What are LP Tokens and How Do They Work?

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If you trade on a Decentralized (DEX) exchange, the words “Liquidity pool” or “Liquidity provider” would not be alien to you. If not, and you are hearing it for the first time, let us break it down for you. Liquidity allows investors to trade their assets. Think of it as the ability to buy and sell an asset. 

The primary source of liquidity on a DEX platform is the liquidity pools. Investors stake or invest their cryptos in a liquidity pool and receive liquidity provider (LP) tokens based on their shares. The LP tokens received consist of one or more cryptocurrencies, and investors believe that these tokens have the potential to increase in value. That is why investors provide liquidity for DEXs. LP tokens and liquidity are tightly knitted with one another and facilitate the existence of DEX platforms. 

While this may sound a little intimidating, trust us, it is more on the fascinating site. If you are wondering how, let us take you on the journey to understand LP tokens in the crypto space and how you can use them.

What Are LP Tokens? 

LP tokens are also known as liquidity pool tokens. It’s an important concept in cryptocurrency and essential for Decentralized Exchanges (DEXs). Platforms like Uniswap or Order Books need LP tokens for their operations. 

If you bring liquidity influx to this pool, you become a liquidity provider, and you’ll receive a liquidity pool token or LP token. These tokens will then act as your receipt to claim your original stake in the pool. 

As per the encyclopedia of PCMag, LP tokens are defined as “(Liquidity Pool or Liquidity Provider token ) Also called “pool tokens” and “liquidity tokens,” an LP token is a crypto token given to users who loan their crypto to a liquidity pool. The LP tokens represent a user’s share of the pool and can always be redeemed for the original tokens. Liquidity pools enable users to easily swap one token for another on a decentralized exchange.”

Decentralized Exchanges (DEXs) generate LP tokens or liquidity pool tokens automatically and issue them to you once you become a liquidity provider. These tokens are proof of what stake you hold in the liquidity pool. A liquidity pool is a pool crowdsourced with cryptocurrencies that enable trades between assets on decentralized exchanges. 

You can also calculate the value of liquidity provider tokens using this formula.

Value of LP Token = Total Value of Liquidity Pool / Circulating Supply of LP Tokens

With LP tokens, you get full custody of your tokens in the liquidity pool. It will earn your interest as well, which you can redeem at any time. 

In essence, LP tokens are similar to tokens you usually trade on the crypto exchange. For example: If an LP token is issued to you on a DEX platform that operates on the Ethereum blockchain, which is an ERC-20 token, you can trade, swap, or stake your DEX token on any Ethereum-based protocol. 

These tokens trace your overall contribution to the liquidity pool and tell about how much you hold concerning the overall liquidity pool. 

How Does Liquidity Providing Tokens Work?

Once you deposit pairs of tokens in a liquidity pool, you’ll receive LPs as the “Receipt” for this transaction. These LPs define the share you hold in the liquidity pools, which you can claim anytime. 

You’ll find these tokens in the same wallet through which you contributed to the liquidity pool. You might also be required to add the smart contract address for your token to see your LP tokens in your wallet. The majority of LP tokens can be transferred to and from the Defi system through your wallet. This action allows you to transfer ownership. However, this isn’t always the case, so check with the DEX platform. Sometimes, transferring the LP tokens without prior knowledge of the procedure can strip you of the owner status permanently. 

Examples of LP Tokens

Typically crypto token prices are determined via market making. However, DEX provides alternatives to trade and utilizes AMMs that allow LP tokens to be traded without permission and via the liquidity pools like Pancake Swap and Sundae Swap. The price on AMM is calculated via smart contracts through a mathematical formula. That is:

K = x * y 

Where,

X and Y: Equal amounts of a liquidity pool’s assets

K: The total or constant amount of pool liquidity

AMMs utilize LP tokens to remain custodial and follow the suit of being permissionless on DEXs. Since full ownership of the crypto is in the hands of the crypto investors on DEXs, AMMs don’t take any ownership of the LP tokens. This helps keep the pricing fair and based on the sentiments of the market. The formula above helps keep the price fair and as per the amount available in the liquidity pool. 

Most DEXs use LP tokens. If you’re trading on Balancer, your LP tokens are called Balanced Pool tokens (BPT). They’re called Sushi Swap Liquidity Provider (SLP) tokens if you’re trading on Sushiswap. If you’re adding liquidity to the pool on Sushiswap for people to trade between USDC and ETH, your LP tokens will be USDC/ETH LP tokens. 

Uses of LP tokens

LP tokens are your receipt for the transaction of adding liquidity on DEX. As such, you can utilize them to perform different functions and earn more profits on the platforms. You can use LP tokens across the different platforms for compounding or as collaterals. Here’s how:

1. Compounding your yield from LP tokens

You can use LP tokens to yield more profits. A preferable way is to earn compound interest on the tokens. You can start by depositing them into a compounder or farm, which are the different liquidity pools across the DeFi blockchain. Compounding increases the value of your LP tokens, and after some time, the LP tokens are staked back into your liquidity pool. This increases your earned interest.

2. Transfer their value

Transferring ownership is another way you can earn profits through your LP tokens. You can transfer them to other traders or investors, but read the terms and conditions before you do so. The specific address of tokens might pose a problem, like high fees in some cases, but in most cases, it’s free. 

For example, you can swap the ETH-USDC token pair with an investor looking to remove the same pair from the liquidity pool. Use an LP token calculator to find the value instead of doing this manually.  

3. As collaterals in your loan

Collaterals for digital loans make it easier for you to get loans without the lengthy process of application submission, documents, or fear of rejection. If you have LP tokens, you’re the winner and can use them as collaterals for your loans on DeFi. 

If you have an ETH or BTC token, you can use it to borrow loans online. However, remember, if you fail to maintain the ratio for the collateral that you put against the value, your loan provider will convert your LP token or liquidate them to compensate for the loss. 

Drawbacks of LP Tokens

Every token carries a risk, and so do LP tokens. These are:

1. Opportunity risk

When you provide your tokens to add liquidity to the liquidity pool, you’ll have an opportunity cost. In some instances, you’ll be earning more profits by investing in other tokens with better returns and more opportunities. However, if you still choose to use them in the liquidity pool, you may have to forego the profits of the opportunities missed. 

2. Theft or permanent loss

If you lose access to your crypto wallet, forget the address, or have weak security for the same, you will lose your LP tokens. A hacker can also get access to your crypto wallet, they can also steal your tokens. This is a vulnerability that accompanies the LP tokens, and you will have to be careful while trading LP tokens. Also, ensure that your password is strong and that you remember it well. 

2. Smart contract failure

Smart contracts are not immune from errors or corrupted files. If that happens, you’ll lose access to your LP tokens, and the loss can be temporary or permanent. When you stake them in a DeFi protocol, you’re putting your trust in the smart contracts. 

In the past, there have been many instances of hackers exploiting smart contracts and stealing funds. In such a case, you can lose the liquidity that you have. But in most cases, your LP tokens are secure through different measures, like bug bounties and such, to keep the smart contracts from being the reason for your loss. 

3. Impermanent loss

This is the most important risk of all. If the dollar value of your investment is greater than the value you withdraw when exiting the pool, you’ll suffer impermanent losses. To reduce this risk, you should go for Stablecoin pairs who often trade in a small price range. This will ensure your loss is minimal. 

Usually, you’ll face more impermanent loss for pairs that trade on a volatile range. 

LP Tokens and Defi Liquidity 

Liquidity is the basic foundation of the Decentralized Finance space. Liquidity means how you can quickly sell or buy assets without causing big waves in the exchange or the tokens’ price. For example, in a traditional market, liquidity refers to the quality of assets that can be converted easily into cash. 

Since the DeFi ecosystem is almost exclusively built on the Ethereum blockchain, ETH is the most liquid asset across any DEX. ETH uses a Proof of Stake (PoS) consensus mechanism that requires staking tokens to create a new chain and stakers get rewarded with new ETH tokens. However, there is an issue with this method. The staked tokens cannot be used anywhere else till the new block is added and validated. It limits the liquidity in the system. 

Liquidity pool tokens have resolved this issue of limited crypto availability and allow investors to use their tokens in multiple ways at the same time. 

Best Place to Buy LP Tokens

The best place to buy LP tokens would be a DeFi platform based on your choice. Make sure you research the platform well before making a decision. You can get LP tokens if you’re a liquidity provider, which is also mandatory. To become a liquidity provider, you will need to lock your assets on a DeFi exchange like Pancake Swap, Uniswap, Curve, and more. 

Your liquidity token has the name of 2 pairs of tokens like ETH-USDC. In the same way, on PancakeSwap, you’ll find CAKE-BNB LP. These pairs supply the liquidity together, and you trade them together as well. 

However, centralized exchanges also provide liquidity through CeFi. Popular exchanges like Bybit offer liquidity mining, which allows you to add liquidity to different liquidity pools and get the LP tokens.

Conclusion

LP tokens play a crucial role in DeFi exchanges. It is also proof of receipt and determines the share of liquidity that you have in the liquidity pool. Despite the risks we’ve discussed with the liquidity pool tokens, they’re a great way to earn passive income. The crypto space is evolving. With that soon, you can anticipate seeing more nuances develop for the LP tokens in the coming times. Till then, wait and watch!

FAQs

1. What is the value of LP tokens?

The value of your LP tokens depends on two things: the invested amount and the value of the pool. For example, if you invest $10 in the liquidity pool having a value of $100, you’ll be a 10% owner of the liquidity pool. The value is represented by the amount you invest and the overall value of the liquidity pool. 

2. Why do automatic market makers use LP tokens?

The primary function of LP tokens is to help AMMs to stay non-custodial. So that investors have control over their tokens and AMMs can maintain the fairness of the decentralized platform. Thus, AMMs use LP tokens.

3. What is the procedure for withdrawing LP tokens?

Most of the DEXs allow you to withdraw your LP tokens from your digital wallet at any time and anywhere. That being said, do check the rules and regulations of your service provider first to find any hidden fees or penalties. 

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