TL;DR

Liquidity pool tokens (also known as LP tokens or Liquidity Provider Tokens) are offered to users who provide liquidity in liquidity pools. These tokens act as a receipt, allowing the user to redeem the original staking amount and the interest earned.

You can also use your LP tokens to capitalize on yield farming interest, make cryptocurrency loans, or transfer your liquidity from staked assets. However, it is important to understand that once you give up custody of your LP tokens, you will have no ownership over the liquidity associated with them.

Introduction

While most DeFi users are aware of liquidity pools, LP tokens are generally an afterthought. However, these cryptoassets have their own use cases beyond unlocking their provided liquidity. Therefore, although there are risks in using your LP tokens in other applications, there are viable strategies to extract more value from these assets.

What does it mean to provide liquidity?

Basically, liquidity is the ability to trade an asset easily without causing significant changes in price. A cryptocurrency like Bitcoin (BTC), for example, is an asset with high liquidity. You can trade virtually any amount of Bitcoin on thousands of exchanges without causing significant changes to its price. However, not every token benefits from this level of liquidity.

When it comes to decentralized finance (DeFi) and smaller projects, liquidity can be low. For example, the currency may be available on only one exchange. Additionally, it can be difficult to find a buyer or seller that matches your order. The liquidity pool model (also known as liquidity mining) can be a solution to this problem.

A liquidity pool contains two assets that can be swapped by users. There is no need for market makers, market takers or an order book and the price is determined by the proportion of assets in the pool. Users who deposit the token pair into the pool and enable trades are known as liquidity providers. They charge a small fee to users who swap using their tokens.

So while providing liquidity means offering your assets to a market, we are explicitly talking about DeFi liquidity pools in the case of LP tokens.

Note that the existence of a liquidity pool for an asset pair does not mean that there is a lot of liquidity. However, you will always be able to place trades using the pool and will not need to rely on someone matching your order

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 represent your share of the pool and allow you to recover your deposit, along with any interest amount earned. Therefore, part of the security of your deposit depends on you holding your LP tokens. If you lose them, you will lose your holdings value.

You find your LP tokens in the wallet you used to provide liquidity. You may need to add the LP token's smart contract address to view it in your crypto wallet. In most cases, LP tokens in the DeFi ecosystem can be transferred between wallets, consequently transferring ownership of them. However, you should always check with your liquidity pool service provider as this is not always the case. The transfer of tokens may, in some cases, cause a permanent loss of the liquidity provided.

Where can I get liquidity pool tokens?

LP tokens are only awarded to liquidity providers. To receive them, you must use a DeFi DApp to provide liquidity, such as PancakeSwap or Uniswap. The LP token system is common across many blockchains, DeFi platforms, Automated Market Makers (AMMs), and decentralized exchanges (DEXs).

However, if you use liquidity pool services on an exchange with a centralized finance (CeFi) setup, you will likely not receive LP tokens. Instead, LP tokens will be held in custody by the custodial service provider.

Your LP token will typically be named after the two tokens chosen to provide liquidity. For example, when you provide CAKE and BNB to the PancakeSwap liquidity pool, you will have a  BEP-20 token called the CAKE-BNB LP token. On Ethereum, LP tokens are generally ERC-20 tokens.

What can I do with liquidity pool (LP) tokens?

Although LP tokens act as a receipt, that is not their only function. In the DeFi sector, you always have the opportunity to use your assets on various platforms and services.

Use for transferring values

Perhaps the simplest use case for LP tokens is the transfer of ownership of their associated liquidity. Some LP tokens are tied to specific wallet addresses, but most allow free transfer of tokens. For example, you could send BNB-wBNB LP tokens to someone who could then remove the BNB and wBNB from the liquidity pool.

However, it is difficult to manually calculate the exact amount of tokens you have in the pool. In this case, you can use a DeFi calculator to calculate the number of staked tokens associated with your LP tokens.

Use as collateral for loans

Because your LP tokens provide ownership of an underlying asset, they are a good option for use as collateral. In the same way that you provide BNB, ETH, or BTC as collateral for a crypto loan, some platforms allow you to offer your LP tokens as collateral. Typically, this allows you to borrow against stablecoins or other assets with a high market capitalization value.

In these cases, we say that the loan is overcollateralized. If you are unable to maintain a certain proportion of collateral, the lender will use your LP tokens to claim the underlying assets and liquidate them.

Yield Farming

One of the most common uses of LP tokens is to deposit them on yield platforms (also known as yield farming). These services use your LP tokens to collect rewards regularly and purchase more amounts of the token pair. Then, the platform adds these tokens back to the stake in the liquidity pool, allowing you to earn with compound interest.

Although the process can be done manually, a yield farming platform, in most cases, offers a more efficient service for compounding yields. High transaction fees can be shared between users and compounding can be done multiple times a day depending on the strategy.

What are the risks associated with LP tokens?

As with any other token, there are risks associated with LP tokens. Including:

1. Loss or Theft: If you lose your LP token, you will lose your liquidity pool holdings and any interest amount earned.

2. Smart contract failure: If the liquidity pool you are using is compromised due to a smart contract failure, your LP tokens will not be able to give you back your liquidity. Likewise, if you stake your LP tokens with a yield farming or lending provider, the smart contracts may also fail.

3. Difficult to Accurately Value: It is practically impossible to estimate the exact value of LP tokens. If there is divergence between token prices, you will experience impermanent losses. Interest must also be considered. These uncertainties can complicate the decision-making process regarding maintaining or exiting your liquidity position.

4. Opportunity Risk: When providing your tokens as liquidity, there is an associated opportunity risk. In some cases, you may be better off investing your tokens elsewhere or using them in a different opportunity.

Final considerations

Next time you provide crypto liquidity to a liquidity pool on a DeFi protocol, it's worth considering whether you also want to use your LP tokens. Depositing into a liquidity pool may just be the first part of a DeFi strategy. So don't just consider HODLing. Evaluate your investment plans and your risk tolerance to decide if additional investment is right for you.