At central exchanges such as Binance and Kraken, investors trade their fiat money in exchange for crypto, or they trade between different crypto trading pairs. However, these trades are only possible because there is sufficient liquidity on such exchanges. In decentralized finance (DeFi), there are no central exchanges and all trading is done through decentralized exchanges, better known as DEXs. These DEXs need liquidity before you use them to trade tokens. Once you provide liquidity to a specific liquidity pool (trading pair), you will receive LP tokens in return. But what are LP tokens and how do they work? Let’s find out in this post!
- Decentralized exchanges
Before we delve deeper into LP tokens, it is important to know the distinction between a central and a decentralized exchange. As the word implies, central exchanges are centrally controlled and usually also have sufficient volume and liquidity to enable trades on their platform. Note that you will always trade one digital asset for another. For example, you can buy Bitcoin (BTC) with fiat money, but you can also buy Bitcoin with Ethereum (ETH). This is all possible because there is sufficient volume on the central exchange.
In DeFi, things work differently. Traders depend on decentralized exchanges (DEXs), which in turn depend on investors. That’s right, they depend on the liquidity that investors lock in the protocol. To enable traders to swap tokens and to keep token pairs in balance (for example, a 50:50 ratio), decentralized exchanges use automated market makers (AMMs).
- Automated Market Maker (AMM)
An order book is used on central exchanges. You can place limit orders so that you can buy or sell assets at a certain fixed price. This price is determined by the buying or selling volume, also known as supply and demand. An AMM is, among other things, highly dependent on the liquidity of the protocol.
An AMM works in the same way as an order book in that there are trading pairs, the only difference being that you don’t need a counterparty to execute the trade. Suppose you are willing to buy Bitcoin at a price of $35,000. This transaction can only be executed when someone is willing to sell Bitcoin at this price. Instead, an AMM works with smart contracts that enable all these transactions. We no longer speak of peer-to-peer transactions (P2P), but of peer-to-contract (P2C) transactions.
Each decentralized exchange is in turn dependent on the liquidity on the platform. The more liquidity and trading pairs available, the more attractive it is for an investor to complete his or her trade in this protocol. Liquidity is also a factor that is built up over the years. This is accompanied by possibilities and trust, among other things. Let’s take a look at the liquidity of the most famous DEXs:
UniSwap was the first AMM and version V1 was launched in November 2018. If we consult the statistics at the top of the menu, we see that there is a total volume of more than 2 billion dollars.
PancakeSwap is the decentralized exchange built on the Binance Smart Chain (BSC). At the time of writing, PancakeSwap has total liquidity of no less than $4.69 billion. But not every DEX has that much liquidity. According to CoinMarketCap, there are now 70 decentralized exchanges and new ones are added regularly. And how does a DEX try to be successful? By guaranteeing sufficient liquidity.
- Providing liquidity
A decentralized exchange is therefore dependent on liquidity. And this comes from investors because they in turn are going to provide their liquidity. The protocol promises very attractive interest rates for liquidity providers when they offer their digital tokens in the protocol. This makes it easier for others to trade and, in addition to this attractive interest, the liquidity providers usually also receive part of the transaction costs that are made on the platform.
Adding liquidity to a protocol is always based on a trading pair with a ratio of 50:50 in value. Suppose you want to add 0.5 ETH to a pool, with the stablecoin DAI as another asset. Suppose the price of Ethereum is currently at $2500, so 0.5 ETH is equivalent to $1250. This means that you still have to add $1250 to DAI. But how does the protocol know who added what? This contribution is paid out by means of LP tokens.
With the new update of UniSwap V3, it is no longer necessary for this split to be 50-50. It is possible to set a range to deviate from this ratio. With UniSwap V2, this ratio still applies.