What is a Liquidity Pool (LP) token?
Liquidity Pool Tokens (sometimes referred to as "Liquidity Provider Tokens") are paid to users who provide liquidity to the liquidity pool. These tokens are used as receipts to redeem the pledge with interest.
LP tokens can also be used to earn compound interest in liquidity mining, obtain cryptocurrency loans, or transfer ownership of pledged liquidity. However, it is important to understand that only by giving up custody of the LP tokens held can truly obtain the corresponding liquidity.
Most decentralized finance (DeFi) users understand liquidity pools, but they don’t know much about LP tokens. In addition to unlocking the liquidity provided by users, these crypto assets also have their own use cases. Therefore, while there are risks in using LP tokens in other applications, there are various viable strategies to extract more value from these unique assets.
What does it mean to provide liquidity?
Essentially, liquidity refers to the ability to easily trade an asset without causing significant price changes. Cryptocurrencies like Bitcoin (BTC) are among the most liquid assets. Any amount of Bitcoin can be easily traded on thousands of exchanges without price impact. However, not all tokens are fortunate to have this level of liquidity.
Decentralized finance (DeFi) and smaller projects have low liquidity. For example, a certain token is only available on a single platform. Or, it can be difficult to find a buyer or seller that matches the order. The liquidity pool model (or "liquidity mining") is the solution to this problem.
The liquidity pool contains two kinds of assets that users can exchange with each other. There is no need for market makers, takers, or order books, and prices are determined by the ratio of assets in the pool. Users who deposit token pairs into the pool to facilitate transactions are called "liquidity providers". Liquidity providers charge a small fee to users who borrow their tokens to complete an exchange.
Therefore, providing liquidity means providing personal assets to the market, but in the case of LP tokens, we are actually talking about Decentralized Finance (DeFi) liquidity pools.
Please note that just because there are asset trading pairs in the liquidity pool does not mean sufficient liquidity. However, this way you can always use the pool to trade without relying on others to match orders. How do Liquidity Pool (LP) tokens work?
After depositing the token pair into the liquidity pool, users will receive LP tokens as a "receipt". The LP token represents the user's share in the pool, and also represents the voucher for redeeming the deposited tokens and receiving profits. Therefore, the LP tokens held can provide security for personal deposits to a certain extent. If the LP token is lost, the invested share will be lost.
When providing liquidity, LP tokens are stored in wallets used by users. To view LP tokens in a personal cryptocurrency wallet, you need to add a smart contract for LP tokens. Most LP tokens in the DeFi ecosystem can be transferred between wallets to transfer ownership. But sometimes there are exceptions, so please be sure to check with the liquidity pool service provider. In some cases, transferring tokens can result in a permanent loss of the provided liquidity.
Where to get liquidity pool tokens?
LP tokens can only be allocated to liquidity providers. Use DeFi DApps such as PancakeSwap or Uniswap to provide liquidity to earn LP tokens. LP token systems are common across various blockchains, DeFi platforms, Automated Market Makers (AMMs) and Decentralized Exchanges (DEXs).
However, if the liquidity pool service is used in the centralized finance (CeFi) setting of the trading platform, it may not be possible to obtain LP tokens. LP tokens are escrowed by custodial service providers.
LP tokens are usually named after two tokens that provide liquidity. For example, if CAKE and BNB are provided in the PancakeSwap liquidity pool, the BEP-20 tokens obtained by users are called "CAKE-BNB LP" tokens. LP tokens in Ethereum are called "ERC-20 tokens".
What are Liquidity Pool (LP) tokens used for?
While the LP token acts like a receipt, the utility is much more than that. In the field of decentralized finance (DeFi), personal assets can be used across multiple platforms, just like stacking Lego blocks to enjoy multiple services at the same time.
For value transfer
Probably the most basic use case for LP tokens is to transfer ownership associated with liquidity. Some LP tokens are tied to specific wallet addresses, but most are free to transfer tokens. For example, BNB-wBNB LP tokens can be sent to users who can remove BNB and wBNB from the liquidity pool.
However, it is difficult to manually calculate the exact number of tokens in the pool. In this case, using the DeFi calculator, you can calculate the number of pledged tokens related to the LP tokens held by the user.
Used as loan collateral
LP tokens provide ownership of the underlying asset, and as collateral would be a desirable use case. Similar to the situation in which BNB, ETH or BTC are offered as collateral for taking out a cryptocurrency loan, some platforms also allow offering LP tokens as collateral. Generally speaking, users can borrow stablecoins or other assets with high market capitalization by staking LP tokens.
This is an over-collateralized loan. If a specific collateral ratio cannot be maintained, the lender can use the borrower's LP tokens to claim and force the liquidation of the underlying asset.
Return on investment
The most common use of LP tokens is to deposit income compounders (also known as "liquidity mining"). These services utilize LP tokens to periodically harvest rewards and purchase additional token pairs. The compounder then pledges these token pairs back to the liquidity pool, allowing users to earn compound interest.
This process can be operated manually, but in most cases, liquidity mining is more effective for reinvestment than manual operation by users. Depending on the strategy, users can share expensive transaction fees with each other and reinvest multiple times a day.
What are the risks of LP tokens?
Similar to other tokens, LP tokens also have risks, including:
Lost or stolen: If the LP token is lost, the share of the liquidity pool and various interests earned will be lost.
Smart contract failure: If the current liquidity pool is damaged due to a smart contract failure, LP tokens will not be able to return the user's liquidity. Likewise, if LP tokens are pledged to liquidity mining or lending providers, their smart contracts may also malfunction.
It is difficult to know the actual value: The specific value of LP tokens is almost impossible to know. If the token price diverges, users will suffer impermanent losses, and interest will also be affected. Faced with these uncertainties, it is difficult for users to make an informed decision to exit liquidity positions in a timely manner.
Opportunity risk: There will be corresponding opportunity costs when tokens are provided for liquidity. Sometimes it may be expedient to invest the coin elsewhere, or to take advantage of it at other times.
Summarize
The next time you want to provide cryptocurrency liquidity to the DeFi protocol liquidity pool, it is worth considering whether you plan to invest in LP tokens. Depositing into a liquidity pool may only be the first step in a DeFi strategy. Therefore, in addition to long-term holdings, users should carefully consider their personal investment plans and their own risk tolerance before deciding whether they are suitable for further investment.
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