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Liquidity pool tokens (or liquidity provider tokens) are awarded to users for contributing assets to liquidity pools. They act as a kind of receipt by which the provider can return the deposited funds along with the interest earned.
LP tokens can also be used to earn interest on yield farming, take out crypto loans, or transfer ownership of liquidity in staking. However, it is important to remember that once the LP tokens are transferred to another person, the user will no longer own the corresponding liquidity.
Introduction
While most DeFi users are aware of liquidity pools, LP tokens are not discussed as often. These crypto assets can be used not only to withdraw deposited assets from the liquidity pool, but also for many other purposes. Although alternative uses come with their own risks, they are suitable for some profit-making strategies.
What does providing liquidity mean?
In simple terms, liquidity is the ability to trade an asset freely without causing significant price changes. For example, Bitcoin (BTC) is a highly liquid asset. It can be traded in almost any volume on thousands of exchanges without significantly affecting the price. However, not every token has such a level of liquidity.
The liquidity of decentralized finance (DeFi) and small projects can be quite low, especially if their coin is only available on one exchange. This can make it difficult to find a buyer or seller for a specific order. The liquidity pool model, also known as liquidity mining, helps solve this problem.
The liquidity pool contains two assets available for swap. It does not require market makers, takers or an order book, and the price is determined by the ratio of assets in the pool. Users who contribute a pair of tokens to the pool and provide trading opportunities are called liquidity providers. As a reward, they receive a small commission for each swap using their tokens.
Thus, by offering their assets to the market, providers contribute them to DeFi liquidity pools and receive LP tokens.
Please note that having a liquidity pool with a pair of assets does not guarantee greater liquidity. And yet the pool provides the opportunity to trade freely and not depend on the execution of an order by another user.
How Liquidity Pool (LP) Tokens Work
After depositing a pair of tokens into the liquidity pool, the provider receives LP tokens as a kind of receipt, which reflects its share of assets in staking and allows the deposit to be returned with accrued interest. Therefore, the safety and security of the deposit depends on the safety of the associated LP tokens: their loss will deprive you of access to your share.
LP tokens are held in a wallet that was used to provide liquidity. You may need to provide the smart contract address of a specific LP token for it to be reflected in your crypto wallet. Most LP tokens in the DeFi ecosystem can be moved between wallets, thereby transferring ownership. However, this option is not always available, so you should check this information with the liquidity pool service provider. In some cases, transferring tokens may result in permanent loss of deposited assets.
How to get liquidity pool (LP) tokens
LP tokens are awarded only to liquidity providers. To receive them, the provider must deposit liquidity using a DeFi DApp such as PancakeSwap or Uniswap. The LP token system is used in many blockchains, DeFi platforms, automated market makers (AMMs), and decentralized exchanges (DEXs).
However, in liquidity pools on centralized finance (CeFi) exchanges, LP tokens will most likely not be credited, but will remain in the custody of the custodial service.
The name of the LP token usually indicates the two tokens that have been contributed to the pool. For example, for contributing CAKE and BNB to the PancakeSwap liquidity pool, the provider will receive a BEP-20 token called CAKE-BNB LP. On Ethereum, LP tokens typically use the ERC-20 standard.
How can you use liquidity pool (LP) tokens?
While LP tokens act as a receipt, they can be used for other purposes as well. The DeFi space allows you to use assets across multiple platforms and experiment with strategies.
Transfer of funds
One of the simplest uses of LP tokens is to transfer ownership of assets in a pool. While some LP tokens are tied to specific wallet addresses, most are free to move. For example, one user sends BNB-wBNB LP tokens, and their recipient withdraws BNB and wBNB from the liquidity pool.
However, it is quite difficult to independently calculate the exact number of your tokens in the pool. To determine the number of staked tokens associated with your LP tokens, we recommend using a DeFi calculator.
Collateral when receiving a loan
Since LP tokens provide ownership of an underlying asset, they can be used as collateral. Some platforms accept LP tokens on par with regular tokens such as BNB, ETH or BTC and allow them to be used as collateral to obtain a crypto loan. Typically, LP tokens can be used to borrow money to purchase stablecoins or other high market capitalization assets.
In these cases, the loan must be overcollateralized: if the borrower fails to maintain a certain collateral ratio, the lender will use LP tokens to withdraw the underlying assets and liquidate them.
Generating income
One of the most popular uses of LP tokens is to deposit them into income generating services (yield farms). These services use the LP tokens they receive, earn rewards, and purchase even more tokens. The service then deposits them back into the liquidity pool, allowing you to earn interest.
Although you can do this yourself, yield farms handle the task more efficiently. High transaction fees are shared among users, and asset allocation can be done multiple times per day depending on strategy.
Risks of LP tokens
As with any other token, LP tokens come with certain risks, including:
1. Loss or Theft: In the event of loss of LP tokens, the provider will lose its assets in the liquidity pool along with the interest earned.
2. Smart Contract Failure: If the liquidity pool is compromised due to a smart contract failure, you will not be able to return the deposited assets. Similarly, the smart contracts of yield farms and loan providers to whom LP tokens were transferred may fail.
3. Difficulty in determining value: Just by looking at LP tokens, it is almost impossible to understand exactly how much they are worth. If the price deviates, there is a risk of facing impermanent losses, and interest must also be taken into account when determining income. Such uncertainty makes it difficult to make an informed decision about when to exit a liquidity position.
4. Opportunity Risk: Providing tokens as liquidity is just one investment option. Sometimes it is better to deposit tokens elsewhere or use them for other tasks.
Summary
When depositing crypto assets into a liquidity pool using the DeFi protocol, users usually receive LP tokens, which can not only be traded. Depositing into a liquidity pool may only be the first part of a DeFi strategy. Review your investment strategy and risk tolerance to decide whether continued investing is right for you.