Liquidity provider tokens or LP tokens are tokens issued to liquidity providers on a decentralized exchange (DEX) that run on an automated market maker (AMM) protocol. Uniswap, Sushi and PancakeSwap are some examples of popular DEXs that distribute LP tokens to their liquidity providers.
LP tokens are used to track individual contributions to the overall liquidity pool, as LP tokens held correspond proportionally to the share of liquidity in the overall pool.
At the most basic level, LP tokens work on the following formula:
Total Value of Liquidity Pool / Circulating Supply of LP Tokens = Value of 1 LP Token
In terms of technical properties, LP tokens aren’t very much different from other tokens on the same network. For example, LP tokens issued by Uniswap and Sushiswap, both of which operate on the Ethereum network, are actually ERC20 tokens. Like any other ERC20 token, these LP tokens can be transferred, traded and staked on other protocols.
Just like any other token, holding LP tokens gives liquidity providers complete control over their locked liquidity. Most liquidity pools allow providers to redeem their LP tokens at any time without interference, although many may charge a small penalty if you redeem them too soon.
The relationship between LP tokens and the proportional share of a liquidity pool is used most commonly in at least two cases:
- To determine the liquidity provider’s share of transaction fees accumulated during the duration of liquidity provision.
- To determine how much liquidity is returned to liquidity providers from the liquidity pools when LPs decide to redeem their LP tokens.
There are many other use cases for LP tokens that are emerging on modern DeFi platforms. These include:
- Staking LP tokens to earn further rewards as a way to incentivize LPs to lock their liquidity into pools. Sometimes, this is called “farming.”
- Using LP tokens values as a qualifying factor to access initial DEX offering (IDOs), i.e., to participate in certain IDOs, one must hold a certain value of LP tokens.
Be a liquidity provider, you may face a reduction in the asset principal when the token is withdrawn, that is the impermanent loss prevalent in the AMM mechanism. For more information, please refer to What is impermanent loss.