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Liquidity tokens or LP are special tokens created by decentralized exchanges. Decentralized exchanges, or DEX for short, are trading platforms through which you can hold or manage your assets and do not need intermediary services. When you fund a liquidity pool, the smart contract rewards you according to the amount of tokens you deposit. This is where cash tokens come into play as these tokens are your reward. Because of this, LP tokens have become a very useful member of the market. This is exactly the way automated market makers (AMMs) work, such as Uniswap, Sushi Swap, Pancake Swap, and Compound.
When tokens are deposited into a liquidity pool, the platform automatically generates a new token representing the depositor’s share of that pool. These tokens are called Liquidity Provision Tokens or LP for short and can be used for many services on the main platform and even other DeFi platforms.
Liquidity tokens are one of the key features of automated market makers. These tokens help ensure that these platforms are non-custodial. This means that instead of holding your tokens with both hands, they encourage decentralization and fairness through automated activities. Liquid tokens open new doors of token transactions for users and make it easier to access the DeFi ecosystem.
The non-custodial functionality of automated market makers is critical to participation in the decentralized financial ecosystem. With automated market makers, you own your assets by receiving liquidity provider (LP) tokens in exchange for providing liquidity to the pool and offering tokens like Ethereum. These tokens are generated by computer codes and humans are not involved in their production. Liquidity tokens essentially represent the liquidity provider’s share of the pool, giving them full control over their assets.
Let’s take an example. Imagine you deposited ten dollars of a token into one of the hundred dollar balancing pools. This gives you ten percent of that pool’s liquidity token because you own ten percent of the pool’s shares. LP tokens actually represent your shares, and with these tokens you can withdraw your deposit at any time without the need for anyone’s intervention. Since these tokens are ERC-20, they can be easily traded and embedded in other protocols.
Liquidity is a fundamental concept in the DeFi space. This term refers to the simple conversion of one asset to another. In traditional finance, cash is considered the most liquid asset because it can easily be converted into gold, stocks, bonds, and other assets. However, cash cannot easily be converted into digital currency. In the digital currency space, Bitcoin is the most liquid asset because it is accepted and traded on almost every central exchange. In the DeFi ecosystem built primarily on top of the Ethereum network, Ethereum is the most liquid asset and is settled on any decentralized exchange.
Prior to the creation of the liquidity token, assets used in the Ethereum ecosystem were not accessible during their useful lives. In fact, tokens are connected to the system when they are used as part of a governance mechanism. For example, in Ethereum’s Proof of Stake consensus mechanism, validating and adding new blocks requires people to deposit and lock their ether into the network. When a cryptocurrency is blocked, it can no longer be used and therefore there will be less liquidity in the system.
The creation of convertible assets in automated market makers called Liquidity Provision (LP) tokens has solved the cryptocurrency liquidity problem, at least in the DeFi ecosystem. With token liquidity, a given token can be used multiple times. Even if that token is invested in a DeFi product or given to the governance mechanism of the network. LPs help solve the liquidity problem in the digital currency space through an indirect form of equity.
Since DeFi is an ecosystem with a very high development speed, the services of this ecosystem are also developing rapidly. What is mentioned in this article as a liquidity token may have a different name depending on the platform. For example, on the Balancer platform, these tokens are known as Balancer Pool Tokens (BPT) or Pool Tokens.
In the UniSwap exchange, these tokens are called pool or liquidity tokens. The Crow platform uses these tokens with the same name as LP or Liquidity Provision Token. Although the words are different, the definition is exactly the same. Cash tokens are actually mathematical proof that you have put your tokens into a pool and can use them to withdraw your wealth.
Another recent concept of the DeFi ecosystem is yield farming. A process that did not exist in the first half of 2020 but has become one of the most popular DeFi services with its emergence. The idea behind yieldfarming is to deposit tokens in different DeFi schemes to get maximum income. This profit can be maximized by transferring tokens in different protocols.
Although both token yieldfarming and liquidity are relatively new ideas in the ecosystem, they are used side by side.
To understand how it works, let’s look at the steps involved in forming a CRV token in the Crow protocol using the DAI token:
Deposit DAI tokens to the Kroo cash pool.
This is how you get LP tokens.
Deposit the received token into the Stakingcro pool.
Get CRV token.
In this scenario, you earn fees and profits by liquidating the DAI token in Crow. At the same time, you can easily earn CRV tokens with earned LP token. In fact, using the liquidity token doubles your liquidity and you can earn a lot of profit by earning commissions and yields in yield farming. Many new terms, technologies and features that can help you emerge in the DeFi ecosystem every day, and liquidity tokens are one of them.
We hope that the example and explanations of the previous part have clarified the concept of UNI token for you. However, the question arises as to what other liquidity tokens have. In response, the rules are the same and will be as follows:
Each liquidity token operates under a unique blockchain and standard. For example, UNI and Sushi run on Ethereum and use the ERC-20 standard. However, Kik runs on the Binance smart chain and is of the BEP-20 type. This means that each token operates on its own network and cannot be exchanged directly.
The value of a liquidity token depends on the total value of the platforms it is traded on, whether DEX or CEX, divided by the total number of tokens in circulation.
If LP tokens are burned for any reason, this will positively affect the value of the token, making it rarer and therefore more valuable.
Now there is a very important aspect to consider and that is that each DEX platform has its own deployment rules that more or less affect the value of the token. For example, direct offering platforms such as UniSwap add value to UNI by increasing adoption and attracting investment.
While platforms like Land expect the value of their tokens to increase by following algorithmic models that adapt token supply and value to their needs. This means that to get the most out of an LP token, you need to understand the structure and functionality of the project that issued it. Knowing this, you can know how the value of the token can increase and how far this increase will go.
Currently, the primary purpose of a liquidity token is to reward liquidity providers, and every platform currently has a way to do this. The most common system is the fair distribution of rewards among participants in the pool, based on the commissions received from the DEX with a certain percentage. Depending on the percentage committed to that goal, the rewards will be more or less.
For example, Bit2Me Earn cash providers can earn a twenty-five percent APY when using B2M tokens to earn rewards. This means that for every €1,000 in the pool, the provider will receive €250 per year for their contribution, paid in B2M tokens.
However, note that the final APR will decrease as your participation in the pool decreases. (because more people sign up for the company and thus the reward is divided among more people) If the APY is 30% in January 2022 and 20% in December, the amount of tokens received will eventually decrease slightly, which is generally Aggregation of tokens and revaluation is compensated.
You may think this is unfair, but the fact is that the system is designed to prevent withdrawal of tokens that are no longer in control and not allow their ultimate value to weaken. In short, it is a strategy to balance the crypto-economy in the ecosystem. This scheme is repeated in most protocols, so it is natural to find new reservoirs of explosive APYs.
Various cash tokens can be very useful for launching new products, especially related to DeFi, but due to their usefulness and many possibilities, cash tokens are used in various platforms such as blockchain games or metaverse. They all do it with a clear purpose. Attract people to these spaces and increase their acceptance. In any case, the success of the cash token depends on the product offered, its benefits and the interest it arouses in the community. If a single cash token does all of these things, we’re probably on the verge of a definitive success.
