What is a Liquidity Token or LP Token? Application of LP token in Defi
Introduction
Liquidity tokens or LP tokens are awarded to liquidity providers in decentralized exchanges (DEX) that run on automated marketing protocols (AMMs). Ionic, sushi, and pancake swaps are well-known examples of decentralized exchanges that distribute LP tokens among their liquidity providers. This article will introduce liquidity tokens or LP tokens in financial markets.
What is a Liquidity Token or LP Token?
LP tokens are used to track individuals’ participation in the total liquidity pool. Because these tokens are proportional to each person’s share of the liquidity pool total.
In straightforward terms, the liquidity token works according to the following formula.
The total value of the liquidity pool divided by the circulating supply of LP tokens = the value of an LP token
Regarding technical characteristics, LP tokens are not much different from other tokens in the network. For example, LP tokens issued on Ion Swap and Sushi Swap, both of which operate on the Ethereum network, are, in fact, ERC-20 tokens. Like other ERC-20 tokens, these tokens can be transferred, exchanged, and stuck on other protocols.
Like any other token, liquidity providers can have complete control of their locked-in liquidity by having LP tokens.
Most liquidity pools allow users to repurchase their cash tokens at any time without any intervention. However, many of them charge you a penalty in case of early repurchase.
The relationship between LP tokens and the relative share of a liquidity pool is often used in at least two cases:
1. To determine the share of the liquidity supplier from the commission of the accumulated transactions during the liquidity period.
2. To determine the amount of liquidity returned to suppliers when repurchasing LP tokens from the pool of liquidity pools.
Other uses are emerging in today’s Defi platforms for liquidity tokens. These include:
1. Stick LP tokens to receive more rewards, which is a way to encourage LPs to lock their liquidity in the pools. This process is sometimes referred to as Farming.
Use the value of the LP token as an eligibility factor to access the centralized Exchange Initial Offer (IDO). In other words, to participate in particular IDOs, a person must have a certain amount of LP tokens.
How does a Liquidity Token or LP Token work?
Ion Swap V2 Edition uses Ethereum-based ERC-20 tokens as liquidity tokens. These LP tokens are proof that you own a portion of the cash pool so that you can withdraw your cryptocurrencies from the cash pool at any time. Fees earned from transactions are deposited directly into the liquidity pool; So the more significant the cash pool, the bigger your tokens will grow.
The new Uni Swap V3 launches in May 2021 and uses non-replaceable tokens (NFT) as LP tokens. Of course, this does not mean that you use works of art or collectibles as liquidity; Rather, NFT tokens have a specific value for themselves.
Given the separate value of each NFT token, Uni Swap V3 allows liquidity suppliers to choose the price range of the cryptocurrency assets they want to provide for that liquidity. This price range is displayed with NFT tokens that can be used to withdraw liquidity at any time.
The protocol introduces this concept as “limited order for profit.” If the cryptocurrency price is outside the price range you have set, the smart contract will remove you from the liquidity pool and sell your cryptocurrencies in exchange for tokens that are still in the price range you are considering.
For example, suppose you can provide $ 1,500 to $ 2,000 in ether liquidity for an ETH / USDC pool within a specified period. If the value of your ether tokens drops to $ 1,500, you can sell DAI tokens for ether and turn all your funds into ether tokens. You can also change the price range you want to provide liquidity and thus adjust your liquidity according to market conditions.
What is an Automated Market Maker (AMM)?
Automated market makers (AMMs) are an alternative to the need for registries used in centralized exchanges. Exchanges such as Kevin Bass and Gemini use investor buying and selling orders to provide liquidity. This is possible because centralized exchanges exert a particular influence on investors’ funds. In the case of decentralized exchanges (DEX), intelligent contracts calculate the price of an asset by dividing the total amount of tokens in the liquidity pool.
The equilibrium of liquidity pools is based on maintaining a 50/50 ratio of cryptocurrencies. Based on their value in dollars, Defi can use the formula X * Y = K to create this equilibrium. In this formula, X and Y represent the value of the cryptocurrencies in the pool in dollars. And K is the total value of the funds used in the collection.
For example, suppose there are 79180 Ethereum tokens and 134457994 USDC tokens in the ETH-USDC liquidity pool. In this case, the total amount of funds in this pool will equal 269084583 dollars.
Based on this information, Uni Swap can obtain the current price of each asset. To do this yourself, you can divide 134457994 by 79140 to get the current price of Ethereum in the ion exchange office, which is equivalent to 1316/1698 dollars.
Farming with liquidity token or LP token
LP Token is proof of your ownership of the part of the cash pool where you encrypt your crypto assets. You will also need an LP to repurchase your support and sell these tokens. But until the time comes, you can use some LP tokens for Yield Farming.
Yield Farming is an investment strategy in which investors move between several liquidity pools to achieve the highest possible interest rates. This will often be possible through position leverage with loans on Defi platforms such as Compound or MakerDao.
Some platforms allow you to stick your LP tokens to receive double rewards in separate cash pools. These platforms are often referred to as small platforms, and you have to risk losing your assets following the failure of smart contracts. So depending on how risk-averse you are, it may be best to stick your cryptocurrency assets in a single pool of liquidity.
What is a liquidity pool?
Liquidity pools use smart contracts on the Ethereum blockchain to provide liquidity to decentralized exchanges. Liquidity suppliers can use their Ethereum wallets to send tokens to a liquidity pool where investors’ funds are collected as cash in DEXs.
Ion Swap receives a fixed fee of 0.3% for each swap. This transaction fee is distributed among investors in proportion to participation in the liquidity pool. Depending on the collection you invest in and the number of transactions in Uni Swap. You can earn from 2 to 50% of the annual interest rate on LP fees.
Security of smart contracts
Although smart contracts have a history of being hacked, most of these contracts are very secure today. An excellent way to gauge the security of a smart contract is to check the value of the funds locked in the contract.
Hackers can be considered prize-winners who see funds locked in smart contracts as “rewards.” The bigger the reward, the less likely hackers will hack into the smart contract in question.
Suppose an intelligent contract contains significant assets, more than $ 1 million. It can be considered safe. This is because if a hacker can hack the contract, he will access all the funds stored in it.
Uses of Liquidity Token (LP Token)
As explained earlier, several uses have been suggested for LP tokens. In the following, we will examine these uses together again.
Proof of ownership in the liquidity pool
We said earlier that the first function of an LP token is to prove your share of liquidity pools. In this way, by having the right of ownership in the liquidity pool, you can benefit from the transaction fee in the Defi network. The amount of this fee will function your trading volume and your relative share of the pool. In calculating liquidity pool receipts, paying attention to the risk of its impermanent loss is also essential.
Build farming or profit cultivation with LP tokens
Yield Farming was a concept that flourished after Sushi Swap came to power and its bloody attack on the previous platform, Uni Swap. Many large exchanges now offer funders double bonuses in SUSHI, CAKE, and government tokens.
Invest in services such as Alfa Homora, Acropolis, and Beef Finance with LP token
Following Yield Farming, converting simple interest to compound interest may not be possible. In this case, profit aggregation/optimization services such as Alfa Homora, Acropolis, and Bifi Finance are activated, which automatically and according to the conditions of each platform (such as gas commission, time payment sequence, etc.), reap the profits earned from Yale. Increase inventory principle and automatically optimize profits.
Use LP tokens as collateral for loan protocols.
You can use your liquidity token as collateral in lending protocols and borrow according to your capital. Numerous services such as Aave and Cream do this with ion swap tokens, pancake swaps, and balancers.
Concluding remarks
In this article, we talked about liquidity tokens or LP tokens. Liquidity suppliers can often earn money in two ways. First, they receive a transaction fee on the Defi platform, which has deposited liquidity. In this case, transaction fees are distributed in proportion to the share of these suppliers in the liquidity pool among LPs; So the more tokens you stick, the more you will earn from commissions.
Some pools also use cash pool rewards as an incentive to stick to cryptocurrencies. These rewards are mainly paid in ERC-20 tokens used on the platform. So if the Ethereum token used by the protocol has a bullish trend, these pools can be a good choice for you. The LP Token acts as proof of your ownership of part of the liquidity pool. It allows you to take actions such as building Farming and borrowing from related platforms.
