Today, virtually all DeFi market participants have heard of liquidity pools, which are digital collections of funds locked in smart contracts. The term liquidity pool token (sometimes referred to as Liquidity Provider Token) may still require clarification of their role. This article takes a close look at this class of tokens and their position in the market.
LP Token: General information
If you ask us to explain the working principle of LP tokens as simply as possible, we will say that they work like “receipts”. When you buy something from a store, you get a receipt that proves you made a purchase. This is what happens in liquidity pools. When you deposit tokens into a pool, you receive LP tokens as proof of your deposit.
Learn more about the mechanism behind liquidity pools here. And here you will find details about the idea of the Automated Market Maker.
In other words, LP tokens are crypto coins generated by a DEX that liquidity providers receive after lending their digital assets to a pool. Sushi, PancakeSwap, and Uniswap are among the most well-known DEXs that distribute LP tokens.
Typically, such tokens are sent to the same wallet you used to provide liquidity. In order to see liquidity pool tokens in your cryptocurrency wallet, you sometimes need to add the LP tokens smart contract address.
LP tokens are usually of the same type as those used in the pools. For example, Sushi and Uniswap are Ethereum-based platforms, and users who select their pools to stake will receive ERC-20 LP tokens.
The amount of LP tokens received is equal to your share of the pool. This means that in the future based on your LP tokens you can call your share, which represents your deposit minus temporary losses and your profits. These profits include the percentage of fees charged for all trades on the platform. The amount of these fees, and consequently your income, may vary according to the rules approved by each pool. For example, Sushi offers a 0.25% fee on all trades, proportional to your stake. Liquidity providers on Uniswap can benefit from a 0.30% fee proportional to their contribution.
If you lose your LP tokens, your share of the pool will be lost. Only by holding your liquidity pool tokens can you be sure that your deposit is safe and you can claim your share back. The situation is similar to traditional receipts.
Typically, users are allowed to transfer LP tokens from one wallet to another, which means they are moving ownership. However, some liquidity providers have different rules and the transfer of LP tokens may result in the loss of provided liquidity. For this reason, it is highly recommended to study the rules of the chosen pool very carefully before making any decisions about the transfer of such tokens.
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