Decentralized finance, or DeFi, is a formidable advancement in the ways it changes access to financial services. Today, you will find most of the DeFi users familiar with the concepts of liquidity pools. However, most people would not have any clarity regarding liquidity provider tokens as they are often pushed back in discussions on DeFi and the decentralized web. LP tokens or liquidity providers crypto have some unique use cases other than offering the desired liquidity in different pools.
Have you heard of yield farming or staking among the popular buzzwords in the crypto space? The DeFi landscape has many protocols offering these services along with decentralized exchanges. What are liquidity providers, and how do LP tokens serve useful applications other than ensuring liquidity? The following post serves you an effective answer with the introduction to LP tokens and their working.
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DeFi and Automated Market Makers
The obvious highlight in a discussion on LP tokens would start with the role of liquidity providers in the crypto landscape. Any individual following the blockchain and crypto space closely must have come across the news of consistently evolving DeFi services. The growth of the DeFi ecosystem has called for the introduction of many new solutions to offer innovative ways of accessing financial services. Automated Market Maker platforms like Balancer, Uniswap, and Curve have evolved as one of the key trends in the radically growing DeFi ecosystem.
On top of it, AMM could present different perspectives on approaches to crypto trading in general. For example, you would need a buyer and a seller in a conventional transaction to achieve finality. Imagine that you have a piece of real estate you want to sell on the open market for $10,000. You can execute the sale only if you find a buyer who is prepared to purchase the property at $10,000.
This does not mean that no one in the world wants to buy your piece of real estate for $10,000. Where will you find the market for your property? The overview of a liquidity provider example could show you how AMM-based liquidity pools can solve this problem. Automatic Market Makers ensures that buyers don’t have to wait for sellers and vice-versa to confirm transactions.
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Crypto Liquidity Providers and LP Tokens
The overview of Automated Market Makers and their practical significance in DeFi sets the foundation for understanding LP tokens. Now, liquidity provider token or LP token is one of the key functions in DeFi ecosystems. One of the notable highlights in “What is liquidity provider token” refers to how they allow AMMs to retain non-custodial features.
Therefore, LP tokens can ensure that AMMs cannot hold your tokens. On the other hand, it would work through automated smart contracts that could encourage decentralization alongside fair transactions. Another important highlight you must note right now refers to the use of LP tokens for unlocking new opportunities in token trading.
At the same time, it is also important to identify how LP tokens can provide revolutionary access to solutions throughout the dApp ecosystem. LP tokens have ensured promising levels of growth for DeFi solutions with the support of formidable network effects. You can obtain a basic impression of how LP tokens work by reflecting on the non-custodial trait in AMM platforms.
It is a crucial trait for ensuring participation in the decentralized finance or DeFi ecosystem. AMM platforms help you maintain control over your assets through the 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. Interestingly, the liquidity pool works through smart contract code rather than human intervention.
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Basics of LP Tokens
The importance of liquidity provider tokens is evident in the basics of their working mechanism. LP tokens represent the share of a liquidity provider in the liquidity pool, and liquidity providers have complete control over the tokens. For example, if you add $10 to a liquidity pool that has $100 in it, then you could claim around a 10% share in the LP tokens of the concerned liquidity pool. You would receive 10% of LP tokens owing to proof of your ownership of 10% of the liquidity pool.
Think of LP tokens as proof of claim for your share in the crypto assets of the concerned liquidity pool. Ownership of LP tokens also offers significant advantages, with comprehensive control over withdrawing your share from the liquidity pool without any interference. You must also notice that LP tokens follow the ERC-20 standards, thereby enabling ease of transferring, exchanging, and staking on different protocols.
Working of LP Tokens
The overview of liquidity providers and what they do offer a viable foundation for understanding the basics of LP tokens. Now, it is important to take a look at how liquidity provider tokens work to enhance liquidity in the DeFi ecosystem. Liquidity is one of the core concepts within the DeFi ecosystem and defines the flexibility of converting an asset into another asset without affecting its price. From the perspective of traditional financial systems, cash has always served as one of the most liquid assets. Cash can be exchanged for gold, bonds, stocks, and many other assets. However, the conversion of cash to crypto is one of the formidable setbacks.
When you look at the crypto market from the eyes of a general user, Bitcoin appears more trustworthy. As a matter of fact, Bitcoin or BTC is one of the most liquid crypto assets in the market owing to the support for its use on almost all centralized exchanges. At the same time, the significance of liquidity providers in crypto liquidity pools is also evident in the foundations of DeFi. Ethereum serves as the foundation for building the DeFi ecosystem, and Ether accounts as the most liquid crypto asset on the platform. As a result, ETH is easily tradable and accepted on different decentralized exchanges.
Before the development of LP tokens, all the assets in use within the Ethereum landscape had been rendered inaccessible during the course of their usage. For example, users had to stake their crypto assets or tokens in the DeFi protocols, which would lock up the assets. Generally, tokens must be locked up to participate in governance mechanisms.
For example, the PoS or Proof of Stake mechanism in ETH 2.0 would call for users to stake ETH for validation and the addition of new blocks to the Ethereum blockchain. Staking showcases a significant difference from the liquidity provider example, as users could not implement the staked assets for any other activities. Subsequently, such systems would imply reductions in the liquidity of crypto assets on these platforms.
The answer to how LP tokens work would focus on the development of easily convertible assets in AMM-based protocols as LP tokens. Subsequently, LP tokens could resolve the setbacks and inefficiencies of crypto liquidity locked within the platform, particularly in the DeFi ecosystem. LP tokens help in using the staked tokens for different applications, even if you have invested them in DeFi protocols or staked in governance mechanisms for different platforms. The working of liquidity provider tokens could also help in resolving the concerns of lower crypto liquidity. LP tokens can open up opportunities for a new and indirect approach to staking, which can help in proving token ownership beyond just staking the tokens.
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Liquidity Provider Tokens and Yield Farming
The indirect approach for staking described in guides on “what is liquidity provider token” would focus on the method of yield farming. DeFi has experienced some rapid advancements over the course of recent years. At the same time, the terms associated with DeFi have been evolving alongside other changes in the domain. For example, LP tokens might have some other terminology according to the platform of application.
For example, LP tokens are called balancer pool tokens or BPT on the Balancer protocol. On the other hand, LP tokens on Uniswap are referred to as simply liquidity tokens or pool tokens. In the case of Curve Finance, they are just liquidity provider tokens and nothing else, thereby solving many confusing propositions. Irrespective of the terminology, LP tokens bear the same meaning and functionality across all DeFi applications.
LP tokens work as mathematical evidence for the fact that you have offered assets to a crypto liquidity pool. They also play a crucial role in validating your claim for the assets. In this case, you need to reflect on another recent term, which has garnered a lot of attention in DeFi. Yield farming has emerged as a formidable phrase in DeFi with global attention.
The concept of yield farming focuses on depositing tokens in various DeFi applications for obtaining passive income or maximizing earnings on crypto deposits. Interestingly, yield farming participants can also rely on transferring tokens in and out of different protocols to maximize their earnings.
The detailed explanations for how liquidity provider tokens work would verify that LP tokens and yield farming are comparatively new ideas. However, DeFi users are capitalizing on the best of both together. You can identify the basics of how LP tokens work together with yield farming by reflecting on an example. Let us find out how you can yield farm CRV tokens on Curve protocol by using a stable asset like DAI. Here are the steps for yield farming with Curve protocol.
- Make DAI deposits in the liquidity pool of Curve.
- Obtain LP tokens in return for your deposits.
- Deposit the LP tokens you received back into the staking pool of Curve Finance.
- Receive a CRV token as a reward for staking your LP tokens.
Now, the DAI would work actively to earn interest alongside fees in the liquidity pool of Curve Finance. On the other hand, LP tokens from the liquidity pool help in earning CRV as rewards for staking LP tokens. Therefore, liquidity provider tokens or liquidity providers crypto can help you obtain dual advantages from the liquidity you offer to Curve.
Risks with LP Tokens
The detailed guide on LP tokens or liquidity providers’ crypto and their work proves how they can serve as vital assets in the future. However, LP tokens also feature risks such as impermanent loss and opportunity loss. For example, locking up your tokens in a liquidity pool can isolate you from other crypto market opportunities. In addition, liquidity pools depend on smart contracts for governance. Therefore, vulnerabilities in the code of liquidity pool smart contracts could result in the loss or theft of tokens.
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Bottom Line
The background for creating LP tokens with AMMs and liquidity providers provides a valid impression of their significance. In addition, the growth of LP tokens in the DeFi ecosystem for yield farming can also influence the future of DeFi. The answers for how LP tokens work present a simple explanation for utilizing crypto assets without any barriers. You don’t have to worry about the liquidity of your crypto assets with LP tokens. The LP tokens don’t lock your crypto assets in a platform. Start learning more about the mechanics of the DeFi ecosystem and become an expert in DeFi.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!
