In our earlier blog posts, we explained the concept of decentralized finance (DeFi), top DeFi platforms, yield farming, Ethereum token standards, and many more. We also discussed the difference between centralized and decentralized exchanges and the concept of automated market makers (AMM) also known as the backbone of decentralized exchanges.
Delving a bit deeper into the working of decentralized exchanges, today we’ll understand the concept of LP tokens also known as liquidity provider tokens. So what are these tokens, how do they benefit the DeFi ecosystem and facilitate yield farming? So let’s start, shall we?
Understanding LP Tokens
To understand LP tokens, we first need to take a step back and refer to our blog post titles – What are Automated Market Makers?
In the blog post, we explained that an automated market maker basically allows traders to buy and sell cryptocurrencies using an algorithm that automatically measures and dictates the price of assets depending on the demand and supply. So with the case of AMMs, users trade directly with a pool of assets rather than with other users. Hence, removing the need for a coincidence of mutual demand while trading crypto assets.
In simple terms, users deposit a pair of assets (for example ETH & DAI) in a liquidity pool, thus allowing traders to swap these two assets with ease. Such users who provide liquidity to these pools are called liquidity providers. In exchange for providing liquidity, these users earn rewards in the form of trading fees charged to traders when they swap their tokens. Now, here comes the concept of liquidity provider tokens.
Liquidity provider tokens can be defined as the claim to a share of assets in a liquidity pool. When a user deposits a pair of tokens to a liquidity pool, they receive LP tokens as their claim on assets in the given pool. Thus allowing liquidity providers to remain in control of their assets and have mathematical proof of their ownership.
How Does it Work?
So, let’s say you provide a pair of tokens in total worth $100 to a liquidity pool that has a total worth of $1000. In this case, you own a 10% share of the liquidity pool, hence you receive 10% of that pool’s LP tokens.
Now, after a while, if the pool’s worth increases to $1200, you have a claim on $120 worth of assets since you own a 10% share of the liquidity pool. You can simply claim this amount by returning back the LP tokens to the pool. But how do LP tokens benefit the DeFi ecosystem and facilitate yield farming opportunities?
Well, LP tokens are basically tokenized versions of liquidity that can be traded across DeFi protocols. Thus it benefits the ecosystem by allowing cross-protocol liquidity movement and opening gates to earn additional yields for traders to deposit and stake these LP tokens on different DeFi platforms.
For example, users can earn LP tokens by depositing DAI to Curve’s crypto liquidity pool and stake these LP tokens in the Curve’s staking pool to earn CRV tokens. Thus earning double interest – rewards from the liquidity pool as well as from the staking pool.