The basics of providing liquidity

The top cryptocurrencies like Bitcoin (BTC) have highly liquid markets where traders can buy and sell with little worry that the price will change significantly as a result of their actions. The same can not be said for smaller projects that are less well-known and only available on a limited number of centralized exchanges.

This is where DeFi can make a tremendous difference as listing those tokens on a decentralized exchange (DEX) can expose them to a much wider trading audience and help increase their trading volumes. In order to do that, the DEX requires a liquidity pool where the token in question is paired with another token, such as a stablecoin like USDC, that can be used to fund token swaps that take place on the exchange.

Since there are no centralized market makers to fund LPs, users in the community can contribute an equal ratio of each token to the pool in exchange for receiving a share of the trading fees generated by that pool that is proportional to their contribution. 

This setup allows a person interested in trading the token in question to do so at any time, day or night, without the need for a counter-party willing to take the trade.

It should be noted that just because there is a liquidity pool for an asset pair, there is no guarantee that it will have a lot of liquidity as not all tokens have a high level of interest and willingness to risk the possibility of impermanent loss.

How do LP tokens work?

Once a user deposits the required pair of tokens into a liquidity pool, they will receive an LP token as proof of their deposit. In order to retrieve the supplied liquidity plus any interest or rewards gained, the LP token is required. If a user loses access to their LP token, they will be unable to retrieve their share of the liquidity pool.

LP tokens are automatically deposited into the wallet that contributed funds to the liquidity pool, and users may need to add the LP token’s smart contract address to their crypto wallet in order to see them. In most cases, LP tokens can be transferred between cryptocurrency wallets as a way to transfer ownership, but this should be verified with the liquidity pool service provider just to be on the safe side.

Some DeFi protocols also offer users the ability to earn an extra yield by depositing their LP tokens on the protocol in question, but it should be noted that this adds an extra layer of risk that each user needs to make sure they are comfortable with.

LP tokens are only granted to liquidity providers, and they can be obtained on a platform that utilizes an LP system including yield farming protocols, automated market makers (AMMs), borrowing and lending platforms and decentralized exchanges.

The token symbol for LP tokens is generally some combination of the two tokens that comprise that liquidity pool, such as BTC-USDT LP or SOMA-USDC LP.

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How can LP tokens be utilized?

As mentioned above, LP tokens can function as more than just a receipt as there are now multiple ways they have been integrated into DeFi to allow their hodlers to earn an extra yield. Some of the available options include:

• Use as a transfer of value - Since the underlying assets have a known value, LP tokens can be used as a way to transfer the ownership of that underlying value.

• Use as collateral for a loan - Some DeFi platforms accept LP tokens as a form of collateral to take out a loan. This allows an LP token holder to tap into the underlying value while also being able to earn a yield for supplying liquidity.

• Earn a compounding yield - Yield farms allow users to deposit LP tokens in a yield compounder which regularly harvests the earned rewards in order to purchase more of the token pair and deposit it back into the liquidity pool.

What are the risks associated with LP tokens?

1. Smart contract failure - If the smart contract for a liquidity pool is compromised or has a fatal flaw, it's possible that the LP tokens may be unable to retrieve their underlying liquidity, in which case it will remain permanently locked in the pool.

2. Loss or theft - If a user loses their LP token, they will lose access to their share of the liquidity pool and any interest earned.

3. Opportunity risk - There is an opportunity cost associated with any time the control over a crypto asset is relinquished. In some situations, there may be other, more lucrative opportunities where tokens can be invested.

4. User confusion - There is no set standard for how LP tokens are measured out, so it can sometimes be a challenge for an LP token holder to know exactly how much their tokens are worth.

5. Impermanent loss - Volatile swings in prices can sometimes result in an LP provider being stuck with a larger amount of an asset that has significantly depreciated, which means that the value of the assets represented by their LP token may be less than the value they originally contributed.

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