How Liquidity Provider (LP) Tokens Work

Crypto Liquidity Providers and LP Tokens

Automated market maker (AMM) platforms like Uniswap, Curve, and Balancer are a central aspect of the fast-growing decentralized finance (DeFi) ecosystem, and present a novel approach to trading in general. A key function of automated market maker platforms is the liquidity provider (LP) token. LP tokens allow AMMs to be non-custodial, meaning they do not hold on to your tokens, but instead operate via automated functions that promote decentralization and fairness. Liquidity provider tokens also unlock new layers of token trade and access across the entire DeFi ecosystem, which has facilitated growth in the form of significant network effects.

The non-custodial feature of AMM platforms is key to being part of the decentralized finance ecosystem. On AMM platforms, you remain in control of your assets by receiving LP tokens in return for providing tokens like ether (ETH) to the crypto liquidity pool, which is managed by code and not by human operation. 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. You receive 10% of the LP tokens because you own 10% of the crypto liquidity pool. The LP tokens become your claim to your share of the pool’s assets. Holding these LP tokens allows you total control over when you withdraw your share of the pool without interference from anyone — even the Balancer platform. And since LP tokens are ERC-20 tokens, they can be transferred, exchanged, and even staked on other protocols.

How LP Tokens Enhanced DeFi Liquidity

Liquidity is a fundamental concept in the DeFi space. The term refers to how easily one asset can be converted to another without causing a drastic change in the asset's price. In traditional finance, cash is seen as the most liquid asset, because you can easily exchange it for gold, stocks, bonds, and other assets. However, cash is not easily converted to crypto. In the broader crypto space, bitcoin (BTC) is currently the most liquid asset, because it is accepted and tradeable on nearly every centralized exchange. In the DeFi ecosystem, which is almost exclusively built on the Ethereum network, ether is the most liquid asset because it is Ethereum’s native asset and accepted and tradeable on every decentralized exchange (DEX).

Prior to the creation of liquidity provider tokens, all assets being used within the Ethereum ecosystem were inaccessible during their period of use. Tokens are most commonly locked up when they need to be staked, normally as part of a governance mechanism. For example, in Ethereum 2.0’s Proof-of-Stake (PoS) mechanism, ETH will be locked up in order to validate and add new blocks to Ethereum’s blockchain. When a token is staked in this instance, it can’t be used for other things, which means there is less liquidity in the system. Creating easily convertible assets in AMMs in the form of LP tokens solves this problem of locked crypto liquidity — at least within DeFi.

With liquidity provider tokens, the same tokens can be utilized multiple times, even if they are invested in a DeFi product or staked in a platform governance mechanism. LP tokens help solve the problem of limited crypto liquidity by opening up an indirect form of staking, one where you prove you own tokens instead of staking the tokens themselves.

Yield Farming with LP Tokens

Since DeFi is a rapidly evolving space, the terms defining the space are also constantly evolving. What this article refers to as LP tokens may have other names depending on the platform. For example, on the Balancer protocol, these tokens are referred to as balancer pool tokens (BPT), or pool tokens. On Uniswap, these tokens are referred to as either pool tokens or liquidity tokens. Curve refers to them as liquidity provider (LP) tokens. Though the terminology may be different, the definition is the same. LP tokens are mathematical proof that you provided assets to a pool — and LP tokens hold the claim to getting those assets back.

Another recent DeFi term is yield farming — a phrase that didn’t exist in the first half of 2020 but has recently gained remarkable traction globally. The idea of yield farming is to deposit tokens in different DeFi applications in order to maximize earnings. By moving tokens in and out of different protocols, profits can be maximized.

Though both yield farming and LP tokens are relatively recent ideas, they are beginning to be used together. To understand how this works, let’s look at the steps to farming the CRV token on the Curve protocol using DAI:

• Deposit DAI to Curve’s crypto liquidity pool

• Receive LP tokens

• Deposit received LP tokens to the Curve staking pool

• Receive the CRV token

In this scenario, your DAI would earn interest and fees in Curve’s crypto liquidity pool. At the same time, the LP token from the liquidity pool earns you CRV tokens as a reward for staking. By using LP tokens, your liquidity works double-time — earning fees and farming yields.