TL;DR
Liquidity pool tokens are given to users who provide liquidity in an exchange’s liquidity pool. This allows you to claim your original stake and interest earned, while also providing a receipt that can be used to move funds within the exchange.
You can also use LP tokens to compound interest in a yield farm, take out crypto loans, or transfer ownership of the staked liquidity. Nonetheless, one important thing to note is that you don't actually own the associated liquidity once you give up custody of your LP tokens.
Introduction
Liquidity pool tokens are important to DeFi as a whole. While the majority of DeFi users have heard of the liquidity pools, LP tokens are often overlooked by those in the community. There are many great use cases for these unique assets, including staking them and even using them to provide liquidity themselves. While there are risks in utilizing your LP tokens in other applications, there are viable strategies for extracting more value from these unique assets.
How do Liquidity Tokens (LP) Tokens Work?
LP tokens are issued to you once you deposit a pair of tokens into the pool. They represent your share of the liquidity pool, and also act as a claim on your deposit, plus any interest gained from it. If you lose your LP tokens, then this means that you will be unable to access your deposit or interest accrued on it.
You can see your LP tokens in your wallet if you used the same one to provide liquidity. You may need to add the LP token's smart contract address to see it in your wallet. You can transfer most LP tokens in the DeFi ecosystem between wallets, thus transfering ownership. However, you should always check with the liquidity pool service provider before transferring tokens. Transferring the tokens may, in some cases, cause a permanent loss of the liquidity provided.
What Does Providing Liquidity Mean?
Liquidity is the ability to easily buy, sell and trade an asset without causing significant price changes. Being able to buy and sell at will makes it easier for you to use your assets when you need them, without affecting their overall value. As an example, an asset like Ethereum is highly liquid. You can buy, sell, or trade it in different exchanges across the world without affecting its price. It is important to note that not every cryptocurrency has this luxury.
When discussing decentralized finance (DeFi) and smaller projects, liquidity is often low. For instance, a coin may only be available on one exchange, or you may find it challenging to find a willing buyer or seller to match your order. Thus, the liquidity pool model is seen as a solution to this problem.
A liquidity pool is a new kind of concept that exists on decentralized exchanges that contains two assets that users can swap between. Unlike an order book, liquidity pools – which require no market makers or traders to make a deal – determine prices based on the ratio of tokens that are deposited in the pool. Users who deposit tokens into the pool are known as liquidity providers and receive a small fee for making swaps possible.
Note that we will be discussing DeFi liquidity pools when it comes to LP tokens.
Where To Get Liquidity Tokens (LP) From?
Liquidity Providers (LP) are the creators of liquidity for decentralized exchanges by providing liquidity to them. To receive LP tokens from a protocol, you will need to provide liquidity by using a DeFi DApp such as PancakeSwap or Uniswap. The LP token system is common to many blockchains, DeFi platforms, automated market makers (AMMs), and decentralized exchanges (DEXs).
You most likely won’t receive LP tokens if you use liquidity pool services on a centralized exchange vs. a decentralized liquidity pool model. Instead, these tokens are stored and managed by the custodial service provider
When providing liquidity for an exchange, your LP tokens will usually have the name of the two tokens your are supplying liquidity in. For instance, providing liquidity for UNI and ETH in a Uniswap liquidity pool will give the user an ERC-20 token called UNI-ETH LP. On BNB Smart Chain, you will receive BEP-20 tokens.
Things You Can Do With LP Tokens
While LP tokens act much like a receipt, that’s not all you can do with them. In DeFi, there’s always the opportunity to use your assets across multiple platforms. This allows for truly liquid and fungible investment opportunities in fractional levels of ownership.
Transfer of Value
The most common use case for LP tokens is when the transfering of ownership of the associated token. Remember to research the token you have sicne some may be tied to specific crypto wallet address, but most allow for teh free transfer of the LP tokens. For example, continuing on our UNI-ETH example, if you wish to transfer ownership of these LP tokens you can send UNI-ETH LP tokens to someone who could then remove the UNI and ETH from the liquidity pool.
Collateral in a Loan
When you take a loan for your crypto assets, you can provide a variety of tokens as collateral. LP tokens are unique in that they represent ownership of an underlying asset, so you can use them as collateral on a platform that accepts them. Some platforms also allow you to borrow for stablecoins and other large market cap assets using LP tokens as collateral.
This a great way to leverage your assets and invest in other assets. Financial smarts 101. Your loan will be overcollateralized. In the event of default or if you cannot keep up a certain collateral ratio, the lender will use your LP tokens to claim the underlying assets and liquidate them.
Compound their Yield
There are many ways to earn returns on your LP tokens. One of the most common ways is by putting them in a Yield Compounder (also known as a yield farm). These services will take your LP tokens, regularly harvest the rewards and purchase more pairs. Then they will stake these back into the liquidity pool, allowing you to compound your interest!
Yield farms can compound more efficiently than human users and the best part is that they do it without costing you a thing! They can often share expensive transaction fees across many users, compounding multiple times a day, depending on the strategy.
What are some Risks with LP Tokens?
Just like any crypto tokens, there are associated risk to owning LP tokens. These include the following:
Loss or Theft:
Losing your LP tokens can result in you losing your share and ultimately losing your origianal tokens along with any interest accrued.
Smart Contract Failure:
If the liquidity pool you're using is compromised due to a smart contract failure, your LP tokens will no longer be able to return your liquidity to you. Similarly, if you stake your LP tokens with a yield farm or loan provider, their smart contracts could also fail.
Impermanet Loss:
Price movements are always uncertain, and when it comes to tokens there's even more uncertainty. When looking at your LP tokens, it's almost impossible to guess exactly what they're worth. If token prices have diverged, you will also have incurred impermanent loss. You also have interest to factor in as well. These uncertainties can make it challenging to make an informed decision about when to exit your liquidity position."
Opportunity Risk:
Providing liquidity is a great way to earn money from your tokens. However, there is an associated opportunity cost. In some cases, you'll be better off investing your tokens elsewhere or using them in a different opportunity.
Final Thoughts
LP tokens are a great way for an investor to leverage their holdings onto other defi projects. LP tokens could be used as collateral or could be staked to gain yield rewards. It is important to always DYOR before making an investment decision.
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