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LP Tokens Explained

  • What are LP Tokens

LP tokens or liquidity provider tokens are tokens that are issued to liquidity providers, who make their digital assets available to the AMM protocol on a decentralized exchange (DEX). By using smart contracts, you will receive these LP tokens in your wallet immediately after the transaction. These serve as a kind of proof of ownership that you have contributed to add liquidity.

As soon as you add liquidity to a pool, you get LP tokens in return. For example, if your stake is 1% of the entire pool, you will receive 1 LP token, if there are 100 LP tokens in total. Your investment is translated into a percentage of liquidity in the pool. Keep in mind that you can always lose money and your investment is not necessarily stored in the LP tokens. Your percentage of liquidity of the pool is stored in the tokens.

Example: You decide to add liquidity on PancakeSwap and you do this by depositing CAKE and BNB into a liquidity pool. For this you will receive CAKE-BNB LP tokens. Thus, the number of LP tokens you receive for this represents your share of the liquidity pool of the trading pair CAKE-BNB. Then when someone trades on PancakeSwap, he or she pays a percentage fee for this trade. Part of this is added as liquidity, and you receive the remaining share as a reward.

These LP tokens represent your share of the pool. You can not trade with these LP tokens. The value of LP tokens is also less relevant. After all, you always exchange it for your underlying liquidity. However, what is possible is to use these LP tokens to achieve even more returns by depositing them in vaults or farms.

  • The value of LP tokens

Although the value of your LP token is less interesting, it is useful to know how to determine this value. You can do this via various online tools, but it can also be done via manual calculation. To determine the value of your LP token, take the total value of the pool and divide it by the number of LP tokens in circulation. You can also check this via EtherScan if you’re providing liquidity on the Ethereum blockchain. If they take place on the Binance Smart Chain, you can visit https://bscscan.com/.

  • Sell ​​LP Tokens

Selling your LP tokens is done in the same way as buying them. After participating in a liquidity pool, you have received these LP tokens and are stored in your MetaMask or TrustWallet. You can sell them at any time. Go to the decentralized exchange where you provided liquidity and go to the relevant pool.

When you’ve added liquidity, the pools you’ve contributed to will automatically load. Here you can choose to sell your LP tokens again. When you do this, you sell your position in the liquidity pool and receive your tokens.

You can sell your LP tokens by re-entering the platform and into liquidity. The pools you participate in automatically load here. In the example of BNB-CAKE, you can immediately recover the liquidity. Confirm that you want to withdraw 100% of your liquidity from this pool and your request will be sent. Within minutes you will receive proof that you are officially no longer a liquidity provider. From now on you will no longer have LP tokens, but separate BNB tokens and CAKE tokens.

  • Yield Farming

Yield Farming is a very attractive reason for many to make the switch to decentralized finance. Beyond the decentralization aspect, we cannot deny that astronomical interest rates affect us. On the contrary. After adding liquidity, we received these LP tokens, and we can sometimes use them to get extra returns. Characteristic of DeFi is the use of APY, which stands for Annual Percentage Yield, whereby compound interest is used. In contrast to the traditional interest rate, this is very attractive and is often used in combination with liquidity providing. In the protocol you can often stake these LP tokens to get extra rewards.

  • Risks

Adding liquidity is not entirely without risks. Of course, the risks with stablecoins are much less than with other digital assets. The greater the risk, the greater the interest. Despite the less attractive percentages, adding liquidity based on two stablecoins can be a good investment, provided you are currently not getting returns on your currency anywhere else.

  • Impermanent losses

The biggest risk with DeFi is the chance of an impermanent loss. This is a term that you have most likely already come across and that everyone is warning you about. Impermanent loss refers to the chance of a temporary drop in the value of your currency due to the volatility in a trading pair. You should never underestimate the volatility of crypto.

  • Conclusion

LP tokens play an important role in DeFi. They act as a proof of ownership for liquidity providers who have deposited their tokens into a liquidity pool. If it wasn’t for these liquidity providers, DEXs wouldn’t be able to function and investors were only able to trade their crypto on regular centralized exchanges.