Liquidity Provider Tokens for DeFi & DEXs: An Overview

What Are Liquidity Provider Tokens?

is a fundamental concept in , a sector that is powered by and lending platforms that operate via automated functions designed to help promote 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 , DeFi platforms generally seek to offer incentives to encourage liquidity provider (LP) participation. Many DeFi protocols have begun offering multifunctional , which help solve the problem of crypto market liquidity by incentivizing users to provide the platform with available crypto assets.

Typically, receive LP tokens in return for providing cryptocurrencies like to a DeFi platform’s . LP tokens represent a crypto liquidity provider’s share of a pool, and the liquidity provider remains entirely in control of their tokens, which are only being lent to the platform’s protocol. When a liquidity provider wants their liquidity back, they must 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 to be , 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 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 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 , which means that holding 1INCH tokens comes with proportional voting rights in 1inch’s administration.

Uniswap: liquidity providers are rewarded with fungibile LP tokens, which makes the tokens across the broader -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 or . It’s important to note that Uniswap liquidity provider tokens are not the same as , which are used to vote on new proposals and other forms of decentralized decision-making.

SushiSwap: liquidity providers receive ERC-20 associated with the specific asset they have deposited. For instance, if a user deposits 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 receive a token-specific LP token rather than an LP token tied to a . For instance, if a user lends ETH to the DeFi platform, it is exchanged for a liquidity token called , 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 (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: 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 . Some projects that are built on top of Balancer pools require users to stake BPT tokens to earn rewards.

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.