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November 2, 2022

What are Liquidity Provider (LP) Tokens?

Liquidity provider tokens are issued to liquidity providers on a decentralised exchange (DEX) that runs on an automated market maker (AMM) protocol.

What are Liquidity Provider (LP) Tokens?

Introduction

The entire DeFi arena is growing incredibly fast and the services available are a great way to earn some passive income on your crypto assets. In this article, we will take a look into what exactly liquidity provider (LP) tokens are and how they can be used.

Let’s get started.

Brief Introduction to AMM DEXs

Automated market maker (AMM) DEXs have been around since Uniswap was launched in 2018 and are designed to solve the low liquidity problem found in order book DEXs.

To prevent low liquidity on AMM DEXs, they use liquidity pools instead of matching buy orders with sell orders (as order book DEXs do).

What are Liquidity Provider (LP) Tokens

Liquidity provider tokens are issued to liquidity providers on a decentralised exchange (DEX) that runs on an automated market maker (AMM) protocol.

When a user provides their tokens to a liquidity pool, they receive LP tokens in exchange.

A decentralised exchange doesn’t hold any information about you, it only knows the wallet address where the liquidity came from, so the LP tokens act as a receipt. In this way, the DEX knows where to send the tokens if and when they are removed from the pool by the liquidity provider.

What is the Benefit of Providing Liquidity to a Pool?

For every transaction performed on an AMM DEX, a small percentage of the fee is taken as a liquidity provider fee. This percentage is paid to all liquidity providers of that pool in a pro-rata amount determined by the amount of LP tokens they hold.

As mentioned above, holding the LP tokens allows the DEX to know which wallet and how much to send to the liquidity provider.

How do LP Tokens Work?

If a user provides 1000 of token A and 1000 of token B to a pool (each pool is made up of a single trading pair), they will receive the corresponding amount of token C (this would be the LP token).

The user then receives the pro-rata LP fee. When the user wants to remove their liquidity from the pool the DEX sends tokens A and B back to the user’s wallet in exchange for token C, the LP token, which is then burned.

This burning ensures that the total number of LP tokens only ever represents the actual liquidity help in the pool.

“To prevent low liquidity on AMM DEXs, they use liquidity pools instead of matching buy orders with sell orders”

What are LP Tokens used for?

In addition to the use mentioned above (proof of liquidity provided), LP tokens can also be used in yield farming, which we will go into more detail on in another post, but for now, we’ll go over it in brief.

Yield Farming with LP Tokens

While the liquidity provider fee is a passive income source for the provider, it doesn’t pay huge amounts (unless you deposit a huge amount into a heavily traded pool…because you own a larger percentage of the LP tokens associated with the pool).

However, because the LP tokens can be easily redeemed for the crypto of the pool they came from, and thus have intrinsic value, many DeFi protocols have started allowing users to yield farm using their LP tokens.

In effect, the initial liquidity provided to the pool is working twice as hard earning the provider more passive income.

Risks of Providing Liquidity and Yield Farming LP Tokens

Providing liquidity does have some inherent risks that need to be factored in if you decide to go for it.

Impermanent (Divergence) Loss

Impermanent loss occurs when the price of the tokens provided in the pool initially changes, this means that it is both unavoidable and we can’t predict to what extent it will occur (hence the greater risk).

Let’s say for example that you deposited your liquidity in the ratio of 1 token A to 100 token B (1:100) and let’s say that the price of each token when you deposited them was; token A = $100 and token B = $1, you’d deposit 1 token A and 100 token B.

If the price of token A goes up to $1000, suddenly the ratio of the two assets has to change. This is because traders looking for an arbitrage will flood the pool with lots of token B and remove the corresponding amount of token A. In effect they are buying token A for $100, which they can then sell on other exchanges for its new price of $1000).

So the ratio changes and your initial liquidity is worth less. However, it is called impermanent loss because the loss is only realised if you remove your liquidity.

If you never remove your liquidity or the price of both assets changes back to where it was initially, the effects will be reversed.

Smart Contract Risks

When yield farming with your LP tokens, you are placing your trust in the DeFi protocol and its underlying smart contracts. In the event of a hack or security breach, you could lose all of your LP tokens, and by extension, the initial crypto you put into a liquidity pool.

Final Thoughts

Providing liquidity (and farming the LP tokens) is a great way to earn passive income on your crypto assets but as with any financial decision you make, you must do your own research, especially into the platform you are using.

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