Optimizing the economic utilization of LP tokens
1Pool.finance’s mission is optimizing the use cases of Liquidity Provider Tokens ( LP tokens). This article is a brief introduction to LP tokens, their role in decentralized finance and how we think the optimum economic utilization of LP tokens can be further explored.
- What are LP tokens?
- Primary and Standard functions of LP tokens.
- Evolving use cases of LP tokens.
- Use LP tokens as Collateral.
1. What are LP tokens?
LP tokens are tokens issued to liquidity providers on a decentralized exchange (DEX) that run on an automated market maker (AMM) protocol.
Some of the most prominent exchanges that award LP tokens for Liquidity providers are Uniswap, Sushi and PancakeSwap — others include Balancer, Curve etc.
LP tokens allow AMMs to be non-custodial, i.e. the LP provider is in full control of the LP tokens they receive in return for digital assets they provided as liquidity. The exchange does not hold or lock up the LP tokens. The Liquidity provider at any time can swap their LP tokens into the underlying assets. Similarly, they can leave liquidity, but periodically claim the liquidity rewards that entail the LP tokens.
LP tokens are a measure of the liquidity provider’s contribution to the overall size of the liquidity pool. Effectively, it corresponds to each provider’s share in relation to the overall size of the pool.
LP tokens work on the following formula:
Value of 1LP token = Total Value of Liquidity Pool / Circulating Supply of LP Tokens
( Ex: if the pool has 100,000 USD worth ETH and USDT assets and 10 LP tokens in circulation, the value of 1LP token would be:100,000 USD/10 = 10,000 USD
Similarly, if the liquidity provider A’s contribution to the overall pool is 1000 USD worth assets, his share of LP token will be: 1000/ 10,000 = 0.1
Generally, LP tokens are founded on the same blockchain as the related DEX is built on. Effectively, LP tokens of The Ethereum mainnet -based decentralized exchanges such as Uniswap and Sushi are ERC 20 while Binance Smart Chain based Pancakeswap uses BEP 20 token standard.
2. Primary and standard functions of LP tokens can be described as follow:
- It tracks the share of each liquidity provider to the LP pool, and by extension, the amount of liquidity and liquidity rewards due to each liquidity provider.
- It enhances the liquidity of given token pair- Much of the previous DEXes were beset by low liquidity. Whereas the new generation of AMMs has managed to sustain liquidity on par with some of the Centralized exchanges. The impetus is the liquidity rewards. i.e. each liquidity provider is entitled to a share of trade fee, which is distributed proportionately to their share in the Liquidity Pool.
- Enhances decentralization, non-custodial, remove the third party.
3. Evolving use cases of LP tokens
‘Farming’ LP tokens are an increasingly popular new addition to the use cases of LP tokens. Farming in practice means locking LP tokens in pools to receive additional rewards.
For instance, the users of Curve can
- Deposit DAI to Curve’s crypto liquidity pool
- Receive LP tokens
- Deposit received LP tokens to the Curve staking pool
- Receive the CRV token
Alternatively, the users can deposit LP tokens of an AMM into a yield aggregator. Given the profit-seeking nature of the ‘farmers’, it would be the platforms that provide the highest potential yield that would attract the lion share of farmers’ deposits
1Pool for instance enables the LP token holders of Uniswap, Sushi and Pancakeswap to deposit their LP tokens in return for a competitive APY in the industry. Farmers would receive 1POOL tokens as their farming rewards. 1POOL’s token emission, which is geared to slow emission ( 24,000 a week on each blockchain) depress the token supply and downward pressure on the price that is generally associated with platforms with higher token emission rates.
Also, some platforms accept LP tokens for Initial Coin offering, Pancakeswap’s initial farm offering is one such experiment. However, given the high volatility of LP tokens and also associated trust factor such measures also entail substantial risk for the teams that opt for this model.
4. Use LP tokens as collateral
LP tokens are an already established form of the digital asset. The volatility of some of the established LP pairs is no more volatile than their standing alone asset. Therefore, LP tokens in essence have the attributes to be used as collateral to obtain a loan against their value.
That would enable the LP token holders to collateralize their LP tokens in order to take a loan in another digital asset. The lender can use the loan to subscribe to a pre-sale, ICO or purchase a real estate asset.
1Pool.finance is trailblazing in lending and borrowing against LP token-based collateral.
The holders of LP tokens ( for instance Sushiswap LP -SLP DAI/ETH) can deposit their LP tokens to 1POOL lending protocol as collateral and obtain a loan in USDC or ETH. The protocol algorithmically set the interest rate depending on the market supply and demand.
Similarly, the Loan to Value Ratio (LVR) would be adjusted according to the overall size of the LP pool and the market cap of the underlying asset.
LVR would be as high as 75 per cent for established high liquidity LP tokens, while much lower for others.
Automated liquidation would occur if the asset depreciates below the LVR. Liquidation would happen in stages, only sizeable enough to sustain the LVR rate. The lender can provide additional collateral to avoid liquidation, or settle a part of the loan by liquidating a portion of the loan.
1Pool initially accepts LP tokens from established and high liquidity AMMs, Uniswap, Sushi and Pancakeswap. More options would be added later, including open ending LP lending pools, where the users themselves can open lending and borrowing pools for LP tokens.
How the 1Pool lending protocol will arbitrate LP lending and borrowing process would be discussed in detail in a seperate article.
