Familiar with the concept of liquidity but don’t know how liquidity provider tokens work? Don’t worry, we’ve got you covered. Let’s dive in!
Decentralized finance has become a topic of global attention with the promises it holds for transforming finance. For example, decentralized exchanges or DEXs based on Ethereum blockchain have evolved as interesting means for exchanging crypto tokens effortlessly. Within just one year, more than $100 billion of cryptocurrency is locked in DeFi protocols.
As of now, the most successful decentralized exchange is Uniswap, which has more than $9 billion of crypto assets as stakes for liquidity. What does liquidity have to do with DeFi? Do you know how liquidity provider tokens work? All of these questions are obvious for any individual trying to explore the practical use cases of DeFi. The following discussion will help you understand the working of liquidity providers and liquidity provider tokens or LP tokens comprehensively.
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Why Do You Need Liquidity?
The first thing that comes to mind when thinking about how LP tokens work would be the specific factors responsible for driving the demand for liquidity. DeFi skyrocketed in popularity and adoption during the COVID lockdown in 2020. As of now, the total value locked in DeFi protocols easily exceeds $200 billion by a healthy margin. Among the many successful DeFi solutions, Uniswap, a decentralized crypto exchange, has shown promising growth with more than $9 billion worth of crypto assets locked in the platform. A closer reflection on Uniswap would provide the ideal answer for queries about the need for liquidity.
Uniswap serves as the foundation of Ethereum blockchain and leverages smart contracts for holding crypto assets in liquidity pools. Investors could trade cryptocurrencies directly from these liquidity pools. You should also note the possibilities of earning transaction fees by providing liquidity to decentralized exchanges like Uniswap. How? This is where you must find out how liquidity provider tokens work in liquidity pools of decentralized exchanges. The ETH-USDC liquidity pool on Uniswap could help investors earn transaction fees which are almost equal to 25% annual interest rate on their investments.
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Understanding Liquidity Pools and Liquidity Provider Tokens
If you have been following the DeFi ecosystem closely, then you must have heard about the term Automated Market Maker or AMM at some point in time. AMM platforms such as Uniswap, Balancer, and Curve are the focal aspects in the rapidly evolving decentralized finance or DeFi ecosystem.
Most important of all, AMMs represent a completely new and transformed approach for trading in the general perspective. What are AMMs? Automated Market Makers create markets where users don’t have to depend on other parties for carrying out a transaction. For example, if you want to swap your Bitcoins for Ether on an AMM system, you don’t have to wait for an Ether owner to carry out the transaction.
On the contrary, the AMM system utilizes a key function known as Liquidity Provider token or LP token. So, what is a liquidity provider? Liquidity providers are actually the investors locking their crypto assets on decentralized exchanges for earning transaction fees. The LP tokens are an important aspect in ensuring liquidity for decentralized exchanges. Most important of all, they ensure that AMMs are non-custodial and don’t hold onto your tokens. As a matter of fact, you may wonder about questions like “how do liquidity providers work crypto?” with AMMs.
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Working of Liquidity Provider Tokens
The liquidity provider tokens or LP tokens are a mandatory highlight of new DEXs based on the Automated Market Maker System. They ensure that AMMs are non-custodial. So, you can notice that LP tokens work without allocating the control of your crypto assets to the DEX. On the contrary, LP tokens work through automated functions, which can drive fairness and decentralization. Subsequently, liquidity provider tokens could also open new avenues for trading and accessing tokens throughout the DeFi ecosystem. The non-custodial trait in AMM platforms is one of the foremost highlights for which they are in the DeFi ecosystem.
You can understand how liquidity provider tokens work by taking note of the fact that you are in control. Liquidity providers get the LP tokens in return for providing assets in the liquidity pools and staying in control of their tokens. It is also important to note that an autonomous code supports the management of the liquidity pool. Without any manual intervention, the liquidity pools provide the assurance of fairness. In addition, the LP tokens also represent the share of the liquidity provider in a specific pool. At the same time, you should also note that the liquidity providers are entirely in control of their LP tokens.
The equal distribution of LP tokens according to the contribution of liquidity providers is a unique highlight in how LP tokens work. If you are contributing $100 USD worth of assets in a Uniswap pool which has a total value of $1000, then you would receive 10% of the LP tokens for the pool. The liquidity provider tokens represent your share in the assets in the liquidity pool. The LP tokens give you complete control over your assets and freedom to withdraw them according to your preferences.
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Applications of Liquidity Provider (LP) Tokens
If you want to find answers to “how do liquidity providers work crypto?” you should also understand the applications of LP tokens. As a liquidity provider, you can leverage your LP tokens for distinct use cases. One of the foremost value propositions associated with LP tokens refers to improvements in liquidity. The other helpful approach for leveraging LP tokens is yield farming. Let us see how LP tokens work for improving liquidity in DeFi and facilitating yield farming.
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Liquidity Provider Tokens and Liquidity
Liquidity is an inevitable requirement in the DeFi space, which can support the conversion of one asset to another without any drastic fluctuations in the price of the asset. In the case of traditional finance, you can find that cash is the most prominent asset with high liquidity. On the other hand, you cannot find easy ways to convert cash into crypto.
Before the arrival of liquidity provider tokens, it was practically impossible to access Ethereum-based tokens. Generally, users had to lock in their assets in the Ethereum ecosystem during the period of use. It was practically impossible for token owners to access their tokens when they were in use.
Before you understand how liquidity provider tokens work, you should identify how tokens are locked up upon staking, generally as a part of governance mechanisms. The Proof-of-Stake or PoS mechanism of Ethereum 2.0 requires token owners to stake their assets in the platform.
ETH owners have to lock their assets in the platform for validating and adding new blocks for earning rewards. In such cases, you can find a stark difference in how LP tokens work. Staking a token in Ethereum basically meant that you couldn’t use it for other purposes. As a result, the liquidity of the system drops down radically.
However, a closer look at how liquidity provider tokens work in AMM-based systems could help you find how they solve the issues of liquidity in DeFi. The interesting fact about LP tokens is that you can use the same tokens multiple times. It doesn’t matter whether you have your tokens locked in a platform governance mechanism or a DeFi solution. LP tokens work by opening up the avenues for indirect staking, which can resolve the issues of limited crypto liquidity. How? LP tokens allow you to prove your ownership of tokens, thereby widening the prospects for using your tokens rather than staking them.
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Yield Farming Prospects
Liquidity providers are also useful instruments for enabling yield farming capabilities in DeFi solutions. Decentralized finance or DeFi is a rapidly evolving space, and a detailed understanding of answers to “how liquidity providers work crypto?” can open up more details about LP tokens. Irrespective of their names across different platforms, LP tokens serve as mathematical proof of your contributions to a liquidity pool. Now, you should also take note of another interesting term in the DeFi space, i.e., yield farming.
Yield farming and LP tokens are closely related if you try to investigate how LP tokens work in depth. Yield farming basically involves depositing tokens in various DeFi solutions for improving earnings from the stakes. You can move tokens between different protocols for maximizing profits. However, using LP tokens and yield farming together has slowly started to gain attention. For example, you can farm for the CRV token on the Curve protocol by using DAI tokens. LP tokens could let your liquidity work for you by earning transaction fees as well as farming yields for you.
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Final Words
The clear overview of how liquidity provider tokens work presents a thorough overview of the potential of DeFi. Liquidity providers are an inseparable aspect of the emerging DeFi landscape, which relies largely on decentralized exchanges such as Uniswap and Balancer. Liquidity providers stake their assets in liquidity pools on these exchanges or other DeFi solutions. The liquidity pools offer the necessary resources for other traders and users on the platform to carry out transactions.
Now, the liquidity providers can exercise their claim over shares in fees for transactions in the liquidity pool. This is where liquidity provider tokens are important. LP tokens show how much you have put in a pool, and the code would decide how much you should get from transaction fees for your contributions. Learn more about DeFi and liquidity provider tokens in detail clearly right now.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!
