1.
What are LP tokens?
Liquidity providers deposit assets into pools to facilitate trades on decentralized exchanges (DEXs) and automated market makers (AMMs) and receive liquidity pool tokens (LP) in return.
Liquidity pool tokens are also called liquidity provider tokens. They act as receipts for liquidity providers, who will use them to claim their original stake and the interest earned. These tokens represent a share of the fees earned by the liquidity pool.
LP tokens have other uses besides unlocking the liquidity provided. They allow liquidity providers to obtain cryptocurrency loans, transfer ownership of staked liquidity, and can earn compound interest through liquidity mining. Compound interest is the interest earned on the original deposited amount. For example, a 10% annual interest rate on $1,000 is $100, and the compound interest in the second year is $1,100, so $110.
Decentralized exchanges (DEX) and automated market makers (AMMs) grant users full custody of their locked assets through LP tokens, and most allow users to withdraw the earned interests at any time after redeeming them.
From a technical perspective, LP tokens are the same as other blockchain-based tokens. For example, LP tokens issued on a DEX running on Ethereum would be ERC-20 tokens. Other examples of liquidity provider tokens include the SushiSwap Liquidity Provider (SLP) token on SushiSwap and the Balancer Pool Token (BPT) on Balancer.
2.
What is a liquidity provider?
In decentralized finance (DeFi), where most tokens have a small market cap and DeFi liquidity is low and availability is low, finding a counterparty to match your order can be challenging. This is where liquidity providers become crucial.
Liquidity makes it convenient to buy and sell any given asset in the market without affecting price changes. Highly liquid assets have many buyers and sellers in the market, which helps to execute trades quickly with minimal costs. In contrast, low-liquidity assets have fewer buyers and sellers, making it more challenging to execute trades, which can lead to price slippage or higher transaction costs.
Liquidity providers deposit two token pairs into the liquidity pool. Once deposited, they can swap between tokens and charge a small fee to users who use their tokens to make the swap.
Platforms like Uniswap, Curve, and Balancer, also known as AMMs, are fundamental building blocks of DeFi. They are based on LP tokens that are necessary to allow the platforms to be decentralized and serve customers in a non-custodial manner. They do not hold users’ tokens, but automated features will make them fair and decentralized.
In order to supply assets such as Ethereum (ETH) to the pool, liquidity providers receive LP tokens representing their share of the pool, which are used to claim any interest earned from trades. LP tokens remain under the control of the provider at all times, and they decide when and where to withdraw their share of the pool.
3.
How do LP tokens work?
Once a cryptocurrency user decides to invest in LP tokens, they can choose a liquidity pool and start depositing crypto assets to receive LP tokens in return.
The LP tokens received are proportional to the amount of liquidity provided, so if a user provides 10% of the liquidity to a pool, they will receive 10% of the LP native tokens in that pool. The tokens will be added to the wallet used for liquidity and can be withdrawn at any time along with the interest earned.
Providing liquidity to a centralized platform does not generate LP tokens because the deposited assets are custodied by the platform. On the other hand, DEXs and AMMs use LP tokens to maintain non-custodial nature.
LP tokens should always be kept safe like any other crypto asset, because losing them means investors will lose their share in the pool. Nevertheless, LP tokens can still flow freely between different decentralized applications (DApps), and only withdrawing from the pool means losing the right to share in the liquidity pool.
4.
How to get LP tokens?
Only liquidity providers can earn LP tokens by contributing liquidity to the DEX platform through their crypto assets.
There are a large number of DApps to choose from to provide liquidity and receive LP tokens. From AMMs to DEXs, the LP token system is relatively common to many protocols.
Platforms such as PancakeSwap, SushiSwap or Uniswap offer liquidity pools where users can lock crypto assets into smart contracts. Traders use the pool to trade their cryptocurrencies, even tokens with small trading volumes.
LP tokens are primarily relevant to decentralized platforms, as they are supposed to maintain the security and decentralization of the protocol. Liquidity can be provided to centralized exchanges; however, the deposited assets will be held by the custodian provider, and no tokens will be returned.
5.
What are the use cases for LP tokens?
In addition to representing a claim on one’s assets, LP tokens can be used across multiple DeFi platforms, increasing the value of the investment.
How do LP tokens gain value? They gain value as a fundamental building block of DeFi, helping in the smooth operation of the DEXs and AMMs used by these DApps.
A major source of passive income for liquidity providers is the proportion of fees generated by transactions earned by the liquidity pool to their investment share.
There are other use cases and revenue streams for LP tokens. Here is an overview of the main ones.
Collateral in a loan
Some cryptocurrency platforms, such as Aave, allow liquidity providers to use their LP tokens as collateral to obtain crypto loans. Crypto lending has become an important part of DeFi, allowing borrowers to use their crypto as collateral while lenders earn interest from borrowers.
The use of LP tokens as collateral is still an emerging trend, with only a few platforms offering this service. This financial instrument is riskier, and if a certain collateral ratio is not maintained, borrowers may lose their assets due to liquidation.
Liquidity Mining
Liquidity mining refers to the practice of depositing LP tokens into a liquidity farm or compounder to earn rewards. Investors can manually transfer their tokens using different protocols and receive LP tokens when they deposit them into another platform.
Alternatively, they can use liquidity pools from protocols like Aave or Yearn.finance, which help liquidity providers earn compound interest more efficiently than humans.
Such a system allows users to share expensive transaction fees and use different compounding strategies depending on the effort and time they want to put into such investments. An example of a compounding strategy is lending cryptocurrencies on a platform that pays interest, and then reinvesting the interest back into the original cryptocurrencies to potentially increase returns. Another example is using algorithmic trading strategies to automatically buy and sell assets to generate reinvestable profits.
LP Staking
Liquidity providers can stake their LP tokens for additional profit. This happens when users transfer their LP assets to the LP staking pool in exchange for new token rewards, just like a bank pays interest on a savings account. It also incentivizes token holders to provide liquidity. Early stakers of a project can earn very high annual percentage yields (APYs), which decline as more LP tokens are staked into the pool.
Where to stake LP tokens
LP tokens function the same as other tokens supported by a blockchain network. For example, tokens issued on Ethereum-based platforms like Uniswap are ERC-20 tokens that can be staked like any other token of their kind.
6.
Are there risks with LP tokens?
Some of the risks associated with holding cryptocurrency also apply to LP tokens. Taking special measures to protect your assets should always be a top security concern.
Lost or Stolen
Just like cryptocurrencies, LP tokens should always be kept safe, preferably stored in a hardware wallet, especially if the owner holds a large number of LP tokens. By losing access to the wallet through a lost or stolen private key, the liquidity provider will lose access to their LP tokens, their share of the liquidity pool, and any interest earned.
Smart contract failure
When providing liquidity, providers lock their assets in a smart contract, which is always vulnerable to cyber attacks and will fail if compromised. Despite huge advances in the past few years, smart contracts have not yet become a secure cryptocurrency tool.
Therefore, it is imperative to choose a DeFi protocol with strong network smart contracts. If the liquidity pool is compromised due to a smart contract failure, the LP tokens will no longer be able to return liquidity to the owner.
Impermanent loss
One of the most significant risks of LP tokens is impermanent loss, which occurs when the amount of assets deposited by liquidity providers exceeds the value they withdraw when exiting the pool due to price changes over time. The best way to mitigate this type of risk is to choose stablecoin pairs when providing liquidity, as they have a smaller price volatility range.