40. Liquidity Provider Tokens (LPs). What are they, and why are they so important?
Liquidity Provider Tokens, abbreviated as LP Tokens, are tokens that are part of a reward mechanism that facilitates transactions between different types of cryptocurrencies.
Decentralized exchanges rely heavily on liquidity providers to ensure an always-active market for digital assets. Whenever a liquidity provider deposits cryptocurrency into the liquidity pool, it receives Liquidity Provider tokens in return. So we can say that they represent the amount that the liquidity provider deposits into the total liquidity pool.
We also have to admit that LPs have become quite popular in the Web3 trend and ecosystem. Especially when we consider them in the context of decentralized finance (DeFi), which we wrote about here [LINK – WHAT IS DEFI – A STARTING LEVEL).
Today we will focus on liquidity providers and better understand how they function in the overall digital asset system.
Liquidity providers – who are they?
To understand what Liquidity Provider tokens are, we first need to clarify what liquidity providers and AMMs are.
Liquidity providers are investors who provide a certain pool of cryptocurrency assets to the liquidity pool. In return for their activity, they receive rewards.
There are various liquidity pools in the cryptocurrency ecosystem, but the most popular are those on DEX. Liquidity providers earn through trading fees paid by investors to DEX for each transaction. Interestingly, some DEX also reward providers with management tokens for their contribution and participation in the overall liquidity pools. The process we mention here is called liquidity mining.
Automated Market Makers (AMM).
They are used in most DEX to facilitate transactions. AMMs are mainly protocols or algorithms that cut out middlemen and order books from the whole process.
AMMs offer full autonomy and use smart contracts for their operation. Each cryptocurrency pair has its liquidity pool to which anyone can contribute liquidity.
Each liquidity pool is balanced. There are appropriate mathematical equations that prevent drastic price changes in cryptocurrencies.
How do Liquidity Provider tokens work?
Now that you know what liquidity providers do and the importance of AMM in the ecosystem, we can focus on how LP works.
LP tokens have one main role – to increase liquidity in the DeFi ecosystem. Liquidity is the flexibility to convert cryptocurrency assets into other assets without affecting their price.
Liquidity provider tokens are very similar to other tokens. They can be transferred, traded or even staked on other protocols. Therefore, liquidity providers have control over locked assets in liquidity pools.It should be noted that the LP tokens also determine the share of the transaction fees, which represent the remuneration of the liquidity providers.
LP tokens represent the liquidity provider’s share of the liquidity pool. Providers have full control over these tokens. Example: If you add $10 to a liquidity pool of $100, you can expect about 10% of the LP token share of that liquidity pool. In return, you get 10% of the LP tokens, as you own 10% of the total liquidity pool. You can imagine that these tokens are a kind of “credential” for the entire pool.
Liquidity Provider Tokens can be staked to earn more rewards (yeld). These, of course, come in the form of new tokens. LP staking shows that a particular provider is committed to supporting LP tokens. This affects the market price of the tokens in question.
Furthermore, this type of token plays an important role in the Initial DEX Offering (IDO). The Initial DEX Offering is a fundraising model in which a project or start-up raises money by relying on its tokens via DEX. In this model, the LP tokens are locked for new tokens offered by the project.
Yeld Farming and staking Liquidity Provider Tokens
Yeld farming is a strategy for investing one’s cryptocurrency assets, where investors use their assets between different pools of liquidity. All with the aim of maximizing their profit or increasing their return share.
An example of this is Compound, which awards its COMP management token to all its users for lending and borrowing while increasing the level of activity in the ecosystem. In this case, liquidity providers earn from users’ transaction fees.
Another revenue opportunity for liquidity providers is staking. Currently, many platforms allow liquidity providers to stack their LPs. They can then earn even more interest on these tokens. However, when stacking, you need to keep in mind the possibility of losses. This can occur if the value of the assets in the liquidity pool is less than the value stored in the cryptocurrency exchange.
Examples of Liquidity Provider Tokens
- There are several decentralized exchanges in the cryptocurrency ecosystem that are responsible for distributing LP tokens. Let us take a look at two of the biggest:
Uniswap. It is a fully automated liquidity protocol built on the Ethereum blockchain. Every smart contract on the network manages a liquidity pool consisting of reserves of two ERC-20 tokens. With this ecosystem, anyone can become a liquidity provider as long as they deposit the equivalent value of each underlying token in exchange for tokens from the pool.
Curve – is also a fully automated market maker. The Curve liquidity pool allows investors to buy new LP tokens and stake them in exchange for a CRV token. In this way, liquidity providers offer an additional layer of utility and profit for initial investments.
Risks associated with LP tokens
There are two main risks with Liquidity Provider Tokens: unsustainable loss and loss of opportunity. Closing your tokens in liquidity pools can result in other opportunities in the cryptocurrency market being closed to you. Furthermore, liquidity pools rely heavily on smart contracts, so any gap in their case can lead to the loss or theft of your tokens.
Today we have explained how LP tokens work and what distinguishes them. Undoubtedly, their importance in DeFi’s ecosystem will have a significant impact on its development. So, before you get interested in staking or yeld farming your LP tokens, you should carefully study the mechanisms and workings of the DeFi ecosystem.