Liquidity pool tokens (sometimes referred to as liquidity provider tokens) are issued to users who provide liquidity in liquidity pools. These tokens act like a receipt, allowing you to claim your original stake and any interest earned.
You can also use your LP tokens to earn interest on a profitable farm, take crypto loans, or transfer ownership of the staked liquidity. However, it is important to understand that you do not own the associated liquidity once you have given up holding your LP tokens.
While most DeFi users are familiar with liquidity pools, LP tokens are often overlooked. However, these crypto assets have their use cases beyond unlocking the liquidity you provided. So, despite the risks of using your LP tokens in other applications, there are viable strategies for getting more value out of these unique assets.
What does providing liquidity mean?
At its core, liquidity is the ability to easily trade an asset without causing large price fluctuations. Cryptocurrency like bitcoin (BTC) for example is a very liquid asset. You can trade it on thousands of exchanges in almost any amount without actively affecting its price. However, not all tokens have this level of liquidity.
Regarding decentralized finance (DeFi) and smaller projects, liquidity can be low. For example, a coin may only be available on an exchange. You may also find it challenging to find the right buyer or seller for your order. The liquidity pool model (sometimes called liquidity mining) can be a solution to this problem.
The liquidity pool contains two assets that users can trade between. There is no need for market makers, takers, or an order book, and the price is determined by the ratio of assets in the pool. Users who contribute a pair of tokens to a pool for trading are called liquidity providers. They charge a small fee to users who trade their tokens.
So while providing liquidity means offering your assets to the market, we are talking about DeFi liquidity pools in the case of LP tokens.
Note that just having a pool of liquidity for a pair of assets does not mean that there is a lot of liquidity. However, you will still be able to trade using the pool and won’t need to rely on someone to match your order.
How do Liquidity Pool (LP) tokens work?
After depositing a couple of tokens into the liquidity pool, you will receive LP tokens as a “receipt”. Your LP tokens represent your share of the pool and allow you to get back your deposit as well as any interest earned. Therefore, part of the safety and security of your deposit depends on the storage of your LP tokens. If you lose them, you will lose your share.
You will find your LP tokens in the wallet you used to provide liquidity. You may need to add the smart contract address of the LP token to see it in your crypto wallet. Most LP tokens in the DeFi ecosystem can be transferred between wallets, thereby transferring ownership. However, you should always contact a liquidity pool provider as this is not always the case. The transfer of tokens may, in some cases, result in an irretrievable loss of the provided liquidity.
Where can I get liquidity pool tokens?
LP tokens are provided only to liquidity providers. To get them, you will need to use a DeFi liquidity DApp like PancakeSwap or Uniswap. The LP token system is common to many blockchains, DeFi platforms, automated market makers (AMMs), and decentralized exchanges (DEXs).
However, if you use the services of centralized finance (CeFi) liquidity pool on an exchange, you are unlikely to receive LP tokens. Instead, they will be stored by the storage provider.
Your LP token will usually be named after the two tokens in which you provide liquidity. For example, CAKE and BNB provided in the PancakeSwap liquidity pool will give you a BEP-20 token called CAKE-BNB LP. In Ethereum, LP tokens are usually ERC-20 tokens.
What can I do with Liquidity Pool (LP) tokens?
While LP tokens act like a receipt, that’s not all you can do with them. In DeFi, there is always the option to use your assets across multiple platforms and stack services like lego.
Use them as a transfer of value
Perhaps the simplest use case for LP tokens is to transfer ownership of the liquidity associated with them. Some LP tokens are tied to specific wallet addresses, but most allow you to transfer tokens for free. For example, you can send BNB-wBNB LP tokens to someone who can then withdraw BNB and wBNB from the liquidity pool.
However, manually calculating the exact number of chips in the pool is difficult. In this case, you can use the DeFi calculator to calculate the number of tokens associated with your LP tokens.
Use them as collateral for a loan
Since your LP tokens provide ownership of the underlying asset, there is a good option for using them as collateral. Just like you provide BNB, ETH, or BTC as collateral for a crypto loan, some platforms allow you to offer your LP tokens as collateral. Typically, this will allow you to borrow a stablecoin or other asset with a large market cap.
In these cases, the amount of the loan is too high. If you cannot maintain a certain collateral ratio, the lender will use your LP tokens to claim and liquidate the underlying assets.
Complete their performance
One of the most common things that can be done with your LP tokens is to put them in a yield mixer (sometimes called a yield farm). These services will accept your LP tokens, receive regular rewards and buy a couple of tokens in the future. The connection will then return them to the cash pool, allowing you to increase the interest.
Although this process can be done manually, in most cases a crop farm can be put together more efficiently than human users. Expensive transaction fees can be shared among users, and capitalization can be made several times a day, depending on the strategy.
What are the risks of LP tokens?
As with any other token, there are risks associated with LP tokens. This includes:
1. Loss or Theft: If you lose your LP token, you will lose your share of the liquidity pool and any interest earned.
2. Smart contract failure: If the liquidity pool you are 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 on a yield farm or loan provider, their smart contracts may also fail.
3. Difficult to understand what they represent: Looking at your LP tokens, it is almost impossible to guess exactly how much they are worth. If the token prices diverge, you will also suffer an irreparable loss. You also have the interest to consider. These uncertainties can make it difficult to make an informed decision about when to exit a liquidity position.
4. Opportunity Risk: Providing your tokens as liquidity has an opportunity cost. In some cases, it may be better to invest your tokens elsewhere or use them in another opportunity.
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