DeFi Basics: What is a “LP” Token?

What is a “LP” Token? ➡️ The Center of Crypto Value

Liquidity pools are fundamental to the DeFi ecosystem and act as the backbone upon which most of cryptocurrency trading relies. At their core, liquidity pools are simply tokens in a smart contract. This system replaces traditional buyer-seller markets, ensuring trades can occur without waiting for a matching party (in a trustless manner).

When users contribute their cryptocurrency assets to a liquidity pool, they receive Liquidity Provider tokens (LP tokens) in return. These tokens represent their stake in the pool and serve as proof of ownership and entitle holders to a share of the trading fees generated within the liquidity pool.

LP Tokens are also redeemable for the underlying assets initially deposited into the pool.

History

To really understand LP Tokens, you must first understand the AMMs (Automated Market Makers) that seamlessly guide the flow of funds in all of DeFi trading.

Uniswap v1

The genesis of automated liquidity, Uniswap v1 introduced the “constant product formula” more commonly referred to as x * y = k. This formula balances the product of reserves of two different tokens in a liquidity pool, ensuring automated price adjustments.

Liquidity providers receive tokens called Liquidity Provider Tokens (LP) that represent their stake in the pool. They are redeemable for the initially pooled tokens and receive a portion of trading fees to incentivize liquidity provision.

Uniswap v2

Diagram from Uniswap representing a liquidity pool

Uniswap v2 is by far the most commonly used structure today for its ease of use and versatility. With v2 came the introduction of ERC20/ERC20 pairs along with a hardened price oracle allowing other contracts on Ethereum to estimate the average price for the two pooled assets over arbitrary intervals (Uniswap v2 Core, 1).

These improvements brought major flexibility to protocols offering liquidity provider rewards — more on that later.

Uniswap v3

A massive leap forward, v3 brought us concentrated liquidity. This concept allows providers to allocate funds within specified price ranges, enhancing capital efficiency.

Because users provide liquidity on their own price curve, the positions can no longer be fungible and represented with the ERC20 token standard. “LP Tokens” in the v3 world are given to providers in the form of NFTs. Read our article on important factors and opportunities to consider regarding your v3 LP positions.

Beyond Trading

Farming/Staking

Farming enables liquidity providers to earn additional rewards on top of trading fees. By staking LP Tokens in different protocols, users are usually rewarded with the token of the protocol itself. See here for more.

Navigating Impermanent Loss

When the profit of your liquidity staking is less than what you would have earned simply holding, you have experienced impermanent loss. Understanding “IL” and mitigating the risk is critical for any skillful liquidity provider. See here for more.

The Importance of Liquidity Locking

One of the very few sources of centralization in Decentralized Finance today is liquidity pools. When a token is created and liquidity is added, the developer has ownership of 100% of the LP Token supply. Investors are trading only at the mercy of the developer.

When ERC20 LP Tokens are locked (v1 and v2 liquidity), the tokens can't be accessed until the unlock time. This means any funds invested in the token until liquidity unlocks are free to trade against the market itself and not against bad-acting developers. Of course, however, many other types of scams do exist… and you can read about them all here.

When v3 liquidity NFTs are locked on UNCX, not only are they safe from rugpulls or hacks, the positions also benefit from our “Full Range Protection” feature and the ability to collect trading fees from the pool. Read more on these features exclusive to our lockers here.

Conclusion

As technology evolves in DeFi, so does the complexity of liquidity pools. With Uniswap v4 on the horizon, new opportunities emerge for developers, traders, and stakers alike. Liquidity pools will continue to stand as the heart of DeFi. One thing is for sure, UNCX Network’s liquidity lockers will continue to be the industry leaders in helping safeguard your Liquidity Provider tokens.

The UNCX Network team

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