Liquidity provider tokens (LP tokens) are tokens allocated to liquidity providers in a DEX (decentralized exchange). DEX runs on an automated market maker (AMM) protocol. But what exactly is a DEX?
Decentralized exchanges or DEXs are peer-to-peer platforms where transactions can be made directly between crypto traders. DEXs are a way to facilitate financial transactions that are not commissioned or regulated by any intermediary such as banks, brokers, and other financial institutions. Uniswap, Sushi, and PancakeSwap are some examples of popular DEXs that distribute LP tokens to liquidity providers.
How do DEXs work?
Reducing the use of middlemen is a fundamental 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 facilitate billions of dollars in trade volume every day. Leading exchanges are expanding to meet the growing demand for digital assets. They offer asset storage and new trading features and functionality.
DEX provides a unique approach to trading digital assets. Decentralized exchanges do not require an intermediary to clear transactions. Instead, they rely on self-executing smart contracts to facilitate trading. This allows for near-instant transactions. These transactions often occur 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 will retain custody of their cryptocurrencies. However, they will also be fully responsible for managing their wallets and personal keys. Control then comes at a price. Private keys can be easily lost.
It’s also important to note that the absence of a broker means that most DEXs have limited counterparty risk.
In a nutshell, DEXs are a peer-to-peer market where traders can make transactions without the oversight or assistance of a broker. These exchanges promise a greater degree of freedom, but also require greater effort from all parties involved. One of the challenges is maintaining liquidity on an ongoing basis. A liquidity provider on the DEX is rewarded with LP tokens.
How LP Tokens Work
LP tokens are used to track individual contributions to the overall liquidity pool as they correspond proportionally to the liquidity share in the overall pool.
At the most basic level, LP tokens work on the following formula:
Total Value of Liquidity Pool / Circulating Supply of LP Tokens = Value of 1 LP Token
In terms of technical features, LP tokens are not much different from other tokens in the same network. For example, LP tokens issued by Uniswap and Sushiswap, both of which run on the Ethereum network, are actually ERC20 tokens. Like all other ERC20 tokens, these LP tokens can be transferred, traded and staked in other protocols.
Like any other token, holding LP tokens gives liquidity providers full control over their locked-in liquidity. Most liquidity pools allow providers to redeem LP tokens at any time without interference, but many may charge a small penalty if you use them too soon.
The relationship between LP tokens and a proportional share of a liquidity pool is most commonly used in at least two situations:
- To determine the liquidity provider’s share of transaction fees accumulated during the liquidity delivery period.
- To determine how much liquidity is returned from liquidity pools to liquidity providers when liquidity providers decide 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 as a way to encourage liquidity providers to lock their liquidity into pools. Sometimes it’s called “farming”.
- Using LP token values as a qualification factor to access the initial DEX offer (IDOs), i.e. having a certain LP token value to participate in certain IDOs.
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