What Are Liquidity Provider Tokens, and How Do They Work?

Decentralized finance ( DeFi) has changed the way people access financial services. Now users have direct ownership of their assets at all times.

Unlike traditional finance which requires intermediaries, DeFi uses blockchain technology to ensure transparency and auditability of all activities. However, DeFi platforms such as the Decentralized Exchange (DEX) can’t function effectively without the liquidity pool.

The liquidity pool facilitates trading, by allowing users to contribute their assets to the pool, and in turn, earn a liquidity provider token (LP token) as a reward.

But what are LP tokens, and what are they used for? Are there any risks associated with them?

What Are Liquidity Provider Tokens, and How Do They Work?
What Are Liquidity Provider Tokens, and How Do They Work? Image by Freepik

What Are LP Tokens?

You could think of LP tokens as some form of receipt issued to a liquidity provider for contributing funds to a liquidity pool on a DEX. They represent a share of ownership in a specific liquidity pool, making the contributors entitled to earning trading fees.

Liquidity providers tokens aren’t mere tokens, they function as other cryptos. That means they can be traded and staked on DeFi protocols. Examples of LP tokens include the UNI token on Uniswap and CAKE on Pancakeswap.

When you hold a liquidity provider token, you have control over your locked asset. You can always redeem it whenever you want, without any form of interference. But if you redeem it too soon, some DeFi protocols may charge you a penalty fee.

Moreover, your share of LP tokens is measured by the quantity of funds you have contributed to the liquidity pool. Let’s say you deposit $10 into a $100 pool, your share will be 10% of the liquidity pool’s value. This is calculated by dividing your deposit by the total value and then multiplying by 100.

In this case, (10/100)*100 = 10%.

What Is a Liquidity Provider?

Let’s briefly talk about the concept of liquidity in trading, before heading over to the liquidity provider.

Imagine you’re selling a piece of old furniture at a garage sale. You can sell quickly at a good price if lots of people want to buy it. But if there aren’t many buyers, it might take longer to sell, and you might eventually sell at a low price. So liquidity refers to the ease at which an asset is traded or converted into another asset without causing its price to change significantly.

In the financial market, market markers play a crucial role in ensuring that buyers and sellers are available at all times.

But what is a market maker?

These are financial institutions like the Centralized Exchange (CEX). They facilitate trading by providing liquidity. This brings buyers and sellers in one place, making it easier to find trading partners quickly.

However, on the Dex, There is no intermediary to control the trading process, just smart contracts and users. The Dex uses a combination of an automated market marker(AMM) algorithm and a liquidity pool to ensure trading happens. This is where liquidity providers come into play.

Liquidity providers are individuals or entities that contribute their crypto assets to a liquidity pool to enable traders to swap their assets for another directly on the blockchain. While the AMM automatically adjusts the prices of assets based on changing supply and demand within the pool.

How Do Liquidity Provider Tokens Work?

When you contribute equal-value tokens, assuming $1000 worth of DAI and $1000 worth of ETH to a DAI/ETH pool, you will receive LP tokens proportional to these amounts. These tokens are basically IOUs representing your share of the pool. So whenever traders swap DAI for ETH or vice versa, they are charged a trading fee. A portion of this fee will be paid to you for providing liquidity to the pool.

LP tokens are stored in your wallet as a record of your participation, you can’t directly send or trade them like other cryptos. Moreover, you can only interact with a liquidity pool and your LP token through your wallet. For instance, you can use your wallet to add more liquidity, withdraw liquidity, or check your LP token balance.

Furthermore, DEXs don’t keep in the custody of users’ funds. They use the liquidity provider token to remain noncustodial. Users can trade directly from their wallets, giving them control over their funds and reducing the risk of hacks or misuse by the exchange.

Uses of Liquidity Provider Token

Governance Participation

In some DeFi protocols, like Uniswap. LP token holders are given the voting right, and can also participate in the governance of the platform. This allows them to vote on proposals, and also have a say on any changes made to the protocol’s parameters or other decisions that can impact the direction of the project.

Collateral for Borrowing

Since LP tokens prove that you own a share of a liquidity pool, you can use them as collateral to borrow other cryptos on a lending platform like Avea.

However, this loan is usually overcollateralized, and you could lose your LP token if you fail to maintain the collateral ratio of the lending platform.

This ensures that the lender is protected from potential losses if the collateral declines in value.

Yield Farming

Yield farming provides users the opportunity to compound their yield when they deposit their crypto assets on a DeFi protocol. You could take advantage of this method. There are two ways to compound your interest in a yield farm.

Either you move your token manually across the different platforms or you could rely on a compounder service like Yearn Finance.  These services help you to maximize your returns by reinvesting your earnings without the need for manual interventions.

Risk of Liquidity Provider Token

Impermanent Loss

Impermanent loss is the most notable risk associated with LP tokens.  It occurs when your share of the asset in the liquidity pool is less than what you had in your wallet before providing liquidity. This happens due to price changes.

One way to mitigate this risk is to choose a stablecoin pair when providing liquidity. They are less prone to price swings, so the potential of impermanent loss will be lower. Additionally, some protocols charge a reasonable amount of trading fees to help shield LPs from the effect of impermanent loss.

Loss or Theft

Just as you would keep your other tokens safe, the same thing applies to LP tokens. I recommend using a hardware wallet if you are holding a substantial amount.

If you lose access to your wallet’s private key, you won’t be able to remove your liquidity or access any reward generated by the pool.

Smart Contract Failure

Smart contracts are codes that run on the blockchain. Sometimes, they can be vulnerable to attack. So before providing liquidity or depositing your LP on any protocol you have to trust the network’s smart contract. Because any failure would lead to the loss of your funds locked in the liquidity pool.

Final Thoughts

LP tokens offer DeFi users the opportunity to earn rewards on their locked assets. You can decide to hold or stake them on DeFi protocols to gain additional interest.

But, you have to be aware of the risk involved, such as the ones mentioned earlier. It is crucial to balance risk with potential rewards while ensuring you’re comfortable with the level of risk you are taking.

Personal Note From MEXC Team

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Ubong Tom

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