What Are Liquidity Pool (LP) Tokens?

Introduction

While many DeFi users are familiar with liquidity pools, LP tokens themselves often don’t receive the same attention. However, these tokens are more than just a way to unlock your liquidity; they have their own unique use cases. While utilizing LP tokens in additional applications carries some risk, there are ways to strategically use these assets to extract even more value from them.

What Does Providing Liquidity Mean?

At its core, liquidity refers to the ease with which an asset can be traded without causing significant price fluctuations. Bitcoin (BTC), for example, is a highly liquid asset. It can be traded across numerous exchanges in large amounts with minimal impact on its price. However, other tokens, particularly those from smaller projects, may not enjoy the same liquidity level.

In decentralized finance (DeFi), liquidity can be a challenge for smaller tokens. Some tokens may only be available on a few exchanges or face difficulty finding matching orders for trades. Liquidity pools (sometimes called liquidity mining) help solve this issue by enabling users to swap between two assets directly within a pool. This model eliminates the need for traditional order books and market makers, with prices determined by the relative quantities of the assets in the pool.

Users who deposit tokens into the pool to facilitate trading are known as liquidity providers. They earn a small fee for each transaction that uses their tokens. Thus, providing liquidity means making your assets available for trading within a DeFi liquidity pool, and LP tokens represent your share of that liquidity.

It’s important to remember that while the existence of a liquidity pool means you can trade an asset pair without finding a matching order, the pool itself may not have substantial liquidity.

How Do Liquidity Pool (LP) Tokens Work?

When you deposit a pair of tokens into a liquidity pool, you receive LP tokens as a "receipt" of your share of the pool. These tokens denote your stake in the pool, allowing you to withdraw your original deposit plus any fees or interest earned. Since holding LP tokens is tied to the security of your deposit, losing them would result in losing your share of the liquidity.

You can find your LP tokens in the wallet you used to provide liquidity. In some cases, you may need to add the LP token's contract address to view it in your crypto wallet. Most LP tokens in DeFi are transferable between wallets, allowing ownership to be transferred. However, always verify with the liquidity provider, as this may vary. In some instances, transferring LP tokens could result in a permanent loss of the provided liquidity.

Where Can I Get Liquidity Pool Tokens?

LP tokens are exclusively granted to liquidity providers who use a DeFi DApp, such as PancakeSwap or Uniswap, to provide liquidity. The LP token system is widely used across DeFi platforms, automated market makers (AMMs), and decentralized exchanges (DEXs). However, if you provide liquidity on a centralized finance (CeFi) platform, you might not receive LP tokens, as they are typically held in custody by the exchange.

Your LP token will usually reflect the two tokens you provided. For instance, providing CAKE and BNB in a PancakeSwap liquidity pool will give you a BEP-20 token called CAKE-BNB LP. On Ethereum, LP tokens typically follow the ERC-20 standard.

What Can I Do with Liquidity Pool (LP) Tokens?

Although LP tokens function as receipts, they offer more possibilities beyond simply holding them. DeFi enables users to leverage assets across multiple platforms, similar to stacking building blocks in Lego.

1. Transfer of Value
   The simplest way to use LP tokens is by transferring ownership of the liquidity they represent. Although some LP tokens are tied to specific wallets, many can be freely transferred. For example, you could send BNB-wBNB LP tokens to another person, who could then remove the underlying BNB and wBNB from the liquidity pool. Calculating your exact token share within a pool can be tricky, so using a DeFi calculator can help determine the value of staked tokens associated with your LP tokens.

   
   

2. Collateral for Loans
   Since LP tokens represent underlying assets, they can serve as collateral. Just like you can use BNB, ETH, or BTC as collateral for a crypto loan, some platforms accept LP tokens as collateral, typically for stablecoins or high-cap assets. These loans are usually overcollateralized, and if your collateral ratio drops below a certain level, the lender can use your LP tokens to claim and liquidate the assets.

   
   

3. Compound Yield
   A popular option for LP tokens is depositing them into a yield compounder or yield farm. These services accept LP tokens, regularly harvest the earned fees, and reinvest in more of the token pair. The compounder then stakes these back in the liquidity pool, allowing you to earn compounded interest. While manual compounding is possible, yield farms typically perform this process more efficiently by sharing transaction fees across users and compounding multiple times per day, depending on the strategy.

What Are the Risks of LP Tokens?

Like any token, LP tokens carry certain risks:

1. Loss or Theft: Losing LP tokens means losing access to your liquidity share and any accrued interest.

   
   

2. Smart Contract Failure: If the smart contract for the liquidity pool fails, you won’t be able to retrieve your liquidity. Similarly, staking LP tokens with a yield farm or loan provider could expose you to the risk of their smart contracts failing.

   
   

   
   

3. Value Uncertainty: It can be challenging to determine the exact value of LP tokens, especially if token prices diverge significantly. This discrepancy results in impermanent loss, and you must also account for interest accrued. These factors make it difficult to decide when to exit a liquidity position.

   
   

4. Opportunity Cost: Using tokens in a liquidity pool comes with an opportunity cost. In some situations, you might earn more by investing in other opportunities instead of providing liquidity.

Closing Thoughts

When you provide crypto liquidity on a DeFi protocol, it’s worth considering whether to put your LP tokens to further use. Depositing tokens into a liquidity pool can be the first step in a broader DeFi strategy. Beyond holding LP tokens, assess your investment goals and risk tolerance to determine if additional opportunities are suitable for you.