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What Is Liquidity Provider (LP) Tokens

Jimmy Khan

Aug 04, 2022 17:04

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The phrase "yield farming" didn't exist in 2020. By switching your LP tokens between several DeFi applications, you may now "farm for yield" and optimize your income.

What does it mean to provide liquidity?

The simplest definition of liquidity is the ease with which an asset may be traded without significantly changing price. A highly liquid asset is a cryptocurrency like Bitcoin (BTC), for instance. Without intentionally influencing its price, you may trade it across thousands of exchanges in practically any quantity. Not all tokens, however, are fortunate enough to enjoy this degree of liquidity.


Liquidity might be a problem for smaller projects and decentralized financing (DeFi). For instance, the currency could only be accessible via a single exchange. Finding a buyer or seller who can fulfill your request may prove to be difficult as well. A solution to this issue is the liquidity pool concept, sometimes referred to as liquidity mining.


Users may exchange between two assets in a liquidity pool. The price is established by the ratio of the assets in the pool; market makers, takers, or an order book are not required. Liquidity providers are users who provide a pair of tokens to the pool to make trading possible. Users who trade using their tokens are subject to a minor fee from them.


Therefore, although providing liquidity refers to making your assets available to the market, in the case of LP tokens, we are specifically referring to DeFi liquidity pools.


Be aware that just because an asset pair has a liquidity pool doesn't always suggest that there is substantial liquidity in the market. However, you won't have to depend on someone matching your order since you may always trade utilizing the pool.

Providers of Crypto Liquidity and LP Tokens

Platforms for automated market makers (AMMs), such as Uniswap, Curve, and Balancer, are a key component of the rapidly expanding decentralized finance (DeFi) ecosystem and provide a fresh perspective on trading in general. The liquidity provider (LP) token is a crucial component of automated market maker systems. With the use of LP tokens, AMMs may act in a non-custodial capacity rather than as custodians and instead use automated processes to further decentralization and justice. The whole DeFi ecosystem may now access unprecedented levels of token trading and access thanks to liquidity provider tokens, which has helped growth via major network effects.


AMM platforms must have the non-custodial functionality in order to participate in the decentralized financial ecosystem. On AMM platforms, you keep ownership of your assets by contributing tokens like ether (ETH) to the crypto liquidity pool, which is run entirely by code and not by humans, in exchange for receiving LP tokens. The ownership of LP tokens, which represent a crypto liquidity provider's portion of a pool, stays wholly with the supplier of the crypto liquidity.


For instance, you would get 10% of the LP tokens from a Balancer pool if you contributed $10 USD worth of assets with a total value of $100. Because you possess 10% of the crypto liquidity pool, you are entitled to 10% of the LP tokens. Your claim to your portion of the pool's assets is established by the LP tokens. By possessing these LP tokens, you may withdraw your portion of the pool whenever you want without any restrictions, not even from the Balancer platform. Furthermore, since LP tokens are ERC-20 tokens, they may be staked, traded, and transferred on different protocols.


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What LP Tokens Did to Improve DeFi Liquidity

A crucial idea in the DeFi area is liquidity. The phrase describes how easily one asset may be changed into another without significantly altering the price of the original item. Cash is regarded as the most liquid asset in conventional finance since it can be quickly converted into gold, equities, bonds, and other assets. However, converting money to cryptocurrency is difficult. Since it is accepted and tradeable on almost all centralized exchanges, bitcoin (BTC) is now the most liquid asset in the larger crypto sector. Ether is the most liquid asset in the DeFi ecosystem, which is almost entirely based on the Ethereum network and is accepted and tradeable on every decentralized exchange (DEX).


All assets utilized within the Ethereum ecosystem were unavailable throughout their time of usage until the establishment of liquidity provider tokens. When tokens need to be staked, usually as part of a governance process, they are most often locked up. For instance, ETH will be locked up in the Proof-of-Stake (PoS) mechanism of Ethereum 2.0 in order to verify and add new blocks to Ethereum's blockchain. There is less liquidity in the system when a token is staked in this situation since it cannot be utilized for other purposes. This issue of locked crypto liquidity is resolved by creating readily convertible assets in AMMs in the form of LP tokens, at least inside DeFi.


The same tokens may be used again with liquidity provider tokens, even if they are staked in a platform governance mechanism or invested in a DeFi product. By enabling an indirect kind of staking where you verify you hold tokens instead of staking the tokens directly, LP tokens assist in resolving the issue of constrained crypto liquidity.

Farming Yields using LP Tokens

DeFi is a fast developing field, and the words used to describe it are likewise continuously changing.


Depending on the platform, what this page refers to as LP tokens may go by several names. These tokens are known as balancer pool tokens (BPT) or pool tokens, for instance, on the Balancer protocol.


These tokens are known as either pool tokens or liquidity tokens on Uniswap. They are known as liquidity provider (LP) tokens according to Curve. Despite any differences in language, the definition is the same. LP tokens contain the claim to recovering the assets you contributed to a pool and are mathematical evidence that you did so.


Yield farming is another new DeFi word that wasn't in use in the first half of 2020 but has lately garnered very significant worldwide momentum. Yield farming is the practice of depositing tokens into several DeFi apps in an effort to increase profits. Profits may be enhanced by switching tokens in and out of various protocols.


Although the concepts of yield farming and LP tokens are relatively new, they are starting to be combined. Let's examine the procedures for farming the CRV token on the Curve protocol utilizing DAI to comprehend how this operates:


Add DAI to the Curve cryptocurrency liquidity pool.


Obtain LP tokens


Add the LP tokens you got to the Curve staking pool.


Grab the CRV token.


In this case, Curve's crypto liquidity pool would provide interest and fees on your DAI. At the same time, staking the LP token from the liquidity pool rewards you with CRV tokens. By using LP tokens, your liquidity earns fees and increases agricultural yields.


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

Although LP tokens function quite similarly to a receipt, you may also use them for other things. The ability to utilize your assets on other platforms and stack services like Lego is always available in DeFi.

Use them as a means of wealth transfer

Transferring ownership of LP tokens' related liquidity is perhaps the simplest use case. While certain LP tokens are bound to particular wallet addresses, the majority allow for unfettered token transfers.


You could, for instance, transfer someone BNB-wBNB LP tokens so they may take the BNB and wBNB out of the liquidity pool.


However, it might be challenging to manually determine the precise number of tokens you have in the pool. In this scenario, you may figure out how many staked tokens are connected to your LP tokens using a DeFi calculator.

Use them as loan collateral

Your LP tokens may be used as collateral since they provide ownership of an underlying asset. Some sites let you use your LP tokens as collateral, much as when you give BNB, ETH, or BTC as security for a crypto loan. This will often allow you to borrow money for a stablecoin or other asset with a high market capitalization.


The loan is overcollateralized in certain situations. The lender will use your LP tokens to claim the underlying assets and liquidate them if you are unable to maintain a certain collateral ratio.

Add up their output

Depositing your LP tokens in a yield compounder is one of the most typical things you can do with them (sometimes known as a yield farm). Your LP tokens will be used by these services to routinely harvest rewards and buy more of the token pair. You may then multiply your interest by having the compounder stake these back into the liquidity pool.


Although the procedure may be carried out manually, a yield farm is often able to compound more quickly than human users. Depending on the technique, expensive transaction fees might be split among users and compounding can occur numerous times per day.


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What dangers do LP tokens pose?

There are dangers involved with LP tokens, just as there are with any other token. These consist of:


  1. Loss or theft: If your LP token is lost or stolen, you forfeit your interest-bearing portion of the liquidity pool.


2. Smart contract failure: Your LP tokens will no longer be able to deliver your liquidity to you if the liquidity pool you are utilizing is compromised as a result of a smart contract failure. The smart contracts of yield farms or loan providers may also malfunction if you invest your LP tokens with them.


3. Difficulty in understanding what they stand for: It's quite hard to determine the precise value of your LP tokens just by looking at them. You will also have suffered a temporary loss if token prices have diverged. You should also take your own interests into account. It may be difficult to decide when to leave your liquidity position wisely due to these risks.


4. Opportunity risk: There is a cost connected with offering your tokens as liquidity. In certain circumstances, you could be better suited using your tokens for a different opportunity or investing them somewhere else.

What Bond Do LP Tokens Have With Automated Market Makers?

The usage of LP tokens is integral to how Automated Market Makers (AMM) operate. DeFi platforms must develop a method to guarantee that buyers and sellers can locate one another since they lack a centralized middleman, such as banks. In the DeFi industry, this is referred to as an automated market maker, a pre-programmed algorithm that automatically connects buyers and sellers. As opposed to trading with other buyers or sellers, AMMs let traders deal directly with a pool of assets. As a consequence, trading cryptocurrencies no longer need a mutual demand coincidence since one may trade directly with an AMM's reserves. The problem is that AMMs need a certain quantity of liquidity to work. At this moment, liquidity providers (LPs) and LP tokens come into play. These participants are asked to provide liquidity to the AMM liquidity pool by depositing a certain amount of cryptocurrency (usually Bitcoin or Ethereum). These liquidity providers get a small share of network fees as payment for their help.

What Effect Do LP Tokens Have on DeFi Liquidity?

In the decentralized financial sector, the idea of liquidity is crucial. It's a straightforward method of exchanging one asset for another without altering the value of either, as the name suggests. In traditional finance, cash is the most liquid asset since it can be quickly converted into a wide range of assets, including gold, equities, bonds, and more. It is more difficult than it seems to convert fiat money to cryptocurrency. Since Bitcoin is accepted and traded on practically all major central exchanges, it has become the most liquid cryptocurrency asset. Ether is the most liquid asset in the DeFi ecosystem since it was the first asset and is recognized and traded on every decentralized exchange. Ether once again becomes very liquid since DeFi is based on the Ethereum network, and it is accepted and traded on all DEXs.

What Elements Affect the Value of the LP Token?

The two elements that determine the value of an LP token are the overall value of a liquidity pool and the total number of LP tokens in circulation. The market prices of the pool's crypto assets are added to determine its total value. When fresh deposits are deposited into a pool, new LP tokens are created.


When investors remove their liquidity deposits, LP tokens are no longer in use. Sam will get 10% of the LP tokens in a liquidity pool worth $10,000, for instance, if he invests $1,000 in it. Sam's LP tokens are now worth US$1,500 if the preceding liquidity pool's total value increases to US$15,000 and he has a 10% interest in it. In this respect, owning an LP token is similar to owning shares in a company. In this instance, though, each member of a DeFi pool owns a portion of the liquidity.


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How Are LP Tokens Burned?

Sending LP tokens to the Ethereum genesis address, also known as the burn address, will burn them. The first address to exist on the Ethereum blockchain without private keys, which implies that any coins supplied to it are permanently destroyed.


For Ethereum and other EVM-compatible chains like Avalanche (AVAX), Fantom (FTM), and others, the burn address is as follows:


0x000000000000000000000000000000000000dEaD


Users won't be able to retrieve any tokens sent to this address. Due to the fact that transferring tokens to the burn address causes tens of billions of them to be destroyed, it is the most valuable address on the blockchain. Burning is most often done to reduce a cryptocurrency's supply and raise its value.


Founders sometimes burn LP tokens to demonstrate that they won't withdraw liquidity as soon as they lose control of the LPs.


Notably, there is no method to truly burn or eliminate coins from existence forever since blockchain is an irreversible record. Sending coins to the null address is referred regarded as "burning," when in reality, we are only transferring ownership there. All of the assets in the genesis address would be in the ownership of whomever has recovered the private keys to that address.


Burning LP tokens builds confidence in a project since it is impossible for someone to withdraw funds from an LP they do not possess. Rug-pulling refers to frauds in which the creator of a cryptocurrency withdraws the tokens, causing the price to drop to zero since there is no liquidity.


Because burnt tokens cannot be recovered, burning is a greater level of security than "locking" tokens, which may be done.

Conclusion

LP tokens act as a proof of ownership for liquidity, making them essential to the decentralized financial ecosystem. Cash is the most liquid asset on conventional markets and is used interchangeably with the word "liquidity". In cryptocurrency trading, "liquidity" refers to high-cap currencies like Ethereum, Tether, or other coins since it is difficult to convert ERC-20 tokens to cash. These coins are used to increase the value of both new and old tokens.


Each LP token denotes ownership of two identically valued cryptocurrencies. Users who own LP tokens have complete control over them and are always able to withdraw their liquidity for both sides of the pair. The LP tokens may also be burned by sending them to the genesis address, transferred to another wallet, or both.