LP tokens – receipts of liquidity providers

LP tokens

Today practically all DeFi market participants have heard about liquidity pools which are digital collections of funds locked in smart contracts. However, the term liquidity pool tokens (sometimes referred to as liquidity provider tokens) may still need clarification regarding their role. This article looks closely at this class of tokens and their position in the market.

LP Tokens : General Info

If you ask us to explain the working principle of LP tokens as simply as possible, we will say that they work like “receipts”. When you buy something at a store, you get a receipt that proves that you’ve made a purchase. Something like that happens in liquidity pools. When you deposit tokens in a pool, you gain LP tokens as proof of your deposit.

Learn more about the mechanism behind liquidity pools here. And here, you will find details about the Automated Market Maker idea.

In other words, LP tokens are crypto coins generated by a DEX that liquidity providers get after loaning their digital assets to a pool. Sushi, PancakeSwap, and Uniswap are among the most well-known DEXs distributing LP tokens.

See also  Uniswap Market Maker

As a rule, such tokens are sent to the same wallet that you’ve used for providing liquidity. Sometimes, to see liquidity pool tokens in your cryptocurrency wallet, you will have to add the smart contract address of the LP tokens to it.

LP tokens are usually the same type as those staked in the pools. For example, Sushi and Uniswap are Ethereum-based platforms, and users who choose their pools for staking will receive ERC-20 LP tokens. 

The amount of LP tokens received corresponds to your share in the pool. It means that in the future, based on your LP tokens, you can retrieve your share that will represent your deposit minus impermanent loss and your gains. These gains include the percentage of the fees taken for all trades on the platform. The size of these fees and, consequently, your income can vary following the rules approved by each pool. For example, Sushi offers a 0.25% fee on all trades proportional to your share. Liquidity providers on Uniswap can profit from a 0.30% fee proportionate to their contribution. 

If you lose your LP tokens, your share in the pool will be lost. Only when you hold your liquidity pool tokens can you be sure that your deposit is securely stored and you can reclaim your share. The situation is similar to traditional receipts.

Usually, users are allowed to transfer LP tokens from one wallet to another, which means moving ownership rights. But some liquidity providers have other rules, and the transfer of LP tokens can lead to the loss of the provided liquidity. That’s why before making any decisions about transferring such tokens, it is highly recommended to check the rules of the chosen pool very attentively.

Learn the details on how we do market making for crypto projects

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.

Learn the details of our role as a liquidity provider for crypto projects