What are liquidity provider (LP) tokens, and how do they work?

Other than representing a claim of one’s assets, LP tokens can be used across multiple DeFi platforms in ways that can accrue the investment’s value.

How do LP tokens gain value? They gain value as a fundamental component of DeFi, contributing to the smooth operation of the DEXs and AMMs used by these DApps. 

One primary source of passive income for liquidity providers is the share of transaction-generated fees earned by the liquidity pool in proportion to their investment share.

There are other use cases and streams of revenue for LP tokens. Here’s an overview of the main ones.

Collateral in a loan

Some cryptocurrency platforms, like Aave, allow liquidity providers to use their LP tokens as collateral to secure a crypto loan. Crypto lending has become a substantial component of DeFi, allowing borrowers to use their crypto as collateral and lenders to earn interest from their borrowers. 

LP tokens used as collateral are still an emerging trend, and only a few platforms offer the service. Such a financial tool is highly risky, and if a certain collateral ratio is not kept, borrowers may lose their assets by being liquidated.

Yield farming

Yield farming is the practice of depositing LP tokens in a yield farm or compounder to earn rewards. Investors can move their tokens manually using different protocols and receive LP tokens when they deposit them on another platform. 

Alternatively, they can use the liquidity pools of protocols like Aave or Yearn.finance, which help liquidity providers earn compounded interest more efficiently than humans.

Such a system allows users to share expensive transaction fees and use different compound strategies according to the effort and time they want to dedicate to this type of investment. One example of a compound strategy is lending out cryptocurrency on a platform that pays interest, and then reinvesting that interest back into the original cryptocurrency to potentially increase returns. Another example is using an algorithmic trading strategy to automate buying and selling of assets to generate profits that can be reinvested.

LP staking

Liquidity providers can stake their LP tokens to gain extra profit. It occurs when users transfer their LP assets to an LP staking pool in exchange for rewards of new tokens, just like how the bank pays interest on a savings account. It also incentivizes tokenholders to provide liquidity. Early stakers in a project can earn a very high annual percentage yield (APY), which decreases as more LP tokens are staked in the pool. 

Where to stake LP tokens 

LP tokens function the same way as other tokens supported by a blockchain network. For example, tokens issued on an Ethereum-based platform like Uniswap is an ERC-20 token and can be staked like any other token of the same kind.