Liquidity pool (LP) tokens are a type of cryptocurrency that are issued to liquidity providers who offer up their assets so that they can be used by others — in return for a small cut of the profits. The tokens represent the provider’s share of the total LP, allowing them to claim back their original assets later, and they can also be used for staking.
In this AAG Academy guide, we’ll explain what a liquidity pool is, how liquidity tokens work, and look at how they can be used to maximize your potential return on investment. We’ll also look at some of the factors that affect an LP token’s value.
A liquidity pool (LP) in decentralized finance (DeFi) is, as its name suggests, a reservoir of digital assets that are locked into a smart contract. They are critical to the cryptocurrency industry, particularly when it comes to the smooth running of decentralized applications (DApps), because they allow transactions to be carried out as quickly and as reliably as possible.
Liquidity pools are commonly used by decentralized exchanges (DEX), AMMs specifically, to enable the trading of different crypto tokens. Unlike many centralized exchanges (CEX), which match buyers with sellers to facilitate trades, buyers can instead trade tokens they already own for those held in the liquidity pool. It is typically a faster and more affordable way of doing things.
LPs essentially allow for a peer-to-peer (P2P) trading system that cuts out any middlemen. This approach does mean that a DEX requires more liquidity than a CEX just to operate effectively, which could be considered a downside by some, but it also gives cryptocurrency investors the opportunity to grow their wealth by investing into liquidity pools.
How do liquidity pool (LP) tokens work?
When a cryptocurrency holder wants to become a liquidity provider, they can lock the tokens they own into a liquidity pool so that they can be used by others when they are needed. In return, they receive LP tokens that represent their share of the assets inside the total pool. This is one of the key purposes of LP tokens, but there are others, which we’ll come back to later.
It is critical that LP tokens are safely stored and protected, just like any other cryptocurrency or digital asset. These tokens are the only proof that their holder owns a share of a liquidity pool, and without them, they would be unable to claim back that share later when they are ready to release their original assets. If you lose them, you also lose what you invested into the LP.
One of the biggest incentives for investing your assets into a liquidity pool is the opportunity to grow your wealth over time. Every time the assets in the pool are used to facilitate a transaction, a certain percentage of the transaction fee (depending on the exchange used) goes back into the liquidity pool. As a result, your share of that pool eventually becomes more valuable.
For instance, let’s say you invest $2,000 worth of crypto into the SushiSwap liquidity pool, and in return, you receive 300 LP tokens. Every time a SushiSwap transaction is carried out using this pool, the user is charged a 0.3% transaction fee, 0.25% of which goes back into the LP. That may seem small, but with thousands of transactions being processed every day, it adds up.
Eventually, the LP tokens you hold end up becoming more valuable. Your share of the liquidity pool may stay the same, but because the pool itself is growing over time, the share is worth more. So, the $2,000 you originally invested could eventually grow to $2,100, $2,500, or more — depending on how long you leave your cryptocurrency locked into the LP.
Alternatively, some LPs distribute that revenue share to liquidity providers directly, so instead of being able to claim a more valuable share of the pot later, you’ll simply be rewarded with additional LP tokens on a regular basis. This allows you to claim a larger share of the LP than you originally contributed when you are ready to exchange your LP tokens.
Of course, how the value of the cryptocurrency you originally invested fluctuates over time also plays a role in this. To make liquidity pools a profitable venture for providers, we rely on the value of that crypto growing or remaining steady over time. If its value falls significantly while your tokens are locked into an LP, then there is a possibility of suffering a loss.
Yield farming with LP tokens
As we hinted in the previous section, there is another use for liquidity pool tokens, and that’s in yield farming (we have an in-depth AAG Academy guide on this if you would like to learn more). Rather than just leaving their LP tokens to sit in their wallets, some liquidity providers will put them into a staking pool so that they, too, can be used to grow their wealth.
Continuing with the example we laid out above, let’s say you take the 300 LP tokens you received from investing into the SushiSwap liquidity pool and you deposit them into the SushiSwap Farm, where they can be used for various things. Now, while their value is growing within the liquidity pool, they are also generating more tokens through the staking process.
This is just one example of how yield farming with LP tokens is possible to maximize your return on investment. We’ve stuck with SushiSwap as an example here just to keep things simple, but there are countless other liquidity pools and staking options available today. We recommend carrying out your own research to discover the best opportunities for you.
How do LP tokens enhance DeFi liquidity?
In the traditional finance industry, cash is considered the most liquid asset since it can be easily exchanged for other things, such as stocks, bonds, and commodities like gold. However, in the crypto industry, cash is not as easily exchanged, so we rely on certain cryptocurrencies instead. The DeFi industry is mostly built on the Ethereum network, so ETH is the most liquid asset.
While assets are being used within the Ethereum ecosystem for things like staking, they are “locked up” and cannot be used for other purposes. This means that we end up with less liquidity on the network, which was an issue in the early days of crypto, before the introduction of LP tokens. However, now that we have LP tokens, the liquidity issue is no longer a problem.
Cryptocurrency owners now have an even greater incentive to provide liquidity since it does not prevent them from putting their cryptocurrency to work elsewhere. As we outlined in the section above, you can continue to take advantage of staking and other yield farming opportunities using your LP tokens while your original cryptocurrency is tied up in a liquidity pool.
What factors affect an LP token’s value?
The main goal when contributing to an LP is to grow your wealth over time, but as we touched on above, a profit is not guaranteed. A number of different factors can affect the value of an LP token and therefore the overall value of your investment. We have already covered a number of those throughout this guide, but to ensure they aren’t missed, we’ve highlighted them here:
Earnings Every time a liquidity pool you have contributed to is used to facilitate a transaction, a share of the transaction fee goes to liquidity providers. This is either distributed directly in the form of more tokens, or the share goes back into the LP to help it grow over time, and providers claim a larger share of the pool when they are ready to withdraw their stake.
Original token price Liquidity tokens are tied to underlying assets, and when the value of those assets falls, so does the value of the LP token. Sticking with the example outlined above again, if the ETH you invest into the SushiSwap LP suffers a decline in value, your LP tokens will also be worth less.
Impermanent loss When contributing to a liquidity pool that uses multiple cryptocurrency tokens in a token pair, we also have to take impermanent loss into account. Impermanent loss occurs when there is a significant price difference between a token pair, and one ends up becoming a lot more valuable than the other, therefore changing the way the LP is structured.
Look out for an in-depth guide on impermanent loss from AAG Academy in the near future.
In addition to the SushiSwap LP tokens we’ve mentioned in this guide, there are countless others in the DeFi ecosystem. Some of the biggest include Balancer, Curve Finance, KeeperDAO, PancakeSwap, and Uniswap.
You can get LP tokens by contributing cryptocurrency to a liquidity pool. To find out how, and which cryptocurrency you’ll need to begin with, it is best to visit the liquidity pool you’re interested in contributing to and following the steps outlined for liquidity providers.
One of the best ways to maximize your earning potential with LP tokens is to stake them so that they can generate rewards or interest. Read our in-depth guide to staking to find out more.
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About the author
Senior content writer
Senior copywriter for AAG Marketing team with the focus of educating our community on all things web3, blockchain and Metaverse.
This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.