Liquidity Providers (LPs)

Liquidity Providers (LPs) use a strategy known as liquidity mining or Automated Market Maker (AMM), where they place their tokens / coins (assets) into a staking on a decentralized exchange (DEX) and earn rewards from transaction fees. These transaction fees are often represented by interest rates, which change in response to various factors at the time the transaction is completed, including the amount of liquidity available and the number of active transactions in the liquidity pools (LP).

For DeFi and minor projects, liquidity can be very low. For example, you can only acquire an asset on one of the DEXs or CEXs (centralized exchange). It can also be difficult to find a buyer or seller who would sell the asset at the price you require. The solution to this problem is the liquidity pool model (or liquidity mining).

A liquidity pool contains two assets and users can swap (exchange) between them. There is no need for traditional market makers, buyers, or order books, and the price is determined by the ratio of assets in the pool. Users who put assets in the pool are known as liquidity providers (LPs).

What is a liquidity pool?

A liquidity pool (LP) is a collection of tokens / coins secured by a smart contract. These, usually pairs of cryptocurrencies, provide DEX with the necessary liquidity. The term "liquidity" refers to the accessibility to exchange one cryptocurrency for another without paying a high slippage tax. Such accessibility is essential to the DeFi ecosystem because of the numerous financial activities taking place there.

The DEX sector contains a large number of liquidity pools, however, only a few have proven to be the right choice for investors. These include, for example, the following protocols: Uniswap, Balancer, Curve Finance.

So while providing liquidity means offering your assets to the market, in the case of LP tokens, we are specifically talking about DeFi liquidity pools.

Note that if there is a liquidity pool for a few assets, it does not automatically mean that there is a lot of liquidity in it. However, you will always be able to use the liquidity pool to trade without relying on a third party to match your order.

What are LP tokens?

LP tokens are assets automatically generated by DEX and issued to liquidity providers as assets are added to the pool. These tokens represent shares of the fees earned by the liquidity pool.

LP tokens give you 100% control over the locked funds. Most DEXs allow you to withdraw your original assets at any time.

Technically, LP tokens are essentially the same as other tokens supported by the blockchain network. For example, an LP token issued on the Uniswap protocol, which operates on the Ethereum blockchain, is the ERC-20 token. The ERC-20 token can be staked, swapped, or traded on any protocol based on the Ethereum blockchain.

Depending on the DeFi platform, LP tokens can be called by different names, but they usually contain the names of two (or more) trading pairs that have been linked together.

PROs

• Price equilibrium
• Liquidity in the market
• Free liquidity creation

CONs

• Vulnerable smart contracts
• Risk of liquidity theft
• Impermanent Loss (IL)

Conclusion

Liquidity Providers and liquidity pools play a key role in DeFi. Not only do they help determine your share in the liquidity pool, but they can also be used as collateral for revenue management. Despite the risks associated with LP tokens, they are an appealing way to earn passive income from your crypto assets.

All in all, the world of DeFi is constantly evolving and along with it, the usability of LP tokens.