cryptocurrency like Bitcoin (BTC), for example, is a highly liquid asset. You can trade this asset on thousands of exchanges for almost any amount without actively affecting its price. However, not all tokens are lucky enough to have this level of liquidity.
In Decentralized Finance (DeFi) and smaller projects, liquidity may be low. For example, the currency may only be available on one exchange. You may also find it difficult to find a buyer or seller who matches your order. The liquidity pool model (sometimes called liquidity mining) can be a solution to this problem.
A liquidity pool contains two assets that users can exchange. There is no need for market makers or takers or an order book, and the price is determined by the proportion of assets in the pool. The users who deposit the pair of tokens into the pool to enable trading are called liquidity providers. They charge a small commission for users to swap tokens.
Therefore, although providing liquidity means offering your assets to the market, in the case of LP tokens we are specifically talking about DeFi liquidity pools.
Keep in mind that just because there is a liquidity pool for an asset pair does not mean there is a lot of liquidity. However, you will always be able to trade in the pool and you will not have to depend on someone to find an order that matches yours.
How do liquidity pool (LP) tokens work?
After depositing a pair of tokens into a liquidity pool, you will receive LP tokens as a “receipt”. Your LP tokens denote your share in the pool and allow you to recover your deposit, in addition to the interest earned. Therefore, part of the safety and security of your deposit depends on you holding onto your LP tokens. If you lose them, you will lose your participation in the pool.
You will find your LP tokens in the wallet you used when providing liquidity. You may need to add the smart contract address of the LP token to see it in the crypto wallet. Most LP tokens in the DeFi ecosystem can be transferred between wallets, thus being able to transfer ownership. However, you should always check with the liquidity pool service provider, as this is not always the case. Transferring the tokens may, in some cases, result in permanent losses of the liquidity provided.
Where can I get liquidity pool tokens?
LP tokens are only granted to liquidity providers. To receive them, you must use a DeFi dApp with which to provide liquidity, such as PancakeSwap or Uniswap. The LP token system is common on many blockchains, DeFi platforms, Automated Market Maker (AAM), and decentralized exchanges (DEX).
However, if you use liquidity pooling services in an exchange's Centralized Finance (CeFi) setup, you may not receive LP tokens. Instead, the custodian service provider will hold them in custody.
Your LP token will typically be named after the two tokens in which you are providing liquidity. For example, CAKE and BNB tokens provided in a PancakeSwap liquidity pool will give you a BEP-20 token called CAKE-BNB LP. On Ethereum, LP tokens are generally ERC-20 tokens.
What can I do with liquidity pool (LP) tokens?
Although LP tokens work more like a receipt, that's not all you can do with them. In DeFi, you always have the opportunity to use your assets on multiple platforms and stack services like a layman.
Use them to transfer value
Perhaps the simplest use case for LP tokens is to transfer ownership of their associated liquidity. Some LP tokens are tied to certain wallet addresses, but many allow free transfer of the tokens. For example, you can send BNB-wBNB LP tokens to someone who could then withdraw BNB and wBNB from the liquidity pool.
However, it is difficult to calculate the exact number of tokens you have in the pool manually. In this case, you can use a DeFi calculator to calculate the number of staked tokens associated with your LP tokens.
Use them as collateral for a loan
Since your LP tokens provide ownership of an underlying asset, there is a good use case for using them as collateral. Just like you offer BNB, ETH or BTC as collateral for a crypto loan, some platforms allow you to offer your LP tokens. Typically, this will allow you to borrow a stablecoin or other large market cap asset.
In these cases, the loan is oversecured. If you are unable to maintain a certain collateral ratio, the lender will use your LP tokens to claim the underlying assets and liquidate them.
Cumulative or compound performance
One of the most common things you can do with LP tokens is to deposit them into a yield compounder (sometimes known as a yield farm). These services will take your LP tokens, regularly harvest the rewards, and purchase more of the pair of tokens. The compounder will then stake the tokens back into the liquidity pool, allowing you to accumulate interest.
Although the process can be done manually, a yield farm can, in most cases, complete the process more efficiently than human users. Expensive transaction fees can be shared between users, and the compounding process can be performed many times a day depending on the strategy.
What are the risks of LP tokens?
Just like any other token, there are risks associated with LP tokens. These risks include:
1. Loss or theft: If you lose your LP token, you lose your share of the liquidity pool and any interest earned.
2. Smart contract failure: If the liquidity pool you are using is compromised due to a smart contract failure, your LP tokens will no longer be able to return your liquidity to you. Similarly, if you stake your LP tokens on a yield farm or loan provider, be aware that their smart contracts could fail.
3. Difficulty knowing what they represent: When you look at your LP tokens, it is almost impossible to guess exactly what their exact value is. If the token prices diverge, you will incur an impermanent loss. You must also take into account interests. These uncertainties can make it difficult to make an informed decision about when to exit your liquidity position.
4. Opportunity risk: When providing your tokens as liquidity, there is an opportunity cost associated. In some cases, it might be better to invest your tokens elsewhere or use them on another occasion.
Conclusions
The next time you provide cryptocurrency liquidity to a liquidity pool in a DeFi protocol, it is worth considering whether you also want to use your LP tokens. Depositing into a liquidity pool may only be the first stage of a DeFi strategy. So, in addition to HODLing, analyze your investment plans and your risk tolerance to decide if it is better for you to invest more.