What is an LP token?
Liquidity Provider Tokens (LP Tokens) are tokens allocated to liquidity providers on a DEX (decentralized exchange). DEX runs on an automated market maker protocol (AMM). But what exactly is a DEX?
Decentralized exchanges, or DEXs, are peer-to-peer platforms where transactions can be conducted directly between crypto traders. DEXs are a way to facilitate financial transactions that are not commissioned or regulated by intermediaries such as banks, brokers, and other financial institutions. Uniswap, Sushi, and PancakeSwap are some examples of popular DEXs distributing LP tokens to liquidity providers.
How do DEXs work?
Reducing the use of intermediaries is a core principle of the blockchain community. This is one of the reasons why DEXs are growing in popularity alongside traditional centralized exchanges. How do they work and how do they differ from their central counterparts?
The global cryptocurrency market relies on cryptocurrency exchanges to provide liquidity. These enable a daily trading volume in the billions. Leading exchanges are expanding to meet the growing demand for digital assets. They offer asset storage and new trading features and functions.
DEX offers a unique approach to digital asset trading. Decentralized exchanges do not require an intermediary to process transactions. Instead, they rely on self-executing smart contracts to facilitate trading. This enables near-instant transactions. These transactions usually take place at a lower price than centralized crypto exchanges can offer.
DEXs adopt a non-custodial structure in the absence of intermediaries. This means that users keep their cryptocurrencies safe. However, they are also fully responsible for managing their wallets and personal keys. Control then has its price. Private keys can easily be lost.
It is also important to note that the lack of a broker means that most DEXs have limited counterparty risk.
In short, DEXs are peer-to-peer marketplaces that allow traders to transact without the oversight or assistance of an intermediary. This exchange promises a greater degree of freedom, but also requires greater effort from everyone involved. One of the challenges is maintaining liquidity on an ongoing basis. A liquidity provider on the DEX is rewarded with LP tokens.
How do LP tokens work?
LP tokens are used to track individual contributions to the overall liquidity pool as they are proportional to the liquidity share of the overall pool.
At the most basic level, LP tokens work according to the following formula:
total value of liquidity pool / circulating supply of LP tokens = value of 1 LP token
Technical In terms of functionality, LP tokens are not significantly different from other tokens on the same network. For example, LP tokens issued by Uniswap and Sushiswap, both running on the Ethereum network, are actually ERC20 tokens. Like all other ERC20 tokens, these LP tokens can be transferred to other protocols, traded and backed.
As with all other tokens, holding LP tokens gives liquidity providers full control over their locked liquidity. Most liquidity pools allow providers to redeem LP tokens at any time without intervention, but many may charge a small penalty if you use them too soon.
The relationship between LP tokens and the proportional share of a liquidity pool is most commonly used in at least two situations:
- To determine the liquidity provider’s share of the transaction fees incurred during the liquidity provision period.
- To determine how much liquidity is returned from liquidity pools to liquidity providers when liquidity providers choose to use LP tokens.
There are many other use cases for LP tokens emerging on modern DeFi platforms. Here are some examples:
- Sharing LP tokens to earn more rewards to encourage liquidity providers to pool their liquidity. Sometimes this involves “Farming”
- Using LP token values as a qualifying factor to access the initial DEX offering (IDOs), i.e. a specific LP token, to participate in certain IDOs have value.