Liquidity provider (LP) tokens are a fundamental part of liquidity pools. They help automate liquidity pools and consequently, many DeFi functions. They also allow users to earn rewards from the tokens they hold.
LP tokens are one of the best examples of how TradFi activities can be executed in a permissionless and automatic way, without third-party intermediaries.
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Solving DeFi’s liquidity problem
Lack of liquidity is one of DeFi’s most significant problems. When a market is low in liquidity, the traders in that market encounter a phenomenon called ‘slippage’, i.e., the difference between the expected price and the executed purchase or sale price.
For instance, you may sell a token at a certain price level but if there are not enough buyers at that level, you will not receive the original price you set. Now, if the market has zero liquidity, there will be no counter-parties to execute a trade.
Automated market makers (AMMs) solve this problem by creating liquidity pools involving various token pairs to facilitate swapping from one token to another. These liquidity pools receive tokens from liquidity providers, who are incentivized by LP tokens to do so.
What are LP tokens?
As liquidity pools rely on LPs to operate effeciently, it is necessary to incentivize LPs to stake their tokens in these pools. In this case, the incentivization comes in the form of LP tokens.
New LP tokens are generated automatically when users stake their tokens in liquidity pools. Every user who stakes token pairs in a liquidity pool receives a number of LP tokens based on the amount they supplied to the pool.
Thanks to a token distribution system that rewards native LP tokens, LPs are incentivized to hold these tokens in liquidity pools. Each time a trade takes place within the liquidity pool, it distributes a part of the fees (depending on the pool’s rules) proportionally to LP token holders.
For example, if a pool holds 1,000 USD worth of tokens and your portion is worth 100 USD, you will receive 10% of all generated fees as a reward.
Once the LP transfers their stake back, the system destroys their LP tokens to stabilize the reward mechanism in accordance with the new number of LPs. And because of crypto’s permissionless environment, anyone can become an LP.
Conversely, anyone can end the stake and remove tokens from the pool. To summarize, LP tokens function as proof that a user has provided a liquidity pool with tokens, and the user can then use the same LP tokens to reclaim their deposited tokens.
In addition, LP tokens can be used for various functions on the liquidity pool’s native platform and other dApps. One such example is yield farming, which allows putting LP tokens to work to earn even more revenue.
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