At the bedrock of every financial system are institutions or structures designed to facilitate transactions. In the crypto space, the Decentralized Finance structure adopts the use of Centralized and Decentralized exchanges to replace traditional financial institutions like banks. For these exchanges to operate smoothly, there is a need for constant and sufficient liquidity that fundamentally facilitates the transactions of paired assets from one wallet to another.
Liquidity represents the availability of coins (capital) for transactions. So, when two cryptocurrencies are paired for trading or converting on an exchange, e.g., USDC/ETH, there is a need for a sufficient supply of the paired coins to ensure constant and everyday trading.
What is a Liquidity Provider Token?
Liquidity Provider or LP tokens are tradable and transferable tokens given to liquidity providers by decentralized exchanges. The tokens run on the Automated Market Marker protocol.
Liquidity providers contribute to liquidity pools of every DEXs and hold LP tokens as an apt representation of the value deposited. With LP tokens, users can track contributions and view their share of the liquidity pool. For instance, the Pancakeswap exchange offers comprehensive liquidity interfaces that allow users to track their contributions, view current asset prices and rewards earned.
Automated Market Makers (AMM) Explained
One of the notable differences between decentralized and centralized crypto exchange is the complete elimination of intermediaries in the former. Decentralized exchanges adopt the Automated Market Makers protocol to facilitate swift transactions without intermediaries or order books.
AMM relies on liquidity pools and smart contracts to determine asset prices and facilitate the swapping or trading of token pairs without a market Maker and Taker. It is important to note that the AMM is not autonomous in determining price; essentially, decentralized exchanges with healthy liquidity pools can proffer a trading system where the constant transaction does not necessarily result in drastic price changes.
How does LP Token work?
Learning how to provide liquidity on cryptocurrency exchanges requires the understanding of how LP tokens work.
First, LP tokens represent a proportional value of what a liquidity provider contributes to the liquidity pool of paired assets. Hence, when a liquidity provider adds a certain amount of tokens into the pool, they receive LP tokens as a form of receipt to represent their ownership of assets. For instance, depositing assets into the POOLX/BUSD liquidity pool, Pancakeswap gives users an LP token called POOLX-BUSD LP.
Liquidity providers must securely store their LP tokens in the wallet used to provide liquidity, which can be seen by adding the token smart contract address. LP token is, therefore, the security of the tokens deposited; hence, a permanent token loss culminates in losing the deposited tokens.
Liquidity provider’s reward on their contribution is determined by the level of transactions and the amount contributed. The share of transaction fees accumulated is paid back to the liquidity providers.
So, imagine that you contribute $200 worth of POOLX/BUSD to a liquidity pool of $2000. You own 10% of the liquidity pool, and the withdrawal fee accrued from those trading the assets determines the reward you earn. The reward varies on each token depending on the number of transactions performed.
Furthermore, Liquidity Provider tokens are used for more extensive protocols like staking, yield farming or Initial Dex Offering (IDO) on platforms such as Poolz Finance. Users can stake the Poolz token, $POOLX, to participate in risk-free and secured IDO of startup projects.
Impact of Liquidity Providers Tokens and Liquidity Pools in the Crypto Space
- Frictionless system
The scalability of a cryptocurrency exchange relies essentially on its ability to facilitate thousands of transactions without delay or friction. However, this cannot be possible without sufficient liquidity that liquidity providers provide.
By supplying coins to the liquidity pools, exchanges enjoy the high liquidity required to ensure that users can trade and explore a trustless environment.
- Less volatile Market
One of the frequently discussed features of cryptocurrency is volatility. Cryptocurrency assets must become highly liquid to keep volatility in check and ensure that users can easily trade assets without causing notable price changes. For instance, Bitcoin and Ethereum are highly liquid assets traded on thousands of exchanges; hence, a significant increase in trading volume does not necessarily affect their prices.
- Swift Transactions
While small projects with low adoptions and DEXs without liquidity pools may be frustrating to trade due to the lack of availability of multiple exchanges, a sufficient liquidity pool on exchange enhances the swapping of two assets. It eliminates the need to match sellers and buyers as we have on centralized exchanges like Binance.
- Passive Earning
Wondering how to earn with the LP tokens? Here is the answer you are looking for. Contributing to liquidity pools on decentralized exchanges comes with a reward. First, the asset price is determined by the amount of liquidity available, and liquidity providers get a certain percentage of the withdrawal fee charged for facilitating the swapping of tokens.
While liquidity provider tokens or LP tokens have a designated purpose in the crypto space, it is also vital that they operate essentially like regular cryptocurrencies and, therefore, can be traded or transferred among users. Transfer of the tokens will effectively move the ownership of the asset deposited in the liquidity pool.
Also, holders of LP tokens must ensure that tokens are securely stored in their wallets. LP tokens are also subject to impermanent loss, which may result from the change in asset price over time.