Understanding LP tokens: much more than just a simple receipt

What You Need to Know About Liquidity Tokens in Crypto

You have probably heard about liquidity pools in DeFi, but do you really know about the LP tokens that come from them? These cryptocurrency assets are distributed to users who provide their liquidity to a pool. Think of them as proof of ownership – a digital receipt that allows you to reclaim not only your initial contribution but also the accumulated returns.

The particularity of LP tokens is that they are not limited to unlocking your liquidity. In reality, these tokens represent a much richer opportunity in the DeFi ecosystem. You can use them to generate additional yields, use them as collateral to borrow in crypto, or even transfer them to other users. However, an important warning: as soon as you relinquish custody of your LP tokens, you lose control of the associated liquidity.

Why is liquidity in crypto crucial?

Before understanding how LP tokens work, one must grasp the problem they solve. Liquidity is the ability to easily trade an asset without drastically affecting its price. Bitcoin is the perfect example – available on thousands of exchanges, it maintains a certain price stability regardless of the traded volume.

Unfortunately, not all tokens have this chance. In DeFi and for emerging projects, liquidity can be extremely limited. You may find a token available on only one platform, with few buyers or sellers willing to execute your transactions.

This is where liquidity pools come into play. Instead of relying on a traditional order book with makers and takers, these pools use a mathematical formula: the price is determined by the ratio of the two assets in the pool. Users who deposit a pair of tokens facilitate the exchanges and receive in return LP tokens, plus a share of the trading fees generated.

How do LP tokens work precisely in crypto?

The mechanism is simple: you deposit two assets into a liquidity pool and instantly receive LP tokens in return. These tokens represent your exact share of the pool and will allow you to withdraw your initial deposit plus the generated interest.

Here is a crucial point: your LP tokens are your proof of ownership. If you lose them, you lose access to your share of the pool. You will find them in the crypto wallet you used to provide liquidity. Some protocols require you to manually add the address of the LP token smart contract for it to appear in your interface.

Most DeFi LP tokens are transferable, meaning that ownership can change hands. You can send your LP tokens to someone else, who can then withdraw the underlying assets. However, always check with the pool provider, as not all LP tokens allow transfers.

Where to obtain LP tokens in crypto?

Only liquidity providers receive these tokens. To obtain them, you need to access a DeFi dApp – platforms like PancakeSwap or Uniswap facilitate this process. The LP token system is universal across many blockchains, DeFi protocols, and decentralized exchanges (DEX) based on automated market makers (AMM).

Note: if you use the liquidity services of a centralized exchange (CeFi), you generally will not receive LP tokens. The exchange will keep them in its possession.

The name of your LP token reflects the pair you are financing. Depositing CAKE and BNB on PancakeSwap gives you a “CAKE-BNB LP” token (format BEP-20). On Ethereum, it is generally an ERC-20 format.

The multiple uses of LP tokens

Beyond simply serving as a receipt, LP tokens offer fascinating possibilities in modular DeFi.

Transfer ownership and value

The most direct use case: transferring your LP tokens to someone else to transfer your share of the pool. However, manually calculating the exact amount of tokens associated with your stake is complex. Use a DeFi calculator to get accurate figures.

Use them as collateral to borrow

Since your LP tokens represent real assets, many platforms accept them as collateral for crypto loans. You can typically borrow a stablecoin or a large-cap asset. The system operates on over-collateralization: if your collateral ratio drops, the lender can liquidate your LP tokens and withdraw the underlying assets.

Compose your yields

The most popular use: deposit your LP tokens in a yield farm. These services automate the process: withdrawal of rewards, redemption of tokens from the pair, restaking in the pool. This way, you compound your interests multiple times a day instead of doing it manually, with transaction fees shared among all users.

Risks Not to Ignore

LP tokens, like any cryptocurrency asset, carry significant risks.

Loss or Theft: Losing your LP tokens means losing your share of the pool and all accumulated yields. This is permanent.

Technical Failures: If the pool's smart contract has a flaw, your LP tokens will no longer allow you to access your funds. The same danger exists for yield farms or borrowing protocols where you stake your LP tokens.

Value Opacity: It is almost impossible to know the exact value of your LP tokens just by looking at them. If the prices of the two tokens in the pair have diverged, you may have incurred an impermanent loss. Adding interest to this equation makes timing decisions complicated.

Opportunity cost: Providing your tokens for liquidity means locking them up. There is always a possibility that those same tokens could have generated more yield elsewhere or in another strategy.

Final Thoughts on LP Tokens

The next time you consider providing crypto liquidity to a pool, ask yourself: how can I maximize these LP tokens? The initial deposit is just the beginning. Explore your options – yield farms, borrowing, transfers – but always in alignment with your risk tolerance and overall investment strategy.