What Are Liquidity Provider (LP) Tokens – And How Do They Work?

You might have heard the buzzwords ‘’yield farming‘’ or “staking for yield.’’ Indeed, they’re popular terms used in the decentralized finance (DeFi) ecosystem, which birthed the concept of decentralized exchanges (DEXs).

To operate, DEXs such as Uniswap use automated market makers (AMMs). These protocols rely on liquidity providers to contribute their assets into a pool to facilitate transactions. Once you become a liquidity provider, you’re issued liquidity provider (LP) tokens.

What are LP tokens? What role do they play in DeFi? Are they risky?

Read on to find out.

What Are LP Tokens?

Liquidity provider (LP) tokens (at times called liquidity pool tokens) are tokens automatically generated by a DEX and issued to a liquidity provider once they contribute assets to a liquidity pool. These tokens represent one’s share of the fees earned by the liquidity pool.

A simple formula to calculate the value of a liquidity provider token is as shown:

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

LP tokens give you full custody of your locked assets. Most DEXs allow you to withdraw them at any time and redeem the interest earned.

Technically, LP tokens are pretty much the same as other tokens supported by a blockchain network. For example, an LP token issued on Uniswap, which runs on the Ethereum blockchain, is an ERC-20 token. With an ERC-20 token, you can stake, swap or trade Uniswap LP tokens on any Ethereum-based protocol.

Depending on the DeFi platform, LP tokens may be called by different terms, but they usually contain the names of the two crypto trading pairs they represent.

For example, on Balancer, the LP tokens are known as Balancer Pool Tokens (BPT). On SushiSwap, they’re called Sushiswap Liquidity Provider (SLP) tokens. If you’re providing liquidity on SushiSwap for people to swap between ETH and USDC, your LP tokens will be USDC/ETH SLP tokens.

Do LP Tokens Have Value?

LP tokens are essential to the smooth operation of a DEX, and are pivotal to the automated market maker (AMM) used by these platforms.

Without them, it would be difficult to track your contribution to the liquidity pool. LP tokens determine your share of fees generated from the transactions on the pool.

Besides unlocking liquidity on DEXs, LP tokens have other uses. For example, you can use them to participate in initial DEX offerings (IDOs), as collateral for crypto loans or stake them for more rewards through yield farming.

LP Tokens and Automated Market Makers

Source: Crypto Robin

In crypto, token prices are determined through market making. Traditional trading platforms such as centralized exchanges rely on market makers, takers and order books to execute trades. However, control over these platforms remains in the hands of a central authority who may maliciously manipulate prices.

However, DeFi has provided an alternative approach to trading through DEXs that use such AMMs as PancakeSwap and SundaeSwap. The price on an AMM is calculated by smart contracts rather than people controlling the order book.

AMMs use LP tokens to remain noncustodial. By not taking ownership of your LP tokens, they promote transparency and fairness. You own the LP tokens and can use them to trade tokens across the DeFi ecosystem and withdraw liquidity without interference.

How LP Tokens Boost DeFi Liquidity

Liquidity refers to the ability to quickly trade an asset without causing a significant change in its price. Currently, Bitcoin is the most liquid asset in the crypto market since you can trade it on many exchanges without impacting its price.

However, the DeFi space typically has low liquidity since some tokens are available on only one exchange. At times, it’s challenging to find someone who wishes to trade a particular token. Moreover, tokens that are locked through staking in proof of stake (PoS) blockchains such as Solana cannot be used for other purposes, which further removes liquidity from the DeFi ecosystem. The solution to the problem of locked liquidity is to use liquidity pools (or liquidity mining) to facilitate trades.

Through AMMs, LP tokens solve the problem of limited crypto liquidity as they function as proof of ownership of your staked tokens and can be used in numerous ways.

How LP Tokens Work

Once you provide a pair of crypto assets to a liquidity pool, the DEX automatically issues you LP tokens in proportion to the amount you deposited. For example, if you deposit assets worth $100 into a liquidity pool whose value is $1,000, you’ll be issued 10 percent of the LP tokens in that pool.

The amount of LP tokens you own represents your value in that pool and will be used to claim any interest earned from transactions. They’ll reflect on your crypto wallet, and you can freely move them around to different DeFi DApps to maximize your profits. When you withdraw LP tokens, you lose your share of the liquidity pool.

Source: Uniswap

How to Get LP Tokens

You can only acquire LP tokens if you’re a liquidity provider. To become one, you need to lock up your crypto assets on DeFi DApps such as Uniswap, Curve or MakerDAO.

However, centralized exchanges now offer liquidity provision through CeFi. Popular exchanges such as Bybit offer liquidity mining, allowing users to provide liquidity to different pools and earn rewards. In this case, you won’t receive LP tokens since custody lies with the centralized exchange.

What to Do With LP Tokens

The main reason for having liquidity provider tokens is to earn passive income from the fees generated by a liquidity pool. However, you can also use them for different purposes across the DeFi network.

Yield Farming

There are two ways to maximize your profits with yield farming. You can either manually move your tokens across different DeFi protocols, or you can deposit your LP tokens into the liquidity pools of various protocols such as Yearn Finance or Aave, which help you earn compounded interest.

To manually move your tokens, start by depositing a crypto token pair into a liquidity pool on a DeFi protocol, then deposit the LP token you receive in another protocol. You’ll earn twice from your liquidity provider token — as a liquidity provider and by farming yields.

Collateral

You can use LP tokens as collateral to secure a crypto loan. Crypto lending, in which lenders receive interest from borrowers, has become a popular DeFi product.

For example, you can use your LP tokens on Aave as collateral for a loan. You can also use them to borrow DAI, ETH, WBTC and stablecoins such as USDC.

Participating in IDOs

An initial DEX offering (IDO) is a crypto token offering held on a DEX. LP token holders on a particular DEX can participate in the IDO of that DEX to invest in a new cryptocurrency project.

Risks of LP Tokens

As with other crypto assets, owning LP tokens isn’t without risk. Here are some of the common risks associated with LP tokens.

Opportunity Loss

Once you opt to lock your tokens into a crypto liquidity pool, you may miss out on other opportunities in the crypto market. For example, instead of providing liquidity to earn LP tokens, your funds might be better off in more lucrative crypto investments.

Impermanent Loss

Perhaps the most inherent risk of owning LP tokens is impermanent loss. By providing liquidity, you may suffer from inherent loss when the value of the amount you’ve deposited is greater than the value you withdraw upon exiting the pool. Impermanent loss occurs due to price changes over time.

Usually, liquidity pools that contain volatile trading pairs are more prone to impermanent loss. To reduce the risk of impermanent loss, you can opt for stablecoin pairs, which often have a smaller price range.

One of the ways some DeFi protocols cushion LP token holders from impermanent loss is by charging substantial fees for transactions. For example, liquidity providers on Uniswap receive a share of 0.3% fees charged on trades. As such, despite the exposure to impermanent loss, you’re compensated by generous transaction fees.

Smart Contract Failure

Liquidity pools are governed by using smart contracts. When you stake LP tokens into a DeFi protocol, you’re trusting the strength of the network’s smart contract. However, smart contracts can fail, or become compromised.

In the past, smart contracts have been exploited, leading to loss of funds. If your LP tokens are locked in a smart contract that fails, you could lose them and the liquidity that you’ve provided.

That said, most platforms have instituted security measures, such as bug bounties, to keep their smart contracts safe from hackers.

Loss or Theft

Similar to other tokens, you could lose your LP tokens permanently if you can’t access your crypto wallet. Thieves could also gain access to your crypto wallet and steal the tokens.

It’s always wise to keep your private keys safe in a cold wallet (offline wallet).

The Takeaway

LP tokens play a critical role in DeFi. Not only do they help determine your share of the liquidity pool, but they can also be used for yield farming, as collateral and to transfer value. Despite the risks associated with LP tokens, they’re an enticing way to earn passive income from your crypto assets.

All told, the DeFi space is constantly evolving, therefore, use cases for LP tokens are continuously being developed. As an LP token holder, diversifying your portfolio shouldn’t be an afterthought. You can work around your risk tolerance to determine how best to reap maximum returns on your LP tokens.