Have you heard of yield farming or staking, two terms that are frequently used in the cryptocurrency world? Decentralized exchanges and these services are supported by several protocols in the Defi ecosystem. What are the benefits and risks of LP tokens and how does it work? Let’s learn more about the LP token now.
Understanding LP Tokens?
Liquidity provider tokens or LP tokens are tokens issued to liquidity providers on a decentralized exchange (DEX) that runs on an automated market maker (AMM) protocol. Uniswap, Sushi, and PancakeSwap are some examples of popular DEXs that distribute LP tokens to their liquidity providers. These tokens represent one’s share of the fees earned by the liquidity pool.
A simple formula to calculate the value of a liquidity provider token is as shown:
Total Value of Liquidity Pool / Circulating Supply of LP Tokens = Value of LP Token
Technically, LP tokens are pretty much the same as other tokens supported by a blockchain network. For example, an LP token issued on Uniswap, which runs on the Ethereum blockchain, is an ERC-20 token. With an ERC-20 token, you can stake, swap or trade Uniswap LP tokens on any Ethereum-based protocol.
Depending on the Defi platform, LP tokens may be called by different terms, but they usually contain the names of the two crypto trading pairs they represent.
For example, on Balancer, the LP tokens are known as Balancer Pool Tokens (BPT). On SushiSwap, they’re called SushiSwap Liquidity Provider (SLP) tokens. If you’re providing liquidity on SushiSwap for people to swap between ETH and USDC, your LP tokens will be USDC/ETH SLP tokens.
LP tokens are essential to the smooth operation of a DEX and are pivotal to the automated market maker (AMM) used by these platforms.
Without them, tracking your contribution to the liquidity pool would be difficult. LP tokens determine your share of fees generated from the transactions on the pool.
Besides unlocking liquidity on DEXs, LP tokens have other uses. For example, you can use them to participate in initial DEX offerings (IDOs), as collateral for crypto loans, or stake them for more rewards through yield farming.
What to Do With LP Tokens
The main reason for having liquidity provider tokens is to earn passive income from the fees generated by a liquidity pool. However, you can also use them for different purposes across the Defi network.
Yield Farming
There are two ways to maximize your profits with yield farming. You can either manually move your tokens across different Defi protocols, or you can deposit your LP tokens into the liquidity pools of various protocols such as Yearn Finance or Aave, which help you earn compounded interest.
To manually move your tokens, start by depositing a crypto token pair into a liquidity pool on a Defi protocol, then deposit the LP token you receive in another protocol. You’ll earn twice from your liquidity provider token — as a liquidity provider and by farming yields.
Collateral
As your LP tokens provide ownership of an underlying asset, there is a good use case for using them as collateral. Like when you provide BNB, ETH, or BTC as collateral for a crypto loan, some platforms allow you to offer your LP tokens as collateral. Typically, this will enable you to borrow for a stablecoin or other large market cap asset. In these cases, the loan is over collateralized. If you cannot keep up a certain collateral ratio, the lender will use your LP tokens to claim the underlying assets and liquidate them.
Participating in IDOs
An initial DEX offering (IDO) is a crypto token offering held on a DEX. LP token holders on a particular DEX can participate in the IDO of that DEX to invest in a new cryptocurrency project.
Risks of LP Tokens
The risk of owning LP tokens is similar to that of other crypto assets. Here are a few of the typical risks related to LP tokens:
Loss or Theft
Similar to other tokens, you could lose your LP tokens permanently if you can’t access your crypto wallet. Thieves could also gain access to your crypto wallet and steal the tokens.
It’s always wise to keep your private keys safe in a cold wallet (offline wallet).
Opportunity Loss
Once you opt to lock your tokens into a crypto liquidity pool, you may miss out on other opportunities in the crypto market. For example, instead of providing liquidity to earn LP tokens, your funds might be better off in more lucrative crypto investments.
Impermanent Loss
Perhaps the most inherent risk of owning LP tokens is impermanent loss. By providing liquidity, you may suffer from inherent loss when the value of the amount you’ve deposited is greater than the value you withdraw upon exiting the pool. Impermanent loss occurs due to price changes over time.
Usually, liquidity pools that contain volatile trading pairs are more prone to impermanent loss. To reduce the risk of impermanent loss, you can opt for stablecoin pairs, which often have a smaller price range.
One of the ways some Defi protocols cushion LP token holders from impermanent loss is by charging substantial fees for transactions. For example, liquidity providers on Uniswap receive a share of 0.3% of fees charged on trades. As such, despite the exposure to impermanent loss, you’re compensated by generous transaction fees.
Smart Contract Failure
If the liquidity pool you're using is compromised due to a smart contract failure, your LP tokens will no longer be able to return your liquidity to you. Similarly, if you stake your LP tokens with a yield farm or loan provider, their smart contracts could also fail.
Conclusion
LP tokens are essential in Defi. They not only help determine your share of the liquidity pool, but they can also be used for yield farming, collateral, and value transfer. Despite the risks associated with LP tokens, they are an appealing way to earn passive income from your crypto assets.
Overall, the Defi space is constantly evolving, so use cases for LP tokens are constantly being developed. Diversifying your portfolio as an LP token owner should not be an afterthought. You can optimize your LP token returns by working around your risk tolerance.