What are LP tokens?
- An LP token is a digital asset that represents an individual’s share of the underlying assets in a liquidity pool
- When individuals deposit assets into a pool, they effectively make those assets available for trading on the platform
- In return, the users will receive LP tokens and earn a share of the trading fees generated by the pool
- When a liquidity provider wants to regain their underlying assets, they can return their LP tokens in exchange for the underlying assets
In the context of decentralized finance (DeFi), a LP token (Liquidity Provider token) is a digital asset that represents an individual's share of the underlying assets in a liquidity pool.
These tokens are typically issued by Decentralised Exchanges (DEXes) and / or automated market maker (AMM) protocols and are used to incentivize individuals to provide liquidity to the pool.
By depositing assets into a pool and receiving LP tokens in return, individuals are effectively making those assets available for trading on the platform and earning a share of the trading fees generated by the pool.
These LP tokens can be used freely and in the majority of cases protocols incentivise individuals to stake their LP tokens into yield farming campaigns.
In case a liquidity provider wants to regain their underlying assets, the individual can return its LP tokens to the protocol in exchange for the underlying asset in addition to potentially realized profits or losses.
As mentioned above, liquidity providers earn a share of trading fees generated by the protocol but are also exposed to the risk of impermanent loss. Please click this link to learn more about impermanent loss.