Liquidity Provider Tokens for DeFi & DEXs: An Overview

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.