Liquidity providers (LP) are essential players in the world of finance. They are most useful in stocks, forex, and even the commodities markets. This article will look at the concept of liquidity provider tokens in cryptocurrencies and explain what they are.
What is DeFi?
To understand what LP tokens are, we need first to explain the concept of decentralized finance (DeFi) and how it works. We will also mention the idea of yield-farming, which is an essential concept in the industry.
DeFi is a fast-growing and evolving industry whose goal is to disrupt the world of traditional finance. It is doing this by targeting many existing initiatives. For example, projects like Aave, Maker, and Compound are disrupting the lending industry. In these platforms, people can borrow money against their ERC tokens.
Similarly, decentralized exchanges (DEXs) like Curve Finance, Balancer, and Bancor are changing how people invest and grow their wealth. Other forms of DeFi platforms are derivatives, payments, and assets.
Most of these DeFi platforms work with the so-called liquidity pools (LP). An LP can be viewed as a basket of cryptocurrencies that are locked in a certain smart contract.
These pools are essential because DeFi differs from how centralized finance organizations like banks work. In most cases, banks have liquidity in the form of customer deposits. While rare, publicly-traded banks can raise liquidity from their shareholders.
According to DeFi Llama, the industry has over $200 billion tied in its smart contracts.
What are AMM and yield farming?
Another thing you need to understand when looking at LPtokens is the concept of Automated Market Makers (AMM). In the dynamic world of DeFi, a key part of the ecosystem is known as AMM.
A market maker is a technology that powers most DEXs like Curve Finance and Uniswap. For example, in a centralized exchange like Binance and Coinbase, when you buy 1 Ether at $3,500, it needs to find a seller who is willing to sell the coin at that fee. Similarly, when you sell a coin at $10, the company automatically finds a buyer for the coin.
Therefore, the company becomes the intermediary or middleman in the transaction, which explains why the cost tends to be high. At times, it also leads to slippage, which is a market condition where the execution price is different from what you selected.
One thing that makes DeFi more appealing to users is that there is no intermediary. Instead, these platforms use AMM, which incentivize people to deposit funds into their pool.
Any person is able to provide liquidity to a DeFi platform and then make some money, depending on how the market operates.
Yield farming in DeFi
The final part that will help you understand what LP tokens are is the concept of yield farming. This is a new term that did not exist a few years ago.
Yield farming is the process of growing your cryptocurrencies by offering your coins to a liquidity pool that is backed by a smart contract. The concept is similar to how a normal bank works. Ideally, when you deposit funds to a bank, you are simply growing its liquidity pool.
That means that the bank can lend these funds to its clients while guaranteeing that you will get your money back whenever you want it. Depending on your account type, you also make interest from your funds.
In yield farming, you generally deposit funds to an automated market maker, and you are guaranteed a return depending on the performance. Therefore, the AMM will match deposits and borrowers and provide financing.
The promise of yield farming is encouraging. For example, instead of just owning a token like ETH, you can make a yield from it by lending it to the market. However, it is possible to lose money depending on the performance of the market.
What are liquidity provider tokens?
Therefore, with the understanding of these concepts, it will be easy to see what a liquidity provider (LP) token is. An LP token is a coin issued by a decentralized exchange to give evidence that you have provided liquidity to its network.
The total value of 1 liquidity provider token is calculated by dividing the total value of the liquidity pool by the circulating supply of LP tokens. By doing this calculation, it can help you to determine the LP share of transaction fees and to examine the amount of liquidity that is returned to LPs from the pool. The chart below shows some liquidity pools and their interest in the Bancor Network.
Examples of LP tokens
The number of LP tokens is seeing a record growth as the DeFi industry expands. Today, the number of DeFi apps built using technologies like Ethereum, Binance, and Solana has seen record growth.
Most DEXs have their AMMs, and thus they offer their Liquidity Pool tokens. It is worth noting that these tokens correspond with the standard for the network. For example, for Ethereum platforms, the LP is an ERC token, while for Binance, the token is BEP-20.
Below are some of the most popular LP tokens.
- Uniswap – The exchange is one of the biggest DeFi marketplaces in the world, with a TVL of over $7 billion. It was one of the first platforms to embrace the concept of AMM and LP tokens.
- Balancer – Here is a project that operates a market maker. It enables people to create liquidity pools of up to 8 tokens. Balancer has a TVL of over $8 billion.
- Bancor – This leading DeFi project enables people to trade cryptocurrencies and earns interest. It has total liquidity of over $1 billion. The chart below shows the performance of the Bancor Token.
This article looks at the vital concept of liquidity providers and their role in the DeFi industry. Most importantly, we have assessed the industry, how it works, and some of the critical concepts you need to know.