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What Are Liquidity Pool (LP) Tokens?

What Are Liquidity Pool (LP) Tokens?


TL;DR

Liquidity pool tokens (generally referred to as liquidity supplier tokens) are given to customers who present liquidity in liquidity swimming pools. These tokens act as a receipt, permitting you to assert your authentic stake and curiosity earned.

You may also use your LP tokens to compound curiosity in a yield farm, take out crypto loans, or switch possession of the staked liquidity. However, it is very important perceive that you do not truly personal the related liquidity when you quit custody of your LP tokens.

Introduction

While most DeFi customers learn about liquidity swimming pools, LP tokens are sometimes an afterthought. However, these crypto belongings have their very own use circumstances other than unlocking your supplied liquidity. So, whereas there are dangers in using your LP tokens in different functions, there are viable methods for extracting extra worth from these distinctive belongings.

What does offering liquidity imply?

At its most simple, liquidity is the power to commerce an asset simply with out inflicting vital value modifications. A cryptocurrency like Bitcoin (BTC), for instance, is a extremely liquid asset. You can commerce it throughout 1000’s of exchanges in nearly any quantity with out actively affecting its value. However, not each token is fortunate sufficient to have this stage of liquidity.

When it involves decentralized finance (DeFi) and smaller initiatives, liquidity will be low. For instance, the coin might solely be obtainable on one change. You might also discover it difficult to discover a purchaser or vendor to match your order. The liquidity pool mannequin (generally referred to as liquidity mining) could be a resolution to this drawback.

A liquidity pool accommodates two belongings customers can swap between. There’s no want for market makers, takers, or an order book, and the worth is set by the ratio of the belongings within the pool. Users who deposit the pair of tokens into the pool to allow buying and selling are referred to as liquidity suppliers. They cost a small charge for customers who swap utilizing their tokens.

So whereas offering liquidity means providing your belongings to a market, we’re explicitly speaking about DeFi liquidity swimming pools within the case of LP tokens.

Note that simply because there’s a liquidity pool for an asset pair, it doesn’t suggest there may be a lot liquidity. However, you’ll all the time have the ability to commerce utilizing the pool and gained’t have to depend on somebody matching your order

How do liquidity pool (LP) tokens work?

After depositing a pair of tokens in a liquidity pool, you will obtain LP tokens as a “receipt”. Your LP tokens denote your share of the pool and let you retrieve your deposit, plus any curiosity gained. Therefore, a part of the protection and safety of your deposit relies on you holding onto your LP tokens. If you lose them, then you’ll lose your share.

You’ll discover your LP tokens within the pockets you used when offering liquidity. You might have so as to add the LP token’s smart contract handle to see it in your crypto wallet. Most LP tokens within the DeFi ecosystem will be transferred between wallets, thereby transferring possession. However, you need to all the time test with the liquidity pool service supplier, as this is not all the time the case. Transferring the tokens might, in some circumstances, trigger a everlasting lack of the liquidity supplied.

Where can I get liquidity pool tokens?

LP tokens are solely granted to liquidity suppliers. To obtain them, you have to to make use of a DeFi DApp to offer liquidity, reminiscent of PancakeSwap or Uniswap. The LP token system is widespread to many blockchains, DeFi platforms, automated market makers (AMMs), and decentralized exchanges (DEXs). 

However, if you happen to use liquidity pool providers in a centralized finance (CeFi) setting on an change, you possible gained’t obtain LP tokens. These will as a substitute be held in custody by the custodial service supplier.

Your LP token will sometimes have the identify of the 2 tokens you are supplying liquidity in. For instance, CAKE and BNB supplied in a PancakeSwap liquidity pool will provide you with a BEP-20 token referred to as CAKE-BNB LP. On Ethereum, LP tokens are normally ERC-20 tokens.

What can I do with liquidity pool (LP) tokens?

While LP tokens act very similar to a receipt, that is not all you are able to do with them. In DeFi, there’s all the time the chance to make use of your belongings throughout a number of platforms and stack providers like lego.

Use them as a switch of worth

Perhaps the only use case for LP tokens is to switch possession of their related liquidity. Some LP tokens are tied to particular pockets addresses, however most enable for the free switch of the tokens. For instance, you may ship BNB-wBNB LP tokens to somebody who may then take away the BNB and wBNB from the liquidity pool.

However, calculating the precise quantity of tokens you might have within the pool is tough to do manually. In this case, you should use a DeFi calculator to calculate the quantity of staked tokens related along with your LP tokens.

Use them as collateral in a mortgage

As your LP tokens present possession of an underlying asset, there’s a good use case for utilizing them as collateral. Like once you present BNB, ETH, or BTC as collateral for a crypto loan, some platforms let you provide your LP tokens as collateral. Typically, this can allow you to borrow for a stablecoin or different giant market cap asset.

In these circumstances, the mortgage is overcollateralized. If you can not sustain a sure collateral ratio, the lender will use your LP tokens to assert the underlying belongings and liquidate them.

Compound their yield

One of the most typical issues to do along with your LP tokens is to deposit them in a yield compounder (generally referred to as a yield farm). These providers will take your LP tokens, commonly harvest the rewards, and buy extra of the token pair. Then, the compounder will stake these again within the liquidity pool, permitting you to compound your curiosity.

While the method will be finished manually, a yield farm can, most often, compound extra effectively than human customers. Expensive transaction fees will be shared throughout customers, and compounding will be finished a number of instances a day, relying on the technique.

What are the dangers of LP tokens?

Just like with every other token, there are risks related to LP tokens. These embody:

1. Loss or theft: If you lose your LP token, then you definately lose your share of the liquidity pool and any curiosity gained.

2. Smart contract failure: If the liquidity pool you are utilizing is compromised as a result of a wise contract failure, your LP tokens will not have the ability to return your liquidity to you. Similarly, if you happen to stake your LP tokens with a yield farm or mortgage supplier, their sensible contracts may additionally fail.

3. Difficulty in figuring out what they characterize: When your LP tokens, it is nearly not possible to guess precisely what they’re value. If token costs have diverged, additionally, you will have incurred impermanent loss. You even have curiosity to think about as properly. These uncertainties could make it difficult to make an knowledgeable determination about when to exit your liquidity place.

4. Opportunity threat: By offering your tokens as liquidity, there’s an related alternative value. In some circumstances, you might be higher off investing your tokens elsewhere or use them in a unique alternative.

Closing ideas

Next time you present crypto liquidity to a liquidity pool on a DeFi protocol, it is value contemplating if you happen to additionally need to put your LP tokens to make use of. Depositing right into a liquidity pool will be simply the primary a part of a DeFi technique. So other than simply HODLing, check out your funding plans and threat tolerance to determine whether or not additional funding is appropriate for you.



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