Liquidity pool tokens (sometimes known as liquidity provider tokens) are given to users who provide liquidity in liquidity pools. These tokens act as a receipt, allowing you to claim your original stake and interest earned.
You can also use your LP tokens to compound interest in a yield farm, take out crypto loans, or transfer ownership of the staked liquidity. However, it is important to understand that you don't actually own the associated liquidity once you give up custody of your LP tokens.
While most DeFi users know about liquidity pools, LP tokens are often an afterthought. However, these crypto assets have their own use cases apart from unlocking your provided liquidity. So, while there are risks in utilizing your LP tokens in other applications, there are viable strategies for extracting more value from these unique assets.
What does providing liquidity mean?
At its most basic, liquidity is the ability to trade an asset easily without causing significant price changes. A cryptocurrency like Bitcoin (BTC), for example, is a highly liquid asset. You can trade it across thousands of exchanges in almost any amount without actively affecting its price. However, not every token is lucky enough to have this level of liquidity.
When it comes to decentralized finance (DeFi) and smaller projects, liquidity can be low. For example, the coin may only be available on one exchange. You may also find it challenging to find a buyer or seller to match your order. The liquidity pool model (sometimes known as liquidity mining) can be a solution to this problem.
A liquidity pool contains two assets users can swap between. There's no need for market makers, takers, or an order book, and the price is determined by the ratio of the assets in the pool. Users who deposit the pair of tokens into the pool to enable trading are known as liquidity providers. They charge a small fee for users who swap using their tokens.
So while providing liquidity means offering your assets to a market, we are explicitly talking about DeFi liquidity pools in the case of LP tokens.
Note that just because there is a liquidity pool for an asset pair, it doesn't mean there is much liquidity. However, you’ll always be able to trade using the pool and won’t need to rely on someone matching your order
How do liquidity pool (LP) tokens work?
After depositing a pair of tokens in a liquidity pool, you'll receive LP tokens as a "receipt". Your LP tokens denote your share of the pool and allow you to retrieve your deposit, plus any interest gained. Therefore, part of the safety and security of your deposit depends on you holding onto your LP tokens. If you lose them, then you will lose your share.
You'll find your LP tokens in the wallet you used when providing liquidity. You may need to add the LP token’s smart contract address 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 check with the liquidity pool service provider, as this isn't always the case. Transferring the tokens may, in some cases, cause a permanent loss of the liquidity provided.
Where can I get liquidity pool tokens?
LP tokens are only granted to liquidity providers. To receive them, you will need to use a DeFi DApp to provide liquidity, such as 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 liquidity pool services in a centralized finance (CeFi) setting on an exchange, you likely won’t receive LP tokens. These will instead be held in custody by the custodial service provider.
Your LP token will typically have the name of the two tokens you're supplying liquidity in. For example, CAKE and BNB provided in a PancakeSwap liquidity pool will give you a BEP-20 token called CAKE-BNB LP. On Ethereum, LP tokens are usually ERC-20 tokens.
What can I do with liquidity pool (LP) tokens?
While LP tokens act much like a receipt, that's not all you can do with them. In DeFi, there's always the opportunity 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 their associated liquidity. Some LP tokens are tied to specific wallet addresses, but most allow for the free transfer of the tokens. For example, you could send BNB-wBNB LP tokens to someone who could then remove the BNB and wBNB from the liquidity pool.
However, calculating the exact amount of tokens you have in the pool is difficult to do manually. In this case, you can use a DeFi calculator to calculate the amount of staked tokens associated with your LP tokens.
Use them as collateral in a loan
As your LP tokens provide ownership of an underlying asset, there is a good use case for using them as collateral. Like when 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 enable you to borrow for a stablecoin or other large market cap asset.
In these cases, the loan is overcollateralized. If you cannot keep up a certain collateral ratio, the lender will use your LP tokens to claim the underlying assets and liquidate them.
Compound their yield
One of the most common things to do with your LP tokens is to deposit them in a yield compounder (sometimes known as a yield farm). These services will take your LP tokens, regularly harvest the rewards, and purchase more of the token pair. Then, the compounder will stake these back in the liquidity pool, allowing you to compound your interest.
While the process can be done manually, a yield farm can, in most cases, compound more efficiently than human users. Expensive transaction fees can be shared across users, and compounding can be done multiple times a day, depending on the strategy.
What are the risks of LP tokens?
Just like with any other token, there are risks associated with LP tokens. These include:
1. Loss or theft: If you lose your LP token, then you lose your share of the liquidity pool and any interest gained.
2. Smart contract failure: If the liquidity pool you're 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 with a yield farm or loan provider, their smart contracts could also fail.
3. Difficulty in knowing what they represent: When looking at your LP tokens, it's almost impossible to guess exactly what they're worth. If token prices have diverged, you will also have incurred impermanent loss. You also have interest to factor in as well. These uncertainties can make it challenging to make an informed decision about when to exit your liquidity position.
4. Opportunity risk: By providing your tokens as liquidity, there’s an associated opportunity cost. In some cases, you may be better off investing your tokens elsewhere or use them in a different opportunity.
Next time you provide crypto liquidity to a liquidity pool on a DeFi protocol, it's worth considering if you also want to put your LP tokens to use. Depositing into a liquidity pool can be just the first part of a DeFi strategy. So apart from just HODLing, take a look at your investment plans and risk tolerance to decide whether further investment is suitable for you.