Liquidity Provider (LP) Tokens | A Complete Guide

More people than ever are participating in the world of decentralised finance (DeFi). In contrast to traditional finance, even every day investors can play a big role in developing the blockchain-powered world of DeFi.

One way that they can support the DeFi world is by providing liquidity to decentralised exchanges (DEX). Unlike centralised financial institutions like banks, which can create liquidity rather easily, DeFi protocols don't have a convenient third party to rely on. For that reason, DeFi protocols almost universally incentivise investors who are willing to provide liquidity to the marketplace.

These individuals, also known as liquidity providers (LPs), are incentivised through liquidity provider (LP) tokens. Let's go over exactly what LP tokens are, why they are important, and how someone can use them to earn passive interest on crypto.

Why Liquidity And Liquidity Providers are Important

Liquidity ensures traders can buy or sell a financial asset. Markets with low liquidity are incredibly volatile, making it hard for traders to get large quantities of an asset at their chosen price.

Most centralised exchanges rely on third parties, like big banks or institutional funds, in order to provide additional liquidity to the markets if needed. These parties, known as market makers, create multiple bid-ask orders to ensure there's always at least some counterparty available for any trade.^[1]

In decentralised exchanges (DEXs), ensuring there's ample liquidity is a crucial issue because there's no centralised party that can act as a market maker. For that reason, many DeFi protocols offer generous rewards for anyone willing to play the role of a liquidity provider. Among other benefits, LP tokens are one of these incentives.^[2]

What Are LP Tokens?

LP tokens are a special type of cryptocurrency rewarded to liquidity providers on decentralised exchanges. These LP tokens are a way to represent individual contributions to the overall liquidity pool.^[3]

How Do LP Tokens Work?

When a liquidity provider deposits their cryptocurrency in a pool on a DeFi protocol, they are awarded a certain amount of LP tokens. When a liquidity provider wants to withdraw their deposited crypto, LP tokens are returned back to the DeFi protocol.^[3]

Most DeFi liquidity pools let liquidity providers redeem their cash in their LP tokens whenever they want, although there may be a small fee if they redeem them too early.^[3]

What Determines The Value Of An LP Token?

Two things determine the value of an LP token, the total value of a liquidity pool, as well as the circulating supply of total LP tokens. The total value of the pool is the combined market value of all its crypto assets.^[4]

As for supply, when new deposits enter a pool, new LP tokens are created. When investors pull back their liquidity deposit, their LP tokens are removed from circulation.^[4]

For example, if Hank invests US$1,000 into a liquidity pool that's worth US$10,000, he'll receive 10% of that pool's LP tokens. If the total worth of the previous liquidity pool increases to US$15,000, and Hank has a 10% claim of the liquidity pool, those LP tokens he earned are now worth US$1,500.

In this way, an LP token is similar to owning shares in a company. Except in this case, one owns a share of the liquidity within a DeFi pool.^[5]

How Are LP Tokens Related To Automated Market Makers?

LP tokens are closely related to how automated market makers (AMM) function. Since DeFi platforms lack a centralised middleman, like a big bank, they need a way to ensure there's a way for buyers and sellers to match with each other.

In the DeFi world, this is called an automated market maker, a pre-programmed algorithm that automatically matches buyers and sellers. However, AMMs differ in that they allow traders to trade directly with a pool of assets instead of other buyers or sellers.^[6]

For this reason, one can trade directly with an AMM's reserves, removing the need for a coincidence of mutual demand when trading cryptocurrencies. The problem, however, is that AMMs require sufficient liquidity in order to operate. That's where liquidity providers (LPs) and LP tokens enter the equation.^[6]

These individuals are encouraged to deposit a certain amount of crypto (usually Bitcoin or Ethereum) to be used as liquidity within the AMM liquidity pool. In exchange, these liquidity providers earn a small percent in terms of network fees for their contribution.^[6]

How To Farm Yields With LP Tokens

One way for DeFi investors to earn passive income is through yield farming. While yield farming is mostly associated with depositing normal cryptocurrencies into a liquidity pool, investors have started to yield farming using LP tokens as well.^[3]

Normally, a liquidity provider stakes their crypto into a DeFi protocol and receives a corresponding amount of LP tokens that can be redeemed into crypto. One benefit to liquidity providers is that they earn a small portion of all transaction fees collected by the pool.

However, because these LP tokens can be redeemed for crypto, they can also function as a form of easily convertible liquidity as well. For that reason, many DeFi protocols accept LP tokens as another form of crypto liquidity that they can earn fees on also.^[3]

Example Of Yield Farming With LP Tokens

To use an example, an investor can deposit some Bitcoin into a liquidity pool owned by DeFi protocol Curve. In exchange, said investor receives a corresponding amount of LP tokens. While they're earning transaction fees for staking Bitcoin into Curve's liquidity pool, other investors can also take their newly acquired LP tokens and stake them back into Curve as well. In exchange, they receive another type of crypto, called CRV, which can be bought and sold just like any other cryptocurrency.^[7]

In other words, crypto investors can yield farm the LP tokens they received for depositing another cryptocurrency. Doing so lets crypto investors make more passive income than they would have otherwise, as their initial liquidity is essentially working double-time, earning both fees and farming yields.^[3]

Most DeFi protocols and large decentralised exchanges allow investors to yield farm their LP tokens. This includes Curve, Uniswap, Sushiswap, Pancakeswap, and others.

Risks Of Yield Farming With LP Tokens

Just like any other investment, crypto investing will always involve a degree of risk. While yield farming with LP tokens can significantly increase total returns, it also exposes investors to more potential dangers.

Impermanent Loss

As is the case when someone becomes a liquidity provider, investing LP tokens means there's the risk that the crypto's value falls in the meanwhile. This is called impermanent loss, which is when the crypto deposited in a liquidity pool fluctuates in value compared to when it was first deposited.^[8]

In theory, these losses (or gains) could reverse themselves, and they technically only become realised once someone withdraws the crypto. However, many liquidity providers have watched the value of their crypto disintegrate, hoping that prices will go back up when they never did. This is especially the case for smaller altcoins, many of whom have crashed and never recovered.

Smart Contract Risks

When staking LP tokens for yields, someone is placing their trust in the DeFi protocol and its underlying smart contracts. In the event of a hack or security breach, they could lose all of their LP tokens, and by extension, the initial crypto they put into a liquidity pool.^[9]

Although hacks on centralised exchanges are becoming rarer, smaller decentralised exchanges are still being hacked even to this day. On March 8th, 2021, the DODO DEX experienced a smart contract hack that stole $3.8 million in cryptocurrency.^[10]

Summary

Liquidity provider tokens are a crucial innovation in the wider DeFi ecosystem. They encourage investors to provide much-needed liquidity to decentralised exchanges pools, which enables AMMs to function in the first place.

They also represent new ways in which cryptocurrencies are being developed and used for. Instead of just acting as a form of digital currency, like Bitcoin, LP tokens represent ownership in a liquidity pool that earns transaction fees, similar to owning common stock in a bank that pays out dividends. It's one of many revolutionary ways in which blockchain technology has evolved over the years.