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

    09 May 2023

    What are LP tokens?

    Liquidity providers deposit assets into a pool 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 a receipt for the liquidity provider, who will use them to claim their original stake and interest earned. These tokens represent one’s share of the fees earned by the liquidity pool.

    LP tokens have other use cases besides unlocking the provided liquidity. They allow the liquidity provider to access crypto loans, transfer ownership of the staked liquidity, and can earn compound interest in yield farming. Compound interest is interest earned on the original sum deposited. For example, 10% annual interest on $1,000 is $100, while the compound interest in the second year is calculated at $1,100, so it will be $110.

    Decentralized exchanges (DEXs) and automated market makers (AMMs) grant their users full custody of their locked assets through LP tokens, and most allow users to withdraw them at any time after redeeming the interest earned.

    From a technical standpoint, LP tokens are the same as other blockchain-based tokens. For example, LP tokens issued on DEXs that run on Ethereum will be ERC-20 tokens. Other liquidity provider token examples are the SushiSwap Liquidity Provider (SLP) tokens on SushiSwap and the Balancer Pool Tokens (BPT) on Balancer.

    What are liquidity providers?

    In decentralized finance (DeFi), most tokens have small market caps and low DeFi liquidity with little availability, and finding a counterpart to match an order may be challenging. This is where liquidity providers become essential.

    Liquidity makes it handy to buy or sell any given asset in a market without impacting price changes. Highly liquid assets have many buyers and sellers in the market, facilitating fast-execution trades at a minimal cost. In contrast, low-liquid assets have fewer buyers and sellers, making it more challenging to execute trades, which can lead to price slippage or high transaction costs.

    Liquidity providers deposit two token pairs into a liquidity pool. Once deposited, they can swap between the tokens and charge a small fee for users who swap using their tokens.

    Platforms such as Uniswap, Curve and Balancer are also called AMMs and are a fundamental component of DeFi. They are based on LP tokens necessary to allow platform decentralization and serve customers in a noncustodial way. They do not hold on to users’ tokens, but the automated functions will enable them to be fair and decentralized.

    For providing assets like Ether (ETH) to the pool, liquidity providers receive LP tokens representing their pool share, which will be used to claim any interest earned from transactions. LP tokens are always under the providers’ control, who decide when and where to withdraw their pool share.

    How do LP tokens work?

    Once crypto users decide to invest in LP tokens, they can choose the liquidity pool and start depositing crypto assets to receive LP tokens in return. 

    The LP tokens received are in proportion to the amount of liquidity provided, so if a user provides 10% of the liquidity to the pool, they’ll be issued 10% of the LP native tokens in that pool. The tokens will be added to the wallet used for liquidity and can be withdrawn along with interest earned at any time.

    Providing liquidity to a centralized platform doesn’t generate LP tokens since the assets deposited are under the platform’s custody. On the other hand, DEXs and AMMs use LP tokens to remain noncustodial.

    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.

    How to get LP tokens?

    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.

    What are the use cases of LP 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.

    Are LP tokens risky?

    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

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