Introduction
While most decentralized finance (DeFi) users are well-acquainted with liquidity pools, the significance of LP tokens is often overlooked. However, these crypto assets serve purposes beyond the simple provision of liquidity. Although utilizing LP tokens in other applications carries risks, viable strategies exist to extract additional value from these unique assets.
Liquidity Provision
At its core, liquidity is the ease of trading an asset without causing substantial price fluctuations. Cryptocurrencies like Bitcoin (BTC) exemplify highly liquid assets that can be sold across numerous exchanges in varying quantities without significantly impacting their prices. However, not all tokens possess such desirable liquidity characteristics.
In the context of decentralized finance (DeFi) and smaller projects, liquidity may be limited. For instance, a coin might only be available on a single exchange, making it challenging to find suitable buyers or sellers to match one's trading order. The liquidity pool model, known as liquidity mining, offers a potential solution to this predicament.
A liquidity pool comprises two assets that users can seamlessly swap between. It eliminates the need for market makers, takers, or order books, as the asset ratio within the pool determines the price. Users who contribute the token pair to the collection, enabling trading, are called liquidity providers. These providers charge a small fee for users who use their tokens in swaps.
Thus, when we discuss liquidity provision, we are specifically referring to offering assets to a market, focusing on DeFi liquidity pools and LP tokens. It is important to note that a liquidity pool for a particular asset pair does not guarantee abundant liquidity. Nevertheless, a liquidity pool ensures that trading can always occur without relying on finding someone to match an order.
The Mechanics of Liquidity Pool (LP) Tokens
When an individual deposits a token pair into a liquidity pool, they receive LP tokens as a form of "receipt." These LP tokens represent the contributor's share of the pool and grant them the ability to reclaim their deposit and any accrued interest. Hence, the safety and security of one's deposit heavily rely on retaining possession of the LP tokens. Losing these tokens would result in the forfeiture of one's share.
LP tokens are typically stored in the wallet used for liquidity provision. To view the LP tokens in your crypto wallet, adding the smart contract address associated with the LP token may be necessary. Although most LP tokens within the DeFi ecosystem can be transferred between wallets, allowing for ownership transfer, it is advisable to consult the liquidity pool service provider for specific guidelines. Transferring tokens may sometimes lead to a permanent loss of the liquidity provided.
Acquiring Liquidity Pool Tokens
LP tokens are exclusively granted to liquidity providers. One must engage with a DeFi decentralized application (DApp) that facilitates liquidity provision to obtain LP tokens, such as PancakeSwap or Uniswap. The issuance of LP tokens is a common feature across various blockchains, DeFi platforms, automated market makers (AMMs), and decentralized exchanges (DEXs).
However, if liquidity pool services are utilized within a centralized finance (CeFi) setting on an exchange, it is unlikely that LP tokens will be received. Instead, the service provider responsible for custody services typically holds these tokens in custody.
LP tokens usually bear the names of the two tokens involved in the liquidity provision process. For example, in a PancakeSwap liquidity pool where CAKE and BNB are contributed, the LP token will be referred to as CAKE-BNB LP, and on Ethereum, LP tokens are generally recognized as ERC-20 tokens.
Utilizing Liquidity Pool (LP) Tokens
While LP tokens function as receipts, their utility extends beyond proof of ownership. In DeFi, these tokens present opportunities to leverage assets across multiple platforms, allowing for a synergistic combination of services.
Transferring Value: A straightforward use case for LP tokens is transferring ownership of the associated liquidity. Although certain LP tokens may be bound to specific wallet addresses, most tickets can be freely shared. For instance, one could send BNB-wBNB LP tokens to another party, enabling them to withdraw the BNB and wBNB from the liquidity pool. However, manually calculating the number of tickets in the collection can be challenging. In such cases, DeFi calculators can assist in determining the staked token quantity associated with one's LP tokens.
Collateralizing Loans: Given that LP tokens represent ownership of underlying assets, they can serve as collateral. Similar to using BNB, ETH, or BTC as collateral for a cryptocurrency loan, certain platforms enable LP token holders to pledge their tokens as collateral. This arrangement typically facilitates borrowing stablecoins or other high-market-cap assets. To ensure the loan's security, over-collateralization is implemented. Failure to maintain the specified collateral ratio may result in the lender seizing the LP tokens and liquidating the underlying assets.
Compound Yield: A common practice involving LP tokens is depositing them into a yield compounder, often called a yield farm. These services leverage LP tokens by regularly harvesting rewards and reinvesting them to acquire more of the token pair. The compounded LP tokens are subsequently staked back into the liquidity pool, enabling interest compounding. While manual execution of this process is possible, yield farms typically offer more efficient compounding than individual users. Yield farms optimize the overall returns by sharing transaction fees and implementing multiple daily compounding cycles, depending on the chosen strategy.
Risks Associated with LP Tokens
Similar to any other token, LP tokens entail certain risks, including:
Loss or Theft: Misplacing LP tokens lead to the forfeiture of one's share in the liquidity pool and any accumulated interest.
Smart Contract Vulnerabilities: If the liquidity pool being utilized experiences a compromise due to a smart contract failure, the LP tokens may no longer be capable of returning the contributed liquidity. Likewise, if LP tokens are staked with a yield farm or loan provider, the failure of their respective smart contracts could jeopardize the tokens' value.
Uncertainty Regarding Value: Assessing the precise value of LP tokens can take time and effort. Diverging token prices can result in impermanent loss, and accounting for interest further complicates matters. These uncertainties make it difficult to make informed decisions regarding the optimal time to exit a liquidity position.
Opportunity Cost: One inevitably incurs an opportunity cost by allocating tokens to liquidity provision. In some instances, alternative investments may yield greater returns or provide different opportunities worthy of consideration.
Closing Remarks
When engaging in liquidity provision for a DeFi protocol's liquidity pool, it is essential to consider the potential uses of LP tokens—depositing tokens into a liquidity pool marks only the initial step in a broader DeFi strategy. Therefore, aside from the traditional HODLing approach, evaluating investment plans and risk tolerance is prudent to determine if additional investment avenues align with one's objectives.
