LP tokens – receipts of liquidity providers

How LP tokens can be used

Of course, if these tokens had only one receipt-like function, we could suppose that they wouldn’t be such a hot topic for discussions today. Apart from the role we’ve already described, they have some other use cases.

LP tokens can be used for transferring ownership

Though some liquidity pool tokens are tied to one wallet address, most can be transferred from one wallet to another without any restrictions. It means that you can send your LP tokens to someone when you need to move some value to this person. Though it can be challenging to manually calculate the exact value of your stake, you always have access to the relevant information provided by the DEX to get the data in real time.

Liquidity pool tokens can function as collateral 

As you already know, tokens of this type demonstrate your ownership rights for staked assets. And given this fact, you can use them as collateral in a loan. You may have already used crypto coins like BTC or ETH as collateral. Some platforms can accept LP tokens for this role. Nevertheless, when you use LP tokens as collateral, it doesn’t mean that a lender won’t have access to your assets if you fail to keep up the asset-collateral ratio. If it happens, the lender can claim your underlying assets from the pool and liquidate them.

You can deposit LP tokens in a yield farm

By depositing your liquidity pool tokens in a yield farm (also known as a compounder), you will be able to get a higher interest. When a yield farm takes your LP tokens, it will harvest rewards regularly and buy more tokens. And then, these tokens will be staked back in the pool. 

Some investors prefer to execute the same process manually without working with a yield farm. However, yield compounding that is automated with some special software tools is much more efficient and can bring better profits.

Pitfalls that you should be aware of

Regardless of all the benefits you can enjoy when you provide liquidity to a pool and get LP tokens for that, there are some pitfalls you should bear in mind when you hold such tokens and want to get the interest. These risks and issues we will enumerate below can be referred to any class of digital assets available today. Nevertheless, it will be essential to highlight them now in the context of liquidity pool tokens.

• Risks of hack or theft. Unfortunately, we have to mention this risk regardless of the crypto asset type we are talking about. And if you lose your LP tokens, you won’t be able to prove your ownership rights for your share in the pool. 
• Challenges in defining the exact value that they represent. As we’ve already written above, after receiving these tokens, it can be practically hard to manually calculate what they are worth at each particular moment, and their value fluctuates. Of course, you have good chances to gain fees, but the risk of impermanent loss also exists.
• Failure of a smart contract. If the liquidity pool fails, you won’t have the opportunity to get your crypto assets back. The same problems are also possible if a yield farm’s smart contract failure takes place.

Closing word

We hope that you understand the concept of LP tokens better and how you can use them to gain interest. As with any other financial investment, your activities related to liquidity pool tokens can be associated with some direct and indirect risks. That’s why please be attentive and analyze the ongoing market conditions before making any decisions.