DeFi
September 28, 2022
What is Token Burn and it's effects on price
An A-Z guide on token burning and how it is largely impacting the cryptocurrency industry.
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The Economy created by cryptocurrency can only be called truly decentralized if the centralized financial services are completely eliminated. Automated market makers (AMM) have made this possible by bringing in decentralized liquidity pools.
However, to ensure the smooth operation of these liquidity pools and to encourage participants to contribute funds to them, LP tokens were created. Apart from that, LP tokens can be used for several operations in the crypto space.
In this article, we are going to understand what LP tokens are, how they work and how you can utilize them to maximize your crypto earnings. Let’s begin by understanding what liquidity pools and LP tokens are.
Liquidity pool is a smart contract that is used to provide liquidity to traders on decentralized exchanges by locking two types of tokens in a 1:1 ratio. However, these liquidity pools are not necessarily created and funded by the traders who utilize them. Liquidity providers are those who contribute to the pool.
Therefore, to facilitate funding to liquidity pools and incentivise people to contribute, we need something known as LP tokens where LP stands for liquidity provider tokens. These LP tokens are distributed to liquidity providers in proportion to the amount of liquidity they provide to the pool.
The value of each DEX's LP token will be determined by the size of the pool and the circulating supply of LP tokens, which will affect the token's worth. Let’s take a closer look at characteristics of LP tokens.
The LP tokens differ from traditional cryptocurrencies in that they have some unique features. Because they are only used for specified purposes, these tokens must adhere to very strict guidelines. So let's look at these characteristics.
As you all must already know, each DEX that is made using the AMM system has to include LP tokens. What these LP tokens do is they ensure that no AMMs are neglected when it comes to their circulation. That is one of the main reasons that you are not required to give up the control of your crypto tokens when you use the LP tokens.
The automated operations of the LP tokens make it possible for the distribution system to become fair and decentralized. Whenever new liquidity providers are introduced in the market, they allow a lot of trading opportunities for the DeFi tokens. These things help in attracting more users to the projects.
When you use the LP tokens, know that you are in charge of the tokens i.e. you completely own them and in order to make up for the liquidity that the LPs provide, they get the LP tokens. Throughout the whole process of the launching of the new tokens, the LPs retain the ownership of the assets.
Liquidity pools make the whole process fair by making sure that the users are not made a part of the process and instead they just get to get the benefits of the results. LP tokens work in the way that they indicate the amount of liquidity a user provides to a pool.
There are two major uses of the Liquidity Provider tokens and they are enhancing the DeFi liquidity as well as earning through Yield Farming. Let us take a look at how the LP tokens achieve them.
Liquidity is essential for DeFi as it provides a way for swapping one asset for the other without affecting the value of either asset. In the old or the traditional way of financing, cash is considered to be the most liquid asset as it can be used to exchange a huge amount of assets that can be anything that the participants want.
Although the traditional exchange or swapping of the assets may seem simple, the process of swapping fiat currency with the cryptocurrencies is not a simple process at all. In the whole crypto market, BTC is the most liquid asset as it is accepted by almost all exchanges.
When it comes to the DeFi ecosystem, Ether becomes the most liquid asset as the DeFi ecosystem was built on the Ethereum network and ETH is the native token of Ethereum. That is the reason why ETH is tradeable on all of the DEXs.
Liquidity pools provide a use case that the assets like BTC or ETH cannot as they can be locked up when they are staked and hence, cannot be used any place else. This leads to less liquidity in the market. That is where the LP tokens come in.
LP tokens are assets that can be easily converted within DeFi. The LP tokens can be used at multiple places at any given time even if they are staked or invested somewhere. This becomes possible because they provide an indirect form of staking where you only have to prove that you own the tokens instead of staking them.
As we already explained, LP tokens help in providing a stable liquidity asset to the DeFi ecosystem. They work as a mathematical proof of how much you have contributed to a DeFi liquidity pool.
When you study Yield Farming, you will realize that LP tokens and yield farming are kind of similar. Yield farming is when you deposit your assets in the DeFi ecosystem to boost the stakeholder income.
Yield Farming enables you to gain the maximum profit by transferring tokens across multiple protocols. When you combine LP tokens with Yield Farming, the result is spectacular and a lot of people are realizing the same.
When you deposit your assets in a liquidity pool, you receive LP tokens. You can then deposit these LP tokens to the same staking pools and receive the native tokens of the project in return as a reward for staking. What this does is that you are using your LP tokens and making the liquidity work double time and hence, you earn fees and farming yields.
LP tokens can help you in earning a lot of money without having to take a lot of risk. LP tokens really enhance the whole DeFi system and if you can work out how to use that to your advantage, then it will prove to be a boon for you.
Liquidity pools are something that not just benefit the project organizations but also the users or the liquidity providers. So make sure you make the most out of them. If you want to learn more about the crypto world, do check out or other articles.
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