What is an LP Token?

LP Tokens or liquidity tokens, are special tokens created by DEX platforms in order to reward users who inject liquidity into their pools in order to make their operation possible, and which have become very useful tokens in the markets.

Un LP token or liquidity provider token (Liquidity Pool Token or LP Token), is a type of token issued by the platforms of decentralized exchange (DEX). The concept is as follows: liquidity providers use their tokens to inject liquidity into the different DEX pools and, consequently, they receive a reward according to the injection of liquidity provided to said pool through the LP token as a form of payment.

This is a model widely used by DEX as Uniswap, Sushi Swap, PancakeSwap, Compound and, in general, by the majority of DEX that use the model of AMM or Automated Market Makers.

How do LP Tokens work?

Now, what technical characteristics can we find in them? Well, this varies according to the project that implements the LP Token as such. To understand this a little better, let's look at the Uniswap platform's UNI LP token. The UNI token is actually a utility token of type ERC-20 that works on the Ethereum blockchain and whose smart contract we can find at this address.

A quick look at the image above reveals some important features and data about the UNI token, among which are:

1. Total issuance of one billion tokens.
2. It is an Ethereum ERC-20 type token.
3. + 297 thousand on-chain holders.
4. + 3 million on-chain transfers since its launch.
5. Contract address 0x1f9840a85d5af5bf1d1762f925bdaddc4201f984, verifiable on the Ethereum blockchain.
6. Precision up to 18 decimal places.
7. Current value of the token and its diluted market capitalization.

All this information makes it clear to us that UNI is a fungible token (as defined by the ERC-20 standard), transferable and freely usable within the Ethereum network. In addition, it informs us that its issuance is limited and therefore the value of the token in relation to the time and usefulness of the platform can be appreciated, an appreciation that is influenced by another important factor: the use of the platform and the total liquidity provided. within the DEX pools.

It is at this point that a formula comes into play that helps determine the value of an LP Token, namely:

LP Token Value = Total Liquidity Pool Value / Circulating Supply of LP Tokens

To understand this formula, let's continue with the UNI token example. We know that Uniswap has a TVL of $7,87 billion. This total is divided into the liquidity locked in your V2:

And the liquidity locked in your V3:

If we also know that the UNI token has a current circulation of 627.286.736,56 UNI, then with these two data we can apply the formula and know the value of its LP Token:

UNI value = 7,87 billion dollars / 627.286.736,56
UNI Value = $12,84

At this point you will surely wonder why the value returned by the formula is lower than what we observe in CoinMarketCap or Etherescan? Because the result of the formula corresponds to the value granted by the token using the data offered only by Uniswap. That is, it does not take into account other markets and exchanges where the token has a presence (such as Bit2Me where you can buy-sell the UNI token), hence the price difference between what we see in those markers and what our previous one shows us. example. That is, if we take the UNI liquidity in those other slots and add them up, we will end up getting the actual final value of the token with minimal error.

Each LP Token is unique

Now, this example with the UNI token has made it clear to you how it works and how we can calculate its market value, but what about the rest of the LP Tokens?

The rules are the same and would be:

1. Each LP Token works under a unique blockchain and standard. For example, UNI and Sushi work on Ethereum and use the standard ERC-20, but CAKE (PancakeSwap's LP Token) works on top of BSC and is of type BEP-20. This means that each token works on its network and cannot be exchanged directly.
2. The value of the LP Token depends on the total value of the platforms where it is traded (whether DEX or CEX) and that value is divided by the total number of tokens in circulation.
3. If an LP token burn occurs for any reason, this will positively affect the value of the token (It will make it more scarce and therefore more valuable).

Now, a very important aspect must also be taken into account and that is that each DEX platform has its own issuance rules, which affect the value of the token to a greater or lesser extent. For example, direct issuance platforms such as Uniswap seek to increase the value of UNI with increased adoption and attract investment. While platforms like Terra they expect their tokens to increase in value by following algorithmic models that adjust the issuance and value of the token according to their needs.

This means that to get the most out of an LP Token you must know the structure and operation of the project that has issued it. If you know this, you will be able to know how the value of the token can increase and how far it can go.

This case applies, for example, to Bit2Me Token (B2M), whose issuance is direct and is used as an LP Token for those who participate in its system of staking Bit2Me Earn. Thus, as the TVL of Bit2Me Earn increases, the value of B2M will be consolidated, while you receive rewards for your participation.

receiving rewards

Now, the main purpose of LP tokens is to offer rewards to liquidity providers, and at this point, each platform has a method for this. The most common system is the equitable distribution of rewards among pool participants, which is possible because of the commissions charged by the DEX, a percentage is used for it. The rewards will be higher or lower depending on the percentage assigned for that purpose.

So, for example, a liquidity provider on Bit2Me Earn can receive an APY of 25% if they use the B2M token to receive said reward. This means that for every €1.000 in the pool, the provider will receive €250 per year for their participation, and this reward will be allocated in B2M tokens. One point to keep in mind is that as your participation is diluted in the pool (because more people sign up for the participation and therefore the reward is divided among more individuals), the final APY decreases.

What does this all mean? That, if you entered the pool in January 2022 with an APY of 30% and in December the APY is 20%, in the end the amount of tokens received will have decreased slightly, which is generally compensated by the consolidation and revaluation of the token. You might think that it is unfair, but the reality is that the system is designed to prevent the issuance of the token from going out of control and ending up undermining its final value.

In short, it is a strategy of balancing the tokenomics within the ecosystem. This scheme is repeated in most protocols, so it is normal to find new pools with explosive APYs, which end up falling rapidly due to this operating system.

Conclusions

LP tokens can be very useful for the adoption of new products, especially those related to the DeFi world. However, given its usefulness and enormous possibilities, LP Tokens are being used in platforms as diverse as blockchain games or metaverses, all with a clear purpose: to attract people to these spaces and increase their adoption.

In any case, the success of the LP Token will depend on the product that is presented, its usefulness and the interest it arouses in the community. If an LP Token achieves all of this, then we are likely to be in for a surefire hit.