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Function of Liquidity Provider (LP) Tokens

The Function of Liquidity Provider (LP) Tokens

Decentralized exchanges (DEXs) are growing rapidly because of the fast expansion of DeFi. There are lots of new investors who want to trade crypto assets through DEXs. This has led to a decrease in the overall liquidity on the platforms. Lack of liquidity means slower transactions and people not getting assets at the price they opted for. This is where the role of cryptocurrency liquidity providers kicks in. Providing liquidity in crypto is a tedious job, and many people are undertaking it for the sake of earning passive income and the principle of decentralization.

Liquidity provider crypto is the reward such users earn in exchange for the liquidity they provide. It is possible only on the DEXs that run on the automated market maker. Now, you must be curious about liquidity provider crypto, so let us find out more about cryptocurrency liquidity providers and how liquidity provider tokens work in this post.

What are Liquidity Provider Crypto Tokens (LP Tokens)?

What are Liquidity Provider Crypto Tokens
Source / How liquidity provider tokens work

Every DEX platform, like Uniswap or Sushiswap, requires a liquidity pool to facilitate the transactions occurring on the exchange. These liquidity pools are supported by users who wish to add their funds to the pools. To reward such users, the exchange transfers them cryptocurrency liquidity provider tokens. These tokens are usually ERC-20 tokens and can be traded, exchanged, or staked. The value of each LP token is decided based on the total value of the liquidity pool divided by the number of LP tokens issued. A cryptocurrency liquidity provider can use these tokens for earning passive income or even stake them.

How Liquidity Provider Tokens Work?

So, how do cryptocurrency liquidity provider tokens work? Liquidity provider cryptos are rewards that the DEXs pay you to help them avoid the liquidity crisis. Let’s understand how they work with an example: In case a liquidity pool requires $10,000 worth of funds, and you invested $1000, then you are owed 10 percent of the total liquidity provider crypto tokens generated by that exchange. These tokens can then be staked, exchanged for value, or reinvested into the pool for compounding purposes. Even DEXs want their users to reinvest these tokens in the pool so that the liquidity keeps increasing.

How LP Tokens Enhance DeFi Liquidity

Bitcoin is the most liquid crypto as it is easily accepted in many places. Liquidity generally means how quickly one asset can be converted to another without changing its value. Other than BTC, Ethereum also has very high liquidity. A DEX platform usually creates a liquidity pool to stake funds that can be used to exchange assets when a bulk order comes in. The LP tokens enhance DeFi liquidity as they are similar ERC-20 tokens as the others coming into the liquidity pools. These tokens can be used repeatedly instead of locked like ETH or BTC. This helps the liquidity pool to always have funds and thus have enhanced liquidity.

Yield Farming with LP Tokens

Every user wants to keep increasing their income through any means possible. This is why using the liquidity provider crypto on multiple DEXs to earn passive income has become a big part of the DeFi world. People are staking their funds on multiple platforms as cryptocurrency liquidity providers to earn these LP tokens. Then they reinvest the LP tokens to initiate compounding. This method of earning passive income is called yield farming with LP tokens. It is a great use of LP tokens based on how liquidity provider tokens work.

Farming with LP tokens

Another method of earning income through cryptocurrency liquidity providers is farming them on a DeFi farm. The users have to stake their LP tokens on a farm and wait for the yields, and the users slowly keep earning rewards in the form of another token. Cultivating the LP tokens on a farm usually occurs with the help of smart contracts. Although it is a much faster and more comprehensive way of earning through liquidity provider crypto, it also involves many risks. The major risk of trusting another user with farming your cryptocurrency liquidity provider tokens through a smart contract makes it a challenging thing to choose.

What are the Risks Associated with Yield Farming of LP Tokens?

Now you know how liquidity provider tokens work, but what are some disadvantages of yield farming with liquidity provider crypto?

Temporary Loss

This loss is associated with staking the crypto assets in the liquidity pools. Users cannot access their funds as long as they are in the liquidity pool. In the meantime, if the currency’s value plummets, the users face an impermanent loss.

Risks of Smart Contracts 

Investing your crypto assets into the liquidity pool is about trusting the smart contracts of the DEX platform. In case of a security breach or a hack, you risk losing all your assets. This is a common risk involved with earning liquidity provider crypto.

What Factors Affect the LP Token’s Value?

As mentioned earlier, cryptocurrency liquidity providers are involved in staking of crypto assets in liquidity pools on various platforms. If the number is large, the pool’s overall value is also larger. The factors on which the LP token’s value depends are the number of LP tokens in circulation and the total value of the liquidity pool. To have a higher value of the LP tokens, the pool must be of high value with lesser LP tokens in circulation.

Conclusion 

Providing users an incentive for liquidity provider crypto has turned out to be a great step by the various DEX platforms. It has even unlocked new ways to earn passive income, i.e., yield farming. Many users are even reinvesting the funds into the pool to compound them. Liquidity provider crypto assets help the liquidity pools to have enough funds for facilitating the trades. It also helps the cryptocurrency liquidity providers earn LP tokens that can be later exchanged or staked to earn more passive income.

Frequently Asked Questions (FAQs)

1. What is a Liquidity Provider Crypto?

An LP token is given as a reward to the liquidity providers on a particular DEX. It can be staked back into the pool or even removed from it to exchange or trade it. Total control is given to the cryptocurrency liquidity providers. 

2. How do you Cash out LP Tokens? 

To cash out the LP tokens, users have to remove their funds from the pool and return the LP tokens to the platform. In return, the DEX platform rewards the user’s equal amount of locked up tokens compared to whatever value the LP tokens held.

3. What is LP Lock in Crypto? 

When the liquidity is locked up, the developers sometimes renounce the value of LP tokens called the rug pull. It is done right after the pool is locked. Here the staked assets are still locked but the LP tokens lose their value. It is up to the developers here if they return and reward the cryptocurrency liquidity providers or not.

4. How do you Withdraw LP Tokens? 

Withdrawing LP tokens is simple; you must pull out your funds from the liquidity pool. The cryptocurrency liquidity provider might have to face the impermanent loss here. But as soon as the funds are withdrawn, the DEX platform also withdraws the LP tokens.

5. How is the Uniswap Price Calculated?

The price of each Uniswap token is calculated against the demand and supply basis. It can be used to provide liquidity on Uniswap. The price keeps fluctuating based on the requirement.

6. Do Decentralized Exchanges put up their own Liquidity?

No DEX platform puts up its own liquidity for the users to trade. The users themselves stake their funds to create a liquidity pool.

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