What is an LP token?

LP tokens are a sought-after tool in the decentralized finance market.

While most DeFi users are aware of liquidity pools, LP tokens are not often discussed. These crypto-assets can be used not only to withdraw deposited assets from a liquidity pool, but also for a variety of other tasks.

In order to understand what LP tokens are and how they work, we first need to understand concepts such as liquidity pools and liquidity providers.

Who are liquidity providers?

Liquidity providers are investors who place their cryptocurrency tokens on DEX to receive transaction fees, often referred to as liquidity mining or market making. These transaction fees are often expressed as percentages, and the percentages vary depending on the amount of liquidity available and the number of transactions in the liquidity pool.

Liquidity providers are also called market makers. They always work only with large volumes of assets, as their task is to create and maintain the right level of liquidity.

Market makers play the role of intermediaries between buyers and sellers. They simultaneously support the quotation of the asset both in the direction of sale and in the direction of purchase. As a result, the price of the token moves smoothly and there are no strong price gaps.

A market maker's strategy aims to provide all market participants with the most favorable buy/sell conditions.

Understanding liquidity pools

A liquidity pool is a repository of funds that are needed to conduct exchange transactions on DeFi exchanges. These pools are provided by individual liquidity providers.

In simple terms, a pool is a vault where two tokens, for example, are placed so that exchange customers can then seamlessly exchange between these tokens.

The purpose of liquidity pools is to provide sufficient liquidity for traders within a decentralized ecosystem. Liquidity providers essentially lock their assets into these pools to ensure smooth and uninterrupted trading for all participants. By contributing their funds, liquidity providers help bridge the gap between buyers and sellers, creating a healthy market for various cryptocurrencies and tokens.

What are LP tokens?

Liquidity provider tokens (sometimes called liquidity pool tokens) are tokens that the user receives when they fund the liquidity pool. In other words, an LP token is a confirmation of the user's share in the liquidity pool. The more liquidity the user adds to the pool, the more LP tokens he gets. For example, if the user contributes 20% of the total value of the liquidity pool, he will receive LP tokens representing a 20% ownership share.

A simple formula for calculating the value of a liquidity provider token is as follows:

Total value of the liquidity pool / circulating supply of LP tokens = value of the LP token

One important aspect of LP tokens is that they can be exchanged for the underlying assets held in the liquidity pool. If liquidity providers want to retrieve their assets or exit a position, they can redeem their LPs, effectively converting them back to the original currency they deposited.

Technically, LPs are regular coins: they can be credited directly to a wallet (like Metamask or Trust), stored, transferred to other addresses, and invested in new DeFi applications.

Essentially, they are LP tokens — a digital receipt that the pool owes you a certain amount of money, borrowed for automatic exchange transactions.

How LP tokens work

To understand how LP tokens work we will give a small example. Let's say there is a decentralized exchange called CryptoSwap. CryptoSwap manages a liquidity pool for trading pairs of A and B tokens. Liquidity providers who wish to contribute their assets to the pool can do so by contributing an equal number of A and B tokens.

Let's say you decide to become a liquidity provider on CryptoSwap. You contribute 10 A tokens and 10 B tokens to the liquidity pool. In return, CryptoSwap gives you LP tokens, which represent your ownership stake in the pooled assets.

With your LP tokens in hand, you can participate in trades on CryptoSwap. When other users trade against the liquidity pool, they pay transaction fees. A portion of these fees is distributed proportionally among all liquidity providers based on their ownership shares represented by the LP tokens. So, if a liquidity provider has 20 LP tokens, you will receive a portion of the transaction fees.

Now consider a scenario in which the value of token A increases significantly compared to token B. Because of this price disparity, the value of your LP tokens may be temporarily lower than if you held the underlying assets separately. This phenomenon is known as a non-permanent loss, and it is important to understand that it is temporary and can be offset by commissions earned from trading activity.

At any time you have the option to redeem your LP tokens and take your share of the underlying assets from the liquidity pool. For example, if you choose to redeem your LP tokens, you will receive 10 A tokens and 10 B tokens, effectively regaining direct ownership of the assets you contributed.

It is important to note that this example is simplified for illustrative purposes. In reality, LP tokens operate on different DEX and liquidity pools, each with its own specific mechanisms and parameters. However, the basic principles remain similar: liquidity providers contribute assets, receive LP tokens, earn commissions and are able to exchange their tokens for their share of the underlying assets.

Examples of uses and applications of LP tokens

LP tokens have a wide range of uses and applications in the decentralized finance ecosystem. Let's take a look at some common uses of these coins.

Yield farming and staking. One popular application of LP tokens is yield farming and staking. Yield farming involves providing liquidity to various pools and receiving additional rewards over and above normal trading commissions. Staking LP tokens allows users to participate in various incentive programs and receive additional tokens as rewards.

Providing liquidity for specific tokens. LP tokens allow users to provide liquidity for specific tokens or trading pairs. For example, by depositing USDT (Tether) on DSF.finance, users can receive DSF LP tokens in return. These LP tokens can be used to participate in activities within the DSF.finance ecosystem.

Participation in decentralized financial protocols. Protocols often require users to provide liquidity to certain pools in order to access credit, loans or other financial services. By owning LP tokens, users can unlock various functionality and benefits.

Trading and market making. LPs can also be actively traded on decentralized exchanges. Traders can buy and sell LP tokens to gain access to certain liquidity pools.

Governance and voting rights. On some DeFi platforms, LP token holders can have governance rights. This allows them to participate in the decision-making process for protocol updates, parameter changes, and other important platform management issues.

It is important to note that the functionality of LP tokens can vary depending on the specific platform and protocol. Users should familiarize themselves with the features, risks and benefits of each service.

LP tokens are a great tool to help DeFi-platform users track their investments in the decentralized finance market.