The crypto market is usually associated with trading, investing, and mining, despite various opportunities to earn a profit. With the growth of the DeFi (Decentralised Finance) sector, liquidity providers have become an integral part of the ecosystem. This article explores the ways LP tokens can be used and their risks and benefits.
First things first: what is liquidity providing?
Regarding DeFi, one of the prominent investors’ concerns is liquidity — the ability to easily trade (buy and sell) an asset without causing significant price changes. Institutions prefer Bitcoin or Ethereum because of their high market capitalization and adoption. Smaller projects with lower volumes usually cannot offer such an advantage and are typically listed on a limited number of crypto exchanges.
How do liquidity pools solve this problem?
Participants provide liquidity to the pool, which it then uses to facilitate trading on other crypto platforms. Everybody wins when the system functions as planned: the pool aggregates liquidity, while the providers earn interest and get LP tokens as a “receipt.” These coins act as ownership proof for the provided liquidity and allow retrieval of funds after the contract expires.
How do LP tokens work?
Since most liquidity pools operate on the Automated market maker principle, the platform does not have access to the user’s private keys and, therefore, coins. That’s where LP tokens come in: they prove the player’s pool’s share. For instance, users who deposit $10 to a $100-worth pool will get 10% of the platform’s LP tokens. It is crucial not to lose access to the received liquidity coins, as they will be used to claim the initial investment.
What can one do with LP tokens?
The obvious choice is holding, but it will not generate an additional income. In case that’s your goal, here are alternative ways of benefiting from LP tokens:
Liquidity pool assets can be used to transfer the value of the associated coins. Therefore, if you sell LP tokens, you sell the ownership of the initial investment and earned interest.
Use as a loan collateral
Since the LP tokens represent a share of the pool, they can be used as collateral in crypto loans. It’s a standard method as it allows market players to earn additional income while still earning interest from providing liquidity. Still, note that if you won’t meet your loan obligations, the lender will claim your initial investment and liquidate it.
You can also use your LP tokens in yield farming, which involves lending or staking cryptocurrency in exchange for interest and other rewards.
Are LP tokens a safe investment?
No investment is 100% safe, and LP tokens are no exception. Beware that the DeFi industry is more susceptible to volatility and usually considered riskier than Bitcoin or Ethereum. Still, it usually offers higher ARPs, making it a sound financial in the hands of an experienced trader or investor.