Liquidity pools are often used for trading purposes. However, the subject of LP tokens (liquidity provider tokens) issued to liquidity providers is often less understood.
Yet, LP tokens are an extremely important concept to grasp in order to properly navigate the world of decentralized finance and to understand all the opportunities but also all the risks it contains.
LP tokens definitions
In fact, LP tokens or liquidity provider tokens are tokens issued in exchange for liquidity provided in a liquidity pool, serving as proof of deposit.
They will be used to retrieve your assets when you want to exit the liquidity pool and recover your investment and the rewards generated by them as well.
As explained above, LP tokens are issued to the liquidity provider in exchange for the liquidity. This means that in order to obtain them you will have to use a Dapp (decentralized application) and deposit liquidity into one of their pools.
These LP tokens will usually carry the standard of the blockchain on which you are providing liquidity e.g. if you are providing liquidity on Pancakeswap (NBB Chain DEX), you will inherit LP tokens carrying the BEP 20 standard (NBB Chain standard).
If you use a DEX based on Ethereum, you will probably inherit LP tokens with the ERC20 token standard.
Be careful, acting in the DeFi, your LP tokens are your responsibility. Without them you will not be able to recover your liquidity.
Why are liquidity providers important?
Liquidity allows traders to buy or sell a financial asset. Markets with low liquidity are incredibly volatile and it is difficult for traders to obtain large quantities of an asset at their chosen price.
Most centralized exchanges rely on third parties, such as large banks or institutional funds, to provide additional liquidity to the markets if needed. These parties, known as market makers, create multiple buy and sell orders to ensure that there is always at least one counterparty available for any trade.
Why are these LP tokens important?
There are two elements that determine the value of an LP token, the total value of a liquidity pool, as well as the outstanding supply of total LP tokens. The total value of the pool is the combined market value of all its crypto assets.
On the supply side, when new deposits enter a pool, new LP tokens are created. When investors withdraw their liquidity deposits, their LP tokens are removed from circulation.
One way DeFi investors can earn passive income is through yield farming. While yield farming is mainly associated with depositing normal cryptocurrencies in a liquidity pool, investors have started to do yield farming using LP Tokens as well.
Normally, a liquidity provider places its cryptocurrencies in a DeFi protocol and receives a corresponding amount of LP Tokens that can be exchanged for cryptocurrencies. An advantage for liquidity providers is that they earn a small portion of any transaction fees collected by the pool.
However, because these LP tokens can be exchanged for crypto-currencies, they can also function as an easily convertible form of liquidity. For this reason, many DeFi protocols accept LP tokens as another form of crypto liquidity on which they can also collect commissions.
You know what there is to know about LP tokens and the opportunities they represent.
Keep in mind that your LPs are your responsibility, so it’s important that you understand all aspects of them. Nevertheless, these aspects will allow you to exploit their full potential and thus make your capital grow thanks to them.