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LP tokens

What Are Liquidity Pool (LP) Tokens?

Published On: November 29, 2022
Liquidity pool tokens are DeFi tokens that are distributed to liquidity providers in decentralized exchanges (DEX-es). You can think of these LP tokens as a form of receipt, which you can trade back to your original staked tokens, plus interest.

The concept of LP tokens was introduced by AMM DEX-es (Automated Market Maker Decentralized Exchanges). With AMM DEX-es, you don’t have to put limit orders within the order books. People put a pair of tokens into the liquidity pool and traders can convert one token to another based on these liquidity pools.

For example, if you want to trade ETH against USDC on an Ethereum DEX, you basically take USDC and give ETH into the liquidity pool of ETH-USDC on that same DEX. The liquidity providers who put USDC and ETH in the first place into that pool are given LP tokens, which then can be traded back to 50% value in USDC and 50% value in ETH.

Liquidity Pools Explained

Liquidity Pools (LP) are a relatively new type of cryptocurrency asset that many DeFi users are already familiar with. People put liquidity into DEX-es because they are always incentivized (e.g. by trading fees). That’s why HODL-ing liquidity pool tokens make sense, since they will receive interests over time as well.

Once you've deposited a pair of tokens in a liquidity pool, you'll receive LP tokens as a receipt. These LP tokens represent your share of the pool and allow you to retrieve your deposit, plus any interest earned. This means part of the safety and security of your deposit relies on you keeping hold of your LP tokens. If you lose them to some hacks or something, then you will lose your share.

You'll find your LPs in the wallet you used when providing liquidity. You may need to add the LP token's smart contract address to see it in your crypto wallet interface. Most LPs in the DeFi ecosystem can be transferred between wallets, thereby transferring ownership. However, you should always check with the liquidity pool service provider, as this isn't always the case. Transferring the tokens may, in some cases, cause an impermanent loss of the liquidity provided.

Liquidity Pool Tokens: What Can You Do With Them?

DeFi allows you to leverage your crypto assets across multiple platforms and stack services like Legos.

They could be used as a means of transferring money between accounts.

A simple way to think about this is that some LP tokens are tied to specific wallets, while others allow for the free transfer of the tokens. You could send BNB-wBNB LP tokens to someone else who could then remove the BNB and wBNB from the liquidity pool.

However, calculating the exact amount of tokens you have in the pool is difficult to do manually. In this case, you can use a DeFi calculator to calculate the amount of staked tokens associated with your LPs.

LP token holders also often lend their tokens as collateral to earn interest on loans. This allows borrowers to access funds without needing to deposit fiat currency into exchanges. For example, a borrower can receive USDT or DAI through a lending platform by using their LP tokens as collaterals.

In this case, the loan is overcollateralized. If you cannot maintain a certain level of collateral, the lender will use your LPs to claim the underlying assets and liquidate them.

The biggest use case for LP tokens is usually all about the interest, though. Many newer DEX-es often provide higher APY to incentivize liquidity providers.

What Are the Potential Risks Associated With LP Tokens?

If you lose your LP token, then you lose access to the liquidity pool and any interest earned.

Also, be aware of possible smart contract failure: If the liquidity pool you're using is compromised due to a smart contract failure, your LP tokens will not be able to return your liquidity to you. Likewise, if you stake your LP tokens with a yield farm or loan provider, their smart contracts could also fail.

Another risk you must be aware of is called impermanent loss. Since redeeming LP tokens always split 50%-50% value in the original tokens, their price would have changed compared to their original price when you get your LP token the first time.

Read our explanation about impermanent loss.

Final Thoughts

A next step after depositing funds into a liquidity pool would be to consider what else you'd like to do with those funds. If you plan to invest in a decentralized application, then you'll likely want to stake some of your LPs. We at DeSpace also have our own DeSwap, which provides a unique opportunity for liquidity providers to maximize their income compared to other DEX-es.
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