LP tokens are rewarded to users who provide crypto assets to a DeFi platform, and often come with benefits when it comes to staking and yield farming.
What Are Liquidity Provider Tokens?
Liquidity is a fundamental concept in decentralized finance (DeFi), a sector that is powered by decentralized exchanges (DEXs) and lending platforms that operate via automated functions designed to help promote decentralization and equitable business models. Integral to the function of DEXs is “liquidity,” which refers to how easily one asset can be converted to another. In the absence of centralized market makers, DeFi platforms generally seek to offer incentives to encourage liquidity provider (LP) participation. Many DeFi protocols have begun offering multifunctional LP tokens, which help solve the problem of crypto market liquidity by incentivizing users to provide the platform with available crypto assets.
Typically, liquidity providers receive LP tokens in return for providing cryptocurrencies like ether (ETH) to a DeFi platform’s liquidity pool. LP tokens represent a crypto liquidity provider’s share of a pool, and the liquidity provider remains entirely in control of their staked tokens, which are only being lent to the platform’s protocol. When a liquidity provider wants their liquidity back, they must burn their LP tokens to receive their original crypto assets, in addition to any accumulated commissions from trading fees or loan interest. LP tokens also allow automated market makers (AMMs) to be non-custodial, meaning you remain in control of your assets and can redeem them at any time. The LP tokens that are created vary in their use cases depending on the platform.
Examples of Crypto Liquidity Provider Tokens
LP tokens can serve as proof that you have lent crypto assets to a DeFi liquidity pool, and that the tokens must be burnt in order to get your assets back. However, in many cases, LP tokens can also be used to unlock new layers of access or yield farming opportunities within a DeFi platform. Below are a few examples of LP tokens used by some of the world’s leading DeFi platforms:
1inch: Crypto liquidity providers using the 1inch DeFi DEX aggregator accrue interest from platform trading fees in the form of the 1INCH token, regardless of the 1inch pool to which they provide liquidity. These 1INCH tokens also serve as the platform’s governance token, which means that holding 1INCH tokens comes with proportional voting rights in 1inch’s decentralized governance administration.
Uniswap: Uniswap liquidity providers are rewarded with fungibile ERC-20 LP tokens, which makes the tokens composable across the broader Ethereum-based DeFi ecosystem. As a result, even though there are generally no direct markets for buying and trading LP tokens themselves, LP tokens like Uniswap’s can be used as collateral in lending protocols such as Aave or MakerDAO. It’s important to note that Uniswap liquidity provider tokens are not the same as UNI governance tokens, which are used to vote on new proposals and other forms of decentralized decision-making.
SushiSwap: SushiSwap liquidity providers receive ERC-20 SushiSwap Liquidity Provider (SLP) tokens associated with the specific asset they have deposited. For instance, if a user deposits DAI and ETH into a pool, they will receive DAI-ETH SLP tokens. These SLP tokens can then be deposited into a designated DAI-ETH SLP liquidity pool to generate SUSHI, SushiSwap’s platform governance token.
Curve: Liquidity providers leveraging the AMM Curve receive a token-specific LP token rather than an LP token tied to a trading pair. For instance, if a user lends ETH to the Compound DeFi platform, it is exchanged for a liquidity token called cETH, which automatically accumulates interest for the holder. In addition to allowing Curve’s crypto liquidity providers the right to withdraw their ETH plus interest from Compound, Curve users are able to stake their cETH in other liquidity pools to generate passive yields and CRV (Curve’s governance token). These LP tokens thereby allow users to achieve an additional layer of utility and potential profits from their initial investment.
Balancer: Balancer is an AMM protocol that enables liquidity pools made up of multiple unevenly weighted assets. Like many of the examples above, Balancer liquidity tokens — called balancer pool tokens (BPT) — are ERC-20 tokens that are composable across the broader Ethereum DeFi ecosystem. However, given Balancer’s unique multi-asset pool configuration, BPT tokens are underpinned by a basket of crypto assets. Some projects that are built on top of Balancer pools require users to stake BPT tokens to earn rewards.
Kyber Network: Kyber Network aggregates liquidity from a variety of reserves, including token holders, market makers, and DEXs, into a single liquidity pool on its network. Liquidity providers in Kyber’s Dynamic Market Maker (DMM) protocol receive DMM LP tokens representing their liquidity pool share. These DMM tokens can then be staked in eligible liquidity mining pools to earn KNC or MATIC (Kyber’s and Polygon’s respective governance tokens) on top of protocol fees earned through the staking program.
LP Tokens Are More Than Collateral
As the above examples illustrate, LP tokens can serve many purposes across the DeFi ecosystem (including via a DEX, an AMM, or a DEX aggregator). While LP tokens are not specifically designed to be traded or sold, many open up new avenues for additional earnings, and DeFi users should weigh the utility of a platform’s LP token against its alternatives whenever they decide which DeFi products and services to use.
Decentralized liquidity pools are essential to the proper functioning and growth of DeFi platforms. Succeeding in the financial industry generally requires effective ways to leverage existing capital, and to that end, LP tokens help provide an invaluable service by broadening the extent to which DeFi users can engage with decentralized lending, yield generation, and governance.
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FAQs
LP tokens represent a crypto liquidity provider's share of a pool, and the crypto liquidity provider remains entirely in control of the token. For example, if you contribute $10 USD worth of assets to a Balancer pool that has a total worth of $100, you would receive 10% of that pool's LP tokens.
What are LP tokens in crypto? ›
Liquidity Provider Tokens, or LP Tokens for short, are a reward mechanism to help facilitate transactions between other different types of currencies. Decentralized exchanges rely on Liquidity Providers to ensure there is an always-on market for the trading of cryptocurrencies.
What are LP tokens good for? ›
LP tokens have other use cases besides unlocking the provided liquidity. They allow the liquidity provider to access crypto loans, transfer ownership of the staked liquidity, and can earn compound interest in yield farming. Compound interest is interest earned on the original sum deposited.
What are examples of liquidity provider tokens? ›
Liquidity provider tokens or LP tokens are tokens issued to liquidity providers on a decentralized exchange (DEX) that run 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.
Does LP tokens increase value? ›
They can gain value in a number of ways, including: Increase in the value of the assets in the liquidity pool: The value of an LP token is typically tied to the value of the assets in the liquidity pool. If the value of the assets in the pool increases, the value of the LP token may also increase.
Where can I find LP tokens? ›
It is a crucial trait for ensuring participation in the decentralized finance or DeFi ecosystem. AMM platforms help you stay maintain control over your assets through receipt of LP tokens. You can gain LP tokens from an AMM-based system by depositing your crypto assets in the system's liquidity pool.
How do LP tokens lose value? ›
It happens when a token's price changes in the market, which causes your deposited assets in the liquidity pool to become worth less than their present value in the market. The bigger this price change, the more your assets are exposed to impermanent loss.
What happens when LP tokens are burned? ›
Burning LP tokens involves sending them to the burn address which is the Ethereum genesis address. This is the first address that existed on the Ethereum blockchain which no one has the private keys to, which means all tokens sent to the address are lost permanently.
Can LP tokens be sold? ›
A few platforms let you use changes in interest value to stake LP tokens in yield farms. However, if you sell your CAKE-LP tokens, you are removing liquidity and returning them to the staked tokens. You must go to Pancakeswap, find the LP token pair, and remove it in order to sell CAKE-LP tokens.
How much is one LP token worth? ›
And from all of this info we can calculate that 1 LP token in the LINK-ETH pool on Uniswap is valued at $577.69.
What is the risk? The risk of providing liquidity is impermanent loss (IL). IL is the difference between the value of the tokens in a liquidity pool and the value of the tokens if they were held in a wallet. The loss does not become permanent until the LP tokens are removed from the liquidity pool.
What is the risk of LP crypto? ›
Beware of risks, however. Liquidity pools are prone to impermanent loss, a term for when the ratio of tokens in a liquidity pool (for example, 50:50 split of ETH/USDT) becomes uneven due to significant price changes. That could result in losing your invested funds.
Is staking LP tokens risky? ›
The risks assocciated with staking LP tokens: impermanent loss - it happens when the prices of the assets in a liquidity pool go in different directions. some pools may have the lock-up periods, which means that you can't access your coins for a certain period of time.
Do liquidity providers make money? ›
How do liquidity providers make money? As we said before, Liquidity providers in Forex make money from the bid-ask spread, which is the difference between what a buyer is willing to pay for an asset and what a seller is willing to accept to sell that asset.
Can you sell liquidity tokens? ›
These LP tokens may be transferred, sold, and staked on other protocols just like any other ERC20 token. Holding LP tokens offers liquidity providers total control over their locked liquidity, just like any other token.
Who is the largest crypto liquidity provider? ›
Top 5 crypto liquidity providers in 2023: Reviewed
- What is a crypto liquidity provider?
- Binance.
- Kraken.
- Huobi.
- Coinbase.
- BitMEX.
- Conclusion.
Theft or permanent loss
If you lose access to your crypto wallet, forget the address, or have weak security for the same, you will lose your LP tokens. A hacker can also get access to your crypto wallet, they can also steal your tokens.
Should you stake LP tokens? ›
LP staking is a valuable way to incentivise token holders to provide liquidity. When a token holder provides liquidity as mentioned earlier they receive LP tokens. LP staking allows the liquidity providers to stake their LP tokens and receive FACTR tokens as rewards.
Are all LP tokens the same? ›
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.
How do you hedge LP tokens? ›
Hedging Your Liquidity Pool Position
To hedge your position, you must borrow a portion of the liquidity that you are providing. In doing so, you are able to rake trading fees during high volume and will benefit the most when there is minimal impermanent loss.
Since staking requires locking up user funds with no opportunity to switch pools, stakers don't have to pay transaction costs. Instead, they earn a percentage of network fees when they validate transactions. When compared to liquidity pools, staking has much lower maintenance costs for generating returns.
Can you make money from liquidity pools? ›
Despite this risk, liquidity pools are still considered very safe. In any other situation, they are highly profitable. Less volatile liquidity pools are less likely to face impermanent loss. It's important to use risk management strategies before investing in any crypto.
Do LP tokens show in wallet? ›
The LP tokens are used to claim liquidity back from the pool and claim any fees that have accrued since adding liquidity. It can be useful to see these tokens in a wallet for one reason or another, however they do not show up in Metamask automatically because they are special tokens.
How much shiba is burned daily? ›
A daily burn rate of over 1.5 billion SHIB tokens can potentially lead to a significant reduction in the token's supply. In the past, burning 100 million SHIB tokens did not have a substantial impact on the asset's value, given its enormous circulating supply of 573 trillion tokens.
Are LP tokens taxable? ›
If you receive a liquidity pool token in return - these transactions are subject to Capital Gains Tax. If you receive new tokens or coins, this would be subject to Income Tax.
Is liquidity staking risky? ›
Staking crypto involves several risks, including market risk, liquidity risk and loss of assets – just like investing in other assets such as shares and stocks,. However, some may consider the reward of cryptocurrency staking outperforms risks because cryptocurrency staking can earn you above-average returns.
Is liquidity staking safe? ›
Finally, staking carries liquidity risk. Staked assets can often be withdrawn or transferred. However, there may be a waiting period before they become available. This means that staked assets may not be as liquid as other investment options.
Can you lose money providing liquidity crypto? ›
By providing liquidity in an AMM, Jack's gains are 50% less than they would have been if he'd held his cryptocurrencies. This loss is called “impermanent” because it is not realized before the LP position is withdrawn. Also, if ETH's value returns to 100 USDT in the above example, the loss will be reversed.
How risky is LP farming? ›
Impermanent loss in yield farming: Assets deposited in an LP can lose their value while locked up. This price fluctuation is usual in crypto, but the loss in value can seriously affect a yield farmer as they often need to pay back their loans from their leveraged yield farming.
How is crypto LP taxed? ›
The IRS classifies cryptocurrency as property or a digital asset. Any time you sell or exchange crypto, it's a taxable event. This includes using crypto used to pay for goods or services. In most cases, the IRS taxes cryptocurrencies as an asset and subjects them to long-term or short-term capital gains taxes.
Some of the best staking platforms in 2023 to consider in your research include:
- Coinbase.
- KuCoin.
- Binance.
- Crypto.com.
- Kraken.
- Cake DeFi.
- Nexo.
- Lido.
Liquidity providers are at risk of experiencing impermanent loss if the price of the tokens in the pool changes significantly. This can happen when the price of one token in the pool increases or decreases more than the other, which can lead to losses for the liquidity provider.
Is liquidity hard to sell? ›
Stocks with low liquidity may be difficult to sell and may cause you to take a bigger loss if you cannot sell the shares when you want to. Liquidity risk is the risk that investors won't find a market for their securities, which may prevent them from buying or selling when they want.
Where do liquidity providers get their money? ›
Liquidity providers are companies that offer a service to make Forex trading easier. To do this, they lend their own money to retail traders willing and able to take on these risks in exchange for a fee.
How much do liquidity providers make crypto? ›
In return for providing liquidity to the market, LPs charge a small fee. This fee is typically 0.1-0.2 pips on each side of the trade (the bid and the ask).
Who are the top Tier 1 liquidity providers? ›
Tier 1 providers include huge international banks such as Morgan Stanley, Bank of America, Goldman Sachs, J.P. Morgan, Barclays Capital Bank, Citi Bank, Nomura, and others.
What is the best liquidity provider? ›
The Best 15 Liquidity Providers
- B2Broker - Best Overall LP.
- FXCM Prime - Best FX LP.
- Finalto - Best Multi Asset LP.
- Advanced Markets - Best LP for Institutional FX Brokers.
- Top FX - Best Retail LP.
- Swissquote Bank - Best ETF LP.
- Saxo Bank - Best Equities LP.
- Invast Global - Best FX Prime of Prime LP.
Coinbase is a leading crypto exchange liquidity provider with over $327 billion in quarterly trading volume and 73 million users across 100 countries.
How much are my LP tokens worth? ›
The price of an LP token is calculated by dividing the total value locked in that pool by the total amount of LP tokens existing at that time.
How do liquidity providers make money? ›
How do liquidity providers make money? As we said before, Liquidity providers in Forex make money from the bid-ask spread, which is the difference between what a buyer is willing to pay for an asset and what a seller is willing to accept to sell that asset.
LP staking is a valuable way to incentivise token holders to provide liquidity. When a token holder provides liquidity as mentioned earlier they receive LP tokens. LP staking allows the liquidity providers to stake their LP tokens and receive FACTR tokens as rewards.
