Everything You Need to Know About Liquidity Provider Tokens

Everything You Need to Know About Liquidity Provider Tokens

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minute read time
Bryan Wilson
Bryan Wilson
Legal Engineer
Bryan Wilson
Published:
September 2, 2022
Last Updated:
October 27, 2022

This is part three in our four part series on the Taxonomy of Tokens. You can see the previous articles on Security/Utility Tokens here, our deep dive on NFT's, and our complete guide on Governance Tokens.

Liquidity Provider Tokens

What Are Liquidity Provider Tokens?

Liquidity Provider Tokens, or LP Tokens for short, are a reward mechanism to help facilitate transactions between other different types of currencies. Decentralized exchanges rely on Liquidity Providers to ensure there is an always-on market for the trading of cryptocurrencies. Anytime a liquidity provider deposits their cash into a "liquidity pool" (used to ensure that trades can be executed on the exchange) they then receive Liquidity Provider tokens. These tokens represent the amount of individual contributions to the overall liquidity pool.

As such, Liquidity Provider Tokens are quite popular throughout the landscape of web3 and especially in the context of Decentralized Finance (DeFi). To understand Liquidity Provider Tokens better, it is helpful to dive into the history of LP Tokens – where did they originate from and what need they serve?

Background

Exchanges are typically marketplaces where a large number of people buy and sell assets like currency, stocks, crypto coins, tokens, etc. In the past, if you were traveling from one country to another and needed to exchange your US Dollars for Euros, you would have to stop at an exchange to do so. The group hosting the exchange would need to have approximately equal amounts of US Dollars and Euros AND they would need an additional financial incentive to facilitate the transaction (typically a fee of some type). With web3 applications, it is possible to design these exchanges in new and interesting ways. However, the wrinkle that web3 brings to exchanges is that they are able to be either centralized (like a traditional currency exchange) or they can be decentralized

Centralized Exchanges (CEX) are similar to traditional exchanges where they act as a third party to facilitate trades and record buy and sell orders in a digital order book. These buy/sell orders are used to provide liquidity. Any CEX is a centralized entity, meaning, they have a certain degree of control over investor funds. Popular CEXs are Binance, Coinbase and Kraken. CEXs are more common and account for about 96% of exchange crypto trading.

Decentralized Exchanges (DEX) are algorithms on a blockchain that facilitate trading of crypto assets between users automatically and without an intermediary. Uniswap is the largest Ethereum DEX with more than 50% market share and $5.95B TVL (Total Value Locked). DEXs discard order books and instead use liquidity pools to provide liquidity. Liquidity pools are collections of crypto assets, sourced from investors, which facilitate users to buy, sell, borrow, lend, and swap tokens. DEXs clear their sell or buy orders using assets within the liquidity pools. These pools help to convert one asset to another easily without causing a drastic change in the asset's price.

Who are Liquidity Providers?

Liquidity Providers (LPs) are investors who provide crypto assets to the liquidity pools and in turn benefit from the rewards earned. Think of LPs as people who decide to serve as an exchange for a certain set of tokens – I might stake a trading pair of 1 Bitcoin and 12.6 Ether – and in exchange for providing this service to people who need it, I am rewarded with Liquidity Provider Tokens like Uniswap. 

And while a variety of liquidity pools exist, the most common type is trading liquidity pools used in DEXs. LPs earn rewards through trading fees that traders pay to DEXs for every transaction. In addition, some DEXs reward LPs with governance tokens for their contribution, based on their share of the total pool liquidity. This entire process is called liquidity mining.

Courtesy of KPMG

Automated Market Makers

Most DEXs use Automated Market Makers (AMM) to facilitate transactions . AMMs are the protocols or trading mechanisms that eliminate intermediaries and order books. It provides autonomy and uses smart contracts to determine the price of assets. For every trading pair of assets, there is an individual liquidity pool and anyone can provide liquidity to these pools. There are preset mathematical equations to balance liquidity pools and eliminate drastic changes in price of assets. Every liquidity pool rebalances to maintain a 50/50 proportion of cryptocurrency assets, which in turn determines the price of the assets.

Courtesy of Publish0x

What Is The Role of Liquidity Provider Tokens

In exchange for providing liquidity, liquidity mining protocol provides LPs with Liquidity Provider Tokens. It represents the share of the pool owned by a liquidity provider. LPs have complete control over their tokens and use LP tokens to redeem their crypto assets from the pool at any time. LP tokens act like balancing mechanism and provide a sense of security to the investor, for the assets deposited in the pool. It is possible to transfer ownership of LP tokens based on the conditions set in the smart contract (liquidity pool). LP tokens can also be used as collateral for loans.

Within DeFi, Liquidity Provider tokens solve the problem of locked crypto liquidity. That means, before LP tokens were introduced, crypto assets were locked or staked for certain mechanisms (including governance) and otherwise remained inaccessible during that time period. This led to low liquidity and lower activity in the crypto ecosystem. With the adoption of LP tokens, it is possible to create larger pools of liquidity for assets contributed by users, improve the liquidity of the market, and financially incentivize LPs through the issuance of LP Tokens in exchange for the service they provide.

How Liquidity Provider Tokens Work

Imagine the following simplified example. You contribute $5 worth of token A and Token B to a liquidity pool worth $100. Based on the buying and selling patterns of participants who use the network for liquidity, you would own 5% of the pool's Liquidity Provider Tokens. Taking this a step farther and imagining a slightly more complex example, let's say lots of people want to buy Token A and very few people want to buy Token B, the fee for withdrawing Token A would be higher than Token B.

Liquidity Provider tokens are similar to other tokens and can be transferred, traded or staked on other protocols. This indirectly gives liquidity providers complete control over their locked crypto assets in the liquidity pool. The LP tokens determine the share of transaction fees accumulated as pay back for the liquidity providers.

To note, Liquidity Provider tokens are subject to the vagaries of slippage. When trading tokens on a DEX, slippage is the price difference between when you submit a transaction and when that transaction is finally confirmed on the blockchain. This can be caused by two issues. First is the slow confirmation times with blockchains (the difference in price between when you hit submit and when the blockchain actually confirms the transaction). The second can be caused by low liquidity; whereby the liquidity pools become unbalanced and cause price distortions.

Liquidity Provider tokens can be staked to earn further rewards (yield) in the form of new tokens. Staking Liquidity Provider tokens shows the willingness to commit to supporting the LP token for an extended period of time and impacts market price.

Liquidity Provider tokens also play an essential role in Initial DEX Offering (IDO). IDO is a new fundraising model, where a new project or startup raises funds against their new tokens through a DEX. It is a token offering similar to ICO, STO or IEO. In IDO, LP tokens are locked for new tokens offered by the startup or project.

Yield Farming

Credit market Compound kicked off the contemporary yield farming phenomenon by awarding its governance token COMP to all its users for borrowing and lending, thereby increasing their activity levels.

Yield farming is an investment strategy where investors move their assets between different liquidity pools to maximize their returns or interest rates. Yield means ‘returns’ and Farming indicates exponential growth by planting “assets” in the pool.

Liquidity providers earning returns from the transaction fee of user, is a simple form of yield farming. But, in the case of Compound, even borrowers receive governance token COMP, merely for using and making the protocol popular. This is quite similar to taking a loan for purchasing a house, where the value of the house will also grow. Similarly, liquidity providers also can ‘grow’ their interest rates for the Liquidity Provider tokens in a yield farm.

Staking

Staking is a form of yield farming. Many platforms allow liquidity providers to stake their Liquidity Provider tokens to earn even more interest on these tokens. Impermanent loss is a risk associated with LP. It is the potential loss that could be incurred if the value of the assets in the liquidity pool is less than the value, if held in a wallet. This deters investors from providing liquidity. Liquidity Provider Staking helps to incentivize the investors as it mitigates the risk of impermanent loss and compensates for the loss.

Let’s say, 1 ETH = $100 and ‘A’ invests 10 ETH and $1000 in a liquidity pool (50:50 ratio for deposits in liquidity pool).

  • Total value ‘A’ invests is $2000.
  • Assume, the liquidity pool is worth $20,000, that is, it has $10,000 and 100 ETH.
  • Then, the share of A is 10%.

If ETH price raises to $110,

  • Liquidity pool rebalances (as per AMM model) to 95.347ETH with value of $10,488.
  • The liquidity pool is now worth $20,976.
  • A would get 10%, that is, $2097.60.
  • A has earned $97.60 from his investment of $2000.

But, if A has held ETH in his wallet,

  • The value would be (for 10 ETH) 10*$110 = $1100.
  • A would have $2100 in his wallet instead of $2097.60.
  • So, A incurred a loss of $2.40 or 0.12%

This amount might be high if he invested more, say 50% or if the price of ETH raises more, say 20%. This is impermanent loss.

How does Liquidity Provider staking help reduce the risk of  Impermanent Loss? ‘A’ receives LP tokens to indicate 10% of his share in the liquidity pool. Instead of holding to the LP tokens, A can stake them for a governance token. Assume, his share of the governance token value has raised by $5, then it helps mitigate his $2.40 loss from liquidity pool rebalancing. Although figures vary between projects, staking usually offers over 10% APY.

Real World Liquidity Provider Token Examples

Some of the popular decentralized exchanges that distribute the Liquidity Provider tokens to liquidity providers are Uniswap, Sushi, Curve, PancakeSwap.

1. Uniswap

Uniswap is an automated liquidity protocol powered by a constant product formula and implemented in a system of non-upgradeable smart contracts on the Ethereum blockchain. Each Uniswap smart contract, or pair, manages a liquidity pool made up of reserves of two ERC-20 tokens. Anyone can become a liquidity provider (LP) for a pool by depositing an equivalent value of each underlying token in return for pool tokens. These tokens track pro-rata Liquidity Provider shares of the total reserves, and can be redeemed for the underlying assets at any time.

"How Uniswap Works" Courtesy of Uniswap.org

Uniswap charges a 0.30% fee on all trades, which is added to the reserves. When the liquidity provider burn their liquidity token in order to reclaim their stake in the liquidity pool, in return they receive a proportionally distributed amount of the total fees accumulated while they were staking.

The Uniswap ecosystem consists of liquidity providers who contribute to liquidity, traders who swap the tokens and developers who interact with smart contracts to develop new interactions for the tokens. There are at least one billion ERC 20 liquidity provider tokens issued with more than 297 thousand UNI token holders. Uniswap deals with different types of liquidity providers including passive Liquidity Providers, professional LPs, LPs interested in token projects and DeFi pioneers.

There are currently three versions of the Uniswap protocol. Uniswap V1 is the first version of the protocol and because of its permissionless nature, it will exist for as long as Ethereum does. Although Uniswap has upgraded to Uniswap V3, it still offers Uniswap V2 which uses Ethereum-based ERC-20 tokens as LP tokens. And the new version uses non-fungible tokens (NFTs) as liquidity provider tokens. Even though there are no direct markets for trading Liquidity Provider tokens, Uniswap LP tokens can be used as collateral in lending protocols.

The defining idea of Uniswap v3 is concentrated liquidity: liquidity that is allocated within a custom price range. In earlier versions, liquidity was distributed uniformly along the price curve between 0 and infinity. With v3, liquidity providers may concentrate their capital to smaller price intervals than (0, ∞). It lets liquidity providers choose the price range of assets that they wish to provide liquidity. This custom price range is represented by an NFT which can be used to remove their share of liquidity at any time.

The features Uniswap v3 introduced are fairly complex and might prevent user-base growth due to a lack of understanding by ordinary crypto holders.

The most considerable risk with trading on UniSwap is buying scam tokens or falling for scam projects like rug pulls. A scam token is a token masquerading as belonging to a legitimate project. Rug pulls or scam tokens are common in DEXs as they can list new tokens free of charge and without audits, creating tokens in open source.

2. Curve

Curve is an automated market maker which differentiates itself by allowing exchange between tokens at low fees and low slippage by only accommodating liquidity pools of similar nature assets. It originally started as StableSwap, a stable coin only DEX. By focusing on stablecoins, Curve allows investors to avoid more volatile crypto assets while still earning high interest rates from lending protocols. It favors stability over volatility by limiting the pools and the type of assets in each pool. Curve is a non-custodial platform meaning the Curve developers do not have access to individual’s tokens. Curve pools are also non-upgradable, which means the logic protecting the funds can never change.

When Curve launched it grew quickly by securing the underdeveloped stablecoin market. The three categories of Curve pool are Plain pool, Lending pool and Metapools. Curve Liquidity pool allows investors to get their new LP tokens and stake them back in exchange for CRV token (Curve’s governance token – Curve DAO Token) which can be bought and sold like other cryptocurrencies. Thereby these Liquidity Provider tokens provide an additional layer of utility and profits to the initial investment.

The main purposes of the Curve DAO token are to incentivize liquidity providers on the Curve Finance platform as well as getting as many users involved as possible in the governance of the protocol. This ensures the protocol continues offering low fees and extremely low slippage. Currently CRV has three main uses: voting, staking and boosting. One of the main incentives for CRV is the ability to boost individual’s rewards on provided liquidity.

Curve recently launched v2, allowing users to swap between uncorrelated (unpegged) assets. Similar to Uniswap v3, it allows concentrated liquidity, that is, liquidity at custom price range, but automated. Curve will automatically concentrate all liquidity from its LPs around the current price to reduce slippage and allow users to exchange large sums without majorly affecting the price of the asset.

Curve integrates with other platforms to maximize investor profits, known as composability. But integration, for example, with Compound puts the assets that Curve has within that platform at risk. In that way, a fault within Compound would adversely affect Curve and its liquidity providers, causing a destructive chain reaction.

This article does not constitute investment and/or legal advice, and is strictly for education purposes only. Upside is not an SEC registered investment advisor, practicing legal entity or any other type of licensed body that can legally provide investment and legal advice. Upside is not responsible for any errors or omissions in this article, due to the changing nature of laws, rules and regulations or otherwise, or for results obtained from use of the information it contains.

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