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

Liquidity providers deposit assets into a excavation to facilitate trades connected decentralized exchanges (DEXs) and automated marketplace makers (AMMs) and person liquidity excavation tokens (LP) successful return. 

Liquidity pool tokens are besides called liquidity supplier tokens. They enactment arsenic a receipt for the liquidity provider, who volition usage them to assertion their archetypal involvement and involvement earned. These tokens correspond one’s stock of the fees earned by the liquidity pool.

LP tokens person different usage cases too unlocking the provided liquidity. They let the liquidity supplier to entree crypto loans, transportation ownership of the staked liquidity, and tin gain compound involvement successful yield farming. Compound involvement is involvement earned connected the archetypal sum deposited. For example, 10% yearly involvement connected $1,000 is $100, portion the compound involvement successful the 2nd twelvemonth is calculated astatine $1,100, truthful it volition beryllium $110. 

Decentralized exchanges (DEXs) and automated marketplace makers (AMMs) assistance their users afloat custody of their locked assets done LP tokens, and astir let users to retreat them astatine immoderate clip aft redeeming the involvement earned.

From a method standpoint, LP tokens are the aforesaid arsenic different blockchain-based tokens. For example, LP tokens issued connected DEXs that tally connected Ethereum volition beryllium ERC-20 tokens. Other liquidity supplier token examples are the SushiSwap Liquidity Provider (SLP) tokens connected SushiSwap and the Balancer Pool Tokens (BPT) connected Balancer.

In decentralized concern (DeFi), astir tokens person tiny marketplace caps and debased DeFi liquidity with small availability, and uncovering a counterpart to lucifer an bid whitethorn beryllium challenging. This is wherever liquidity providers go essential.

Liquidity makes it useful to bargain oregon merchantability immoderate fixed plus successful a marketplace without impacting terms changes. Highly liquid assets person galore buyers and sellers successful the market, facilitating fast-execution trades astatine a minimal cost. In contrast, low-liquid assets person less buyers and sellers, making it much challenging to execute trades, which tin pb to terms slippage oregon precocious transaction costs.

Liquidity providers deposit 2 token pairs into a liquidity pool. Once deposited, they tin swap betwixt the tokens and complaint a tiny interest for users who swap utilizing their tokens.

Platforms specified arsenic Uniswap, Curve and Balancer are besides called AMMs and are a cardinal constituent of DeFi. They are based connected LP tokens indispensable to let level decentralization and service customers successful a noncustodial way. They bash not clasp connected to users’ tokens, but the automated functions volition alteration them to beryllium just and decentralized. 

For providing assets similar Ether (ETH) to the pool, liquidity providers person LP tokens representing their excavation share, which volition beryllium utilized to assertion immoderate involvement earned from transactions. LP tokens are ever nether the providers’ control, who determine erstwhile and wherever to retreat their excavation share.

Once crypto users determine to put successful LP tokens, they tin take the liquidity excavation and commencement depositing crypto assets to person LP tokens successful return. 

The LP tokens received are successful proportionality to the magnitude of liquidity provided, truthful if a idiosyncratic provides 10% of the liquidity to the pool, they’ll beryllium issued 10% of the LP autochthonal tokens successful that pool. The tokens volition beryllium added to the wallet utilized for liquidity and tin beryllium withdrawn on with involvement earned astatine immoderate time.

Providing liquidity to a centralized level doesn’t make LP tokens since the assets deposited are nether the platform’s custody. On the different hand, DEXs and AMMs usage LP tokens to stay noncustodial.

LP tokens should ever beryllium kept harmless similar immoderate different crypto asset, arsenic losing them means investors volition suffer their stock of the pool. Still, LP tokens tin beryllium freely moved astir antithetic decentralized applications (DApps), and lone withdrawing from the excavation means losing the close to the stock of the liquidity pool.

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

Plenty of DApps tin beryllium chosen to supply liquidity and person LP tokens. From AMMs to DEXs, the LP token strategy is comparatively communal to galore protocols. 

Platforms specified arsenic PancakeSwap, SushiSwap oregon Uniswap connection liquidity pools wherever users fastener up crypto assets into astute contracts. Traders usage that excavation to commercialized their cryptocurrency, adjacent the little-volume tokens.

LP tokens are chiefly associated with decentralized platforms due to the fact that they should sphere the protocol’s information and decentralization. It’s imaginable to supply liquidity to a centralized exchange; however, the deposited assets volition beryllium kept nether the power of the custodial work supplier without returning immoderate tokens.

Other than representing a assertion of one’s assets, LP tokens tin beryllium utilized crossed aggregate DeFi platforms successful ways that tin accrue the investment’s value.

How bash LP tokens summation value? They summation worth arsenic a cardinal constituent of DeFi, contributing to the creaseless cognition of the DEXs and AMMs utilized by these DApps. 

One superior root of passive income for liquidity providers is the stock of transaction-generated fees earned by the liquidity excavation successful proportionality to their concern share.

There are different usage cases and streams of gross for LP tokens. Here’s an overview of the main ones.

Collateral successful a loan

Some cryptocurrency platforms, similar Aave, let liquidity providers to usage their LP tokens arsenic collateral to unafraid a crypto loan. Crypto lending has go a important constituent of DeFi, allowing borrowers to usage their crypto arsenic collateral and lenders to gain involvement from their borrowers. 

LP tokens utilized arsenic collateral are inactive an emerging trend, and lone a fewer platforms connection the service. Such a fiscal instrumentality is highly risky, and if a definite collateral ratio is not kept, borrowers whitethorn suffer their assets by being liquidated.

Yield farming

Yield farming is the signifier of depositing LP tokens successful a output workplace oregon compounder to gain rewards. Investors tin determination their tokens manually utilizing antithetic protocols and person LP tokens erstwhile they deposit them connected different platform. 

Alternatively, they tin usage the liquidity pools of protocols similar Aave oregon Yearn.finance, which assistance liquidity providers gain compounded involvement much efficiently than humans.

Such a strategy allows users to stock costly transaction fees and usage antithetic compound strategies according to the effort and clip they privation to dedicate to this benignant of investment. One illustration of a compound strategy is lending retired cryptocurrency connected a level that pays interest, and past reinvesting that involvement backmost into the archetypal cryptocurrency to perchance summation returns. Another illustration is utilizing an algorithmic trading strategy to automate buying and selling of assets to make profits that tin beryllium reinvested.

LP staking

Liquidity providers tin involvement their LP tokens to summation other profit. It occurs erstwhile users transportation their LP assets to an LP staking excavation successful speech for rewards of caller tokens, conscionable similar however the slope pays involvement connected a savings account. It besides incentivizes tokenholders to supply liquidity. Early stakers successful a task tin gain a precise precocious yearly percent output (APY), which decreases arsenic much LP tokens are staked successful the pool. 

Where to involvement LP tokens 

LP tokens relation the aforesaid mode arsenic different tokens supported by a blockchain network. For example, tokens issued connected an Ethereum-based level similar Uniswap is an ERC-20 token and tin beryllium staked similar immoderate different token of the aforesaid kind. 

Some of the risks associated with holding cryptocurrency use to LP tokens also. Taking peculiar measures to support one’s assets should ever beryllium a superior information concern.

Loss oregon theft 

Just similar with cryptocurrency, LP tokens should beryllium kept harmless astatine each times and preferably stored successful a hardware wallet, particularly if the proprietor has a bully magnitude of them. By losing entree to a wallet — done a mislaid oregon stolen private key — the liquidity supplier loses entree to their LP tokens, their stock of the liquidity excavation and immoderate involvement gained.

Smart declaration failure 

When supplying liquidity, a supplier locks up their assets successful a astute contract, which is ever susceptible to cyberattacks and fails if compromised. Despite monolithic improvements successful the past fewer years, astute contracts person yet to go unafraid cryptocurrency tools. 

Therefore, choosing DeFi protocols with a beardown network’s astute contracts is imperative. If the liquidity excavation is compromised owed to a astute declaration failure, LP tokens tin nary longer instrumentality the liquidity to the owner. 

Impermanent loss

One of the astir important risks for LP tokens is impermanent loss, which occurs erstwhile the magnitude of assets deposited by liquidity providers exceeds the worth they retreat upon exiting the excavation owed to terms changes implicit time. The champion mode to mitigate specified hazard is to take stablecoin pairs erstwhile providing liquidity due to the fact that they determination wrong a smaller terms range.