LP tokens are rewarded to users who provide crypto assets to a DeFi platform, and sometimes include benefits when it involves staking and yield farming.
Summary
In the absence of centralized market makers, decentralized finance (DeFi) platforms must offer incentives to encourage liquidity provider (LP) participation. Many DeFi protocols offer LP tokens that represent a crypto liquidity provider’s share of a pool. Many LP tokens are often utilized in staking, yield farming, governance, lending, and interest-bearing financial products while the underlying liquidity remains locked up. Well-known samples of decentralized exchanges (DEXs) that make use of LP tokens include SushiSwap, Curve, Balancer, and Kyber Network.
What Are Liquidity Provider Tokens?
Liquidity could be a fundamental concept in decentralized finance (DeFi), a sector that’s powered by decentralized exchanges (DEXs) and lending platforms that operate via automated functions designed to assist promote decentralization and equitable business models. Integral to the function of DEXs is “liquidity” which refers to how easily one asset will be converted to a different. within the absence of centralized market makers, DeFi platforms generally seek to supply incentives to encourage liquidity provider (LP) participation. Many DeFi protocols have begun offering multifunctional LP tokens, which help solve the matter of crypto market liquidity by incentivizing users to produce the platform with available crypto assets.
Typically, liquidity providers receive LP tokens reciprocally 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 also the liquidity provider remains entirely on top of things of their staked tokens, which are only being lent to the platform’s protocol. When a liquidity provider wants their liquidity back, they have to burn their LP tokens to receive their original crypto assets, additionally 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 up to the mark of your assets and may redeem them at any time. The LP tokens that are created vary in their use cases betting on the platform.
Examples of Crypto Liquidity Provider Tokens
LP tokens can function as proof that you just have lent crypto assets to a DeFi liquidity pool, in which the tokens must be burnt to urge your assets back. However, in many cases, LP tokens can even be accustomed to unlocking new layers of access or yield farming opportunities within a DeFi platform. Below are some samples of LP tokens utilized by a number of the world’s leading DeFi platforms:
1inch: Crypto liquidity providers using the 1inch DeFi DEX aggregator accrue interest from platform trading fees within the sort of the 1INCH token, no matter the 1inch pool to which they supply liquidity. These 1INCH tokens also function as the platform’s governance token, which implies that holding 1INCH tokens comes with proportional voting rights in 1inch’s decentralized governance administration.
Uniswap: Uniswap liquidity providers are rewarded with fungible ERC-20 LP tokens, which makes the tokens composable across the broader Ethereum-based DeFi ecosystem. As a result, although there are generally no direct markets for getting and trading LP tokens themselves, LP tokens like Uniswap’s will be used as collateral in lending protocols like Aave or MakerDAO. It’s important to notice that Uniswap liquidity provider tokens aren’t identical to UNI governance tokens, which are accustomed vote on new proposals and other types of decentralized decision-making.
SushiSwap: SushiSwap liquidity providers receive ERC-20 SushiSwap Liquidity Provider (SLP) tokens related to the particular asset they need to be deposited. For example, if a user deposits DAI and ETH into a pool, they’ll receive DAI-ETH SLP tokens. These SLP tokens can then be deposited into a delegated DAI-ETH SLP liquidity pool to get SUSHI, SushiSwap’s platform governance token.
Curve: Liquidity providers leveraging the AMM Curve receive a token-specific LP token instead of an LP token tied to a trading pair. as an example, if a user lends ETH to the Compound DeFi platform, it’s exchanged for a liquidity token called cETH, which automatically accumulates interest for the holder. additionally, to allow Curve’s crypto liquidity providers the correct to withdraw their ETH plus interest from Compound, Curve users are ready to stake their cETH in other liquidity pools to get passive yields and CRV (Curve’s governance token). These LP tokens thereby allow users to realize an extra layer of utility and potential profits from their initial investment.
Balancer: Balancer is an AMM protocol that allows liquidity pools made 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 spread of reserves, including token holders, market makers, and DEXs, into one 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 ineligible 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 over 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 don’t seem to be specifically designed to be traded or sold, many open up new avenues for added 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 correct functioning and growth of DeFi platforms. Succeeding within the financial industry generally requires effective ways to leverage existing capital, and thereto end, LP tokens help provide a useful service by broadening the extent to which DeFi users can engage with decentralized lending, yield generation, and governance.
