Understanding Liquidity Provider Tokens | ZebPay

10 May 2023 | ZebPay Trade-Desk

Liquidity provider tokens act as a receipt for the liquidity provider, who will use them to claim their original stake and interest earned. These tokens represent one’s share of the fees earned by the liquidity pool. Apart from unlocking the liquidity that is provided, LP tokens also have other uses. It allows a liquidity provider to access crypto loans, transfer ownership of staked liquidity, and earn a compound interest in agricultural yields. Compound interest is the interest earned on the initial deposit. For example, 10% yearly interest on $5,000 is $500, whereas compound interest is computed at $5,500 in the second year, so it will be $550. 

Customers receive guardianship of their locked assets in the shape of LP tokens by the Automated market makers and DEXs which can be withdrawn at any time after offsetting the interest earned. Essentially, LP tokens are very similar to that of any blockchain based coin. For example, LP tokens issued on Ethereum-based DEXs will be ERC-20 tokens. SushiSwap Liquidity Provider (SLP) tokens on SushiSwap and Balancer Pool Tokens (BPT) on Balancer are two other options.

Liquidity makes it useful to buy or sell assets in a market without affecting price changes. Highly liquid assets have many buyers and sellers in the market, allowing for quick execution of trades at minimal cost. Conversely, illiquid assets have fewer buyers and sellers, making trades more difficult to execute, which can result in falling prices or high transaction costs. Liquidity providers deposit two pairs of tokens in a liquidity pool. After depositing, they can trade between the tokens and charge a small fee to the users who trade their tokens.

There are a lot of Automated Market Makers (AMM) which are also platform examples such as Uniswap, Balancer etc which are the key part of DeFi. These platforms are actually based on the LP coins, which are required to facilitate decentralisation of the forum and serve clients without guardianship. The AMMs don’t actually act as a custodian of the customer’s tokens but this characteristic makes them fair & distributed. To provide assets such as Ether (ETH) to the pool, liquidity providers receive LP tokens representing their share of the pool, which are used to collect interest on transactions. These coins at any point in time remains under the guardianship of the owners who only have the right to decide when and where to withdraw their part from the pool 

LP tokens received are proportional to the amount of liquidity provided. For example if a customer provides 20% of the total liquidity pool, they would be getting 20% of the in house LP coins in that particular pool. The coins are added up to the crypto wallet which provide liquidity and withdrawal at any time along with the earned interest. Providing liquidity to a centralised platform does not generate LP tokens as the deposited assets are in the custody of the platform. On the other hand, DEXs and AMMs use LP tokens to stay out of custodial duty. The Liquidity Provider coins should always be kept in a safe & secure space as losing them means loss of a part in the pool by the investor. Yet they can be transferred freely among various Decentralised applications.

Read more: What is a DEX

To act as a provider of liquidity and to receive LP coins many DApps can be chosen. Starting from WMA to DEX, the LP coin infrastructure is prevalent across various protocols. For example DeFi protocols like SushiSwap, PancakeSwap or Uniswap supply liquidity pools where clients lock crypto in the smart contract.  Traders use this pool to trade their crypto, even small tokens. LP tokens are primarily associated with decentralised platforms due to the need to maintain the security and decentralisation of the protocol. It is also possible to provide liquidity to a centralised exchange. However, the deposited assets remain under the control of the escrow service provider.

These tokens are acquiring value as a key component of DeFi, presenting to the proper working of the DEXs and AMMs utilised by these DApps. It acts as a prime source of passive earning for the liquidity providers as it is the proportion of the fees produced by transactions that the pool makes in proportion to its principal investment share. There are other use cases and revenue streams for LP tokens. Here is an overview of the most important ones.

Collateral for a loan

Various Crypto platforms such as Aave, provide the facility of taking out a loan based on the collateral of their LP tokens. The lending of crypto has become a key part of the DeFi ecosystem, permitting their customers to utilise their crypto as collateral and lenders to make interest from their borrowers. LP tokens used as collateral is still an emerging trend, with few platforms offering the service. Such a financial instrument is very risky and if a certain collateral ratio is not respected, borrowers may lose their assets upon liquidation.

Yield Farming

Yield Farming has been one of the famous ways of earning passive income through crypto. What essentially happens is the deposit of LP tokens into a yield farm or terrain to receive rewards. Investors can manually take out their tokens via different protocols and receive LP coins by depositing them on some other platform. Another way to do this they can utilise the liquidity pools from protocols such as Yearn.finance or Aave, whose role is also facilitation of liquidity providers to generate compound interest more efficiently as compared to humans. 

System like this allows the customers to share costly transaction fees and make use of various compounding strategies given the conditions of how much effort & time they want to invest. An example of a compounding strategy is lending crypto on a platform that pays interest and then reinvesting that interest back into the original crypto to potentially increase returns. Another example is using an algorithmic trading strategy to automate the buying and selling of assets to generate profits that can be reinvested.

Tokens to be staked

Liquidity providers can stake their LP tokens for additional profit. It occurs when users transfer their LP assets into an LP staking pool in exchange for rewards for new tokens, similar to how the bank pays interest on a savings account. There are also incentives for token holders to provide liquidity. Early entrants into a project can earn a very high annualised return (APY), which diminishes as more LP tokens are put into the pool.

Loss or Theft

Like cryptos, LP tokens should be kept safe at all times and preferably stored in a hardware wallet, especially if the owner holds a large amount of them. By losing access to a wallet through a lost or stolen private key, the liquidity provider loses access to LP tokens, its share of the liquidity pool and any interest earned.

Smart Contract Error

By providing liquidity, a provider locks its assets in a smart contract, which is always vulnerable to cyberattacks and fails if compromised. Despite massive improvements in recent years, smart contracts have yet to become secure crypto tools. Therefore, it is imperative to choose DeFi protocols with smart contracts from a strong network. If the liquidity pool is compromised due to a smart contract failure, LP tokens can no longer return liquidity to the owner.

Impermanent Loss

One of the biggest risks for LP tokens is the temporary loss that occurs when the amount of assets deposited by liquidity providers exceeds the value they withdraw when exiting the pool due to price changes over time. The best way to mitigate this risk is to select stablecoin pairs.