Summary

Liquidity pool tokens (sometimes called “liquidity provider tokens”) are paid to users who provide liquidity to the liquidity pool. These tokens serve as receipts for redemption and pledge with interest.

LP tokens can also be used to earn compound interest in liquidity mining, obtain cryptocurrency loans, or transfer ownership of pledged liquidity. However, it is important to understand that only by giving up custody of the LP tokens held can the corresponding liquidity be truly obtained.

Introduction

Most decentralized finance (DeFi) users know about liquidity pools but have little understanding of LP tokens. In addition to unlocking user-provided liquidity, these crypto-assets also have their own use cases. So while there are risks associated with using LP tokens in other applications, a variety of viable strategies can still extract more value from these unique assets.

What does it mean to provide liquidity?

At its core, liquidity is the ability to easily trade an asset without causing significant price changes. Cryptocurrencies like Bitcoin (BTC) are assets with excellent liquidity. Any amount of Bitcoin can be easily traded on thousands of exchanges without the price being affected. However, not all coins are blessed with this level of liquidity.

Decentralized finance (DeFi) and smaller projects have very low liquidity. For example, a certain token is only available on a single platform. Or, it may be difficult to find a buyer or seller that matches the order. The liquidity pool model (or “liquidity mining”) is the solution to this problem.

The liquidity pool contains two assets that users can exchange with each other. There are no market makers, takers, or order books required, and the price is determined by the ratio of assets in the pool. Users who deposit token pairs into the pool to facilitate transactions are called “liquidity providers.” Liquidity providers charge a small fee to users who borrow their tokens to complete the exchange.

So, providing liquidity means providing individual assets to the market, but in the case of LP tokens, we are actually talking about decentralized finance (DeFi) liquidity pools.

Please note that just because there are asset trading pairs in the liquidity pool, it does not mean that there is sufficient liquidity. However, this way you can always use the fund pool to trade without having to rely on others to match orders.

How do Liquidity Pool (LP) tokens work?

After depositing a token pair into a liquidity pool, users receive LP tokens as a "receipt." LP tokens represent the user's share invested in the pool, and also represent certificates for redeeming deposited tokens and collecting profits. Therefore, holding LP tokens can provide security for personal deposits to a certain extent. If LP tokens are lost, all the invested shares will be lost.

When providing liquidity, LP tokens are stored in the wallet used by the user. If you want to view the LP tokens in your personal cryptocurrency wallet, you need to add the smart contract of the LP tokens. Most LP tokens in the DeFi ecosystem can be transferred between wallets, thereby transferring ownership. However, there are sometimes exceptions, so be sure to check with your liquidity pool service provider. In some cases, transferring tokens can result in a permanent loss of the liquidity provided.

Where to get liquidity pool tokens?

LP tokens can only be allocated to liquidity providers. Use DeFi DApps such as PancakeSwap or Uniswap to provide liquidity and you can earn LP tokens. LP token systems are common in various blockchains, DeFi platforms, automated market makers (AMMs) and decentralized exchanges (DEX).​

However, if you use the liquidity pool service in the centralized finance (CeFi) setting of the trading platform, you may not be able to obtain LP tokens. LP tokens are hosted by custody service providers.

LP tokens are usually named after the two tokens that provide liquidity. For example, if CAKE and BNB are provided in the PancakeSwap liquidity pool, the BEP-20 tokens obtained by the user are called "CAKE-BNB LP" tokens. The LP tokens in Ethereum are called "ERC-20 tokens".

What are Liquidity Pool (LP) tokens used for?

While LP tokens function like receipts, they are used for much more than that. In the field of decentralized finance (DeFi), personal assets can be used across multiple platforms, just like stacking Lego blocks to enjoy multiple services at the same time.

used for value transfer

Probably the most basic use case for LP tokens is the transfer of ownership associated with liquidity. Some LP tokens are tied to specific wallet addresses, but most allow the tokens to be transferred for free. For example, BNB-wBNB LP tokens can be sent to users who can remove BNB and wBNB from the liquidity pool.

However, it is difficult to manually calculate the exact number of tokens in the pool. In this case, using a DeFi calculator, you can calculate the number of staked tokens associated with the LP tokens held by the user.

used as loan collateral

LP tokens provide ownership of the underlying assets and would be a desirable use case for use as collateral. Similar to providing BNB, ETH or BTC as collateral to obtain a cryptocurrency loan, some platforms also allow LP tokens to be provided as collateral. Generally speaking, users can borrow stablecoins or other high market capitalization assets by mortgaging LP tokens.

This situation is classified as an over-mortgage loan. If a specific collateral ratio cannot be maintained, the lender can use the borrower's LP tokens to demand and force the underlying asset to be liquidated.

Reinvestment income

The most common use of LP tokens is to deposit income compounders (also known as "liquidity mining"). These services utilize LP tokens to regularly harvest rewards and purchase additional token pairs. The compounder then stakes these token pairs back into the liquidity pool, allowing users to earn compound interest.

The process can be operated manually, but in most cases, liquidity mining is more effective in reinvesting than manual operations by users. Depending on the strategy, users can share expensive transaction fees with each other and reinvest multiple times a day.

What are the risks of LP tokens?

Much like other tokens, LP tokens also have risks, including:

1. Lost or stolen: If you lose LP tokens, you will lose your share of the liquidity pool and various interests earned.

2. Smart contract failure: If the liquidity pool being used is damaged due to smart contract failure, LP tokens will not be able to return the user's liquidity. Likewise, if LP tokens are pledged to liquidity mining or loan providers, their smart contracts may also malfunction.

3. It is difficult to know the actual value: The specific value of LP tokens is almost impossible to know. If token prices diverge, users will suffer impermanent losses and interest will also be affected. Faced with these uncertainties, it is difficult for users to make wise decisions to exit liquidity positions at the right time.

4. Opportunity risk: Providing tokens for liquidity will have corresponding opportunity costs. Sometimes it may be expedient to invest the token elsewhere or choose another opportunity to utilize it.

Summarize

The next time you want to provide cryptocurrency liquidity to a DeFi protocol liquidity pool, it is worth considering whether you still plan to invest in LP tokens. Depositing into a liquidity pool may be just the first step in a DeFi strategy. Therefore, in addition to long-term holdings, users should carefully consider personal investment planning and their own risk tolerance before deciding whether further investment is suitable.