What are liquidity provider (LP) tokens, and how do they work?

LP tokens should always be kept safe like any other crypto asset, as losing them means investors will lose their share of the pool. Still, LP tokens can be freely moved around different decentralized applications (DApps), and only withdrawing from the pool means losing the right to the share of the liquidity pool.

Only liquidity providers can get LP tokens by contributing to the DEX platform liquidity with their crypto assets.

Plenty of DApps can be chosen 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 lock up crypto assets into smart contracts. Traders use that pool to trade their cryptocurrency, even the little-volume tokens.

LP tokens are mainly associated with decentralized platforms because they should preserve the protocol’s safety and decentralization. It’s possible to provide liquidity to a centralized exchange; however, the deposited assets will be kept under the control of the custodial service provider without returning any tokens.

Other than representing a claim of one’s assets, LP tokens can be used across multiple DeFi platforms in ways that can accrue the investment’s value.

How do LP tokens gain value? They gain value as a fundamental component of DeFi, contributing to the smooth operation of the DEXs and AMMs used by these DApps.

One primary source of passive income for liquidity providers is the share of transaction-generated fees earned by the liquidity pool in proportion to their investment share.

There are other use cases and streams of revenue for LP tokens. Here’s an overview of the main ones.

Collateral in a loan

Some cryptocurrency platforms, like Aave, allow liquidity providers to use their LP tokens as collateral to secure a crypto loan. Crypto lending has become a substantial component of DeFi, allowing borrowers to use their crypto as collateral and lenders to earn interest from their borrowers.

LP tokens used as collateral are still an emerging trend, and only a few platforms offer the service. Such a financial tool is highly risky, and if a certain collateral ratio is not kept, borrowers may lose their assets by being liquidated.

Yield farming

Yield farming is the practice of depositing LP tokens in a yield farm or compounder to earn rewards. Investors can move their tokens manually using different protocols and receive LP tokens when they deposit them on another platform.

Alternatively, they can use the liquidity pools of protocols like Aave or Yearn.finance, which help liquidity providers earn compounded interest more efficiently than humans.

Such a system allows users to share expensive transaction fees and use different compound strategies according to the effort and time they want to dedicate to this type of investment. One example of a compound strategy is lending out cryptocurrency on a platform that pays interest, and then reinvesting that interest back into the original cryptocurrency to potentially increase returns. Another example is using an algorithmic trading strategy to automate buying and selling of assets to generate profits that can be reinvested.

LP staking

Liquidity providers can stake their LP tokens to gain extra profit. It occurs when users transfer their LP assets to an LP staking pool in exchange for rewards of new tokens, just like how the bank pays interest on a savings account. It also incentivizes tokenholders to provide liquidity. Early stakers in a project can earn a very high annual percentage yield (APY), which decreases as more LP tokens are staked in the pool.

Where to stake LP tokens

LP tokens function the same way as other tokens supported by a blockchain network. For example, tokens issued on an Ethereum-based platform like Uniswap is an ERC-20 token and can be staked like any other token of the same kind.

Some of the risks associated with holding cryptocurrency apply to LP tokens also. Taking special measures to protect one’s assets should always be a primary security concern.

Loss or theft

Just like with cryptocurrency, LP tokens should be kept safe at all times and preferably stored in a hardware wallet, especially if the owner has a good amount of them. By losing access to a wallet — through a lost or stolen private key — the liquidity provider loses access to their LP tokens, their share of the liquidity pool and any interest gained.

Smart contract failure

When supplying liquidity, a provider locks up their assets in a smart contract, which is always vulnerable to cyberattacks and fails if compromised. Despite massive improvements in the last few years, smart contracts have yet to become secure cryptocurrency tools.

Therefore, choosing DeFi protocols with a strong network’s smart contracts is imperative. If the liquidity pool is compromised due to a smart contract failure, LP tokens can no longer return the liquidity to the owner.

Impermanent loss

One of the most significant risks for LP tokens is impermanent loss, which occurs when the amount of assets deposited by liquidity providers exceeds the value they withdraw upon exiting the pool due to price changes over time. The best way to mitigate such risk is to choose stablecoin pairs when providing liquidity because they move within a smaller price range.

Source: https://cointelegraph.com/explained/what-are-liquidity-provider-lp-tokens-and-how-do-they-work