By Larry Wright
Introduction
Cryptocurrencies are in many ways like commodities such as metals and crops etc. Therefore, there are many functions of stocks that cryptocurrencies are unable to provide the investors such as dividend income. However, cryptocurrency investors have come up with new ways to generate passive income with the ownership of their tokens.
This article will shed light on the subject of Liquidity Pools and Liquidity Pool Tokens or LPTs for the benefit of the reader.
What is a Liquidity Pool?
Anyone who has invested or taken an interest in cryptocurrency has heard about the term liquidity time and again. Liquidity is the quality of an asset to be convertible into fiat or any other medium of exchange as soon as possible.
Since DeFi is a predominantly decentralized trading market therefore liquidity is like the backbone of an important decentralized product. The disastrous collapse of the crypto exchange FTX was a direct result of the lack of liquidity available to sustain the pressure of all the withdrawals on the network.
Therefore, it is important for investors to always measure how much liquidity a DEX or CEX platform holds before investing. Many cryptocurrency organizations allow investors to stake their tokens in a group wallet. These wallets or reserves are called Liquidity pools.
The main aim of the Liquidity pool is to make sure that every cryptocurrency project has sufficient liquidity available for investors at all times. The liquidity should be enough that the crypto enterprise can handle emergency trading incidents.
How does a Liquidity Pool Work?
A liquidity Pool is like a commercial or communal digital wallet or digital currency reserve. It ensures that the investors who are trading the cryptocurrencies can easily exchange their reserves with other currency options.
A cryptocurrency exchange is like a bank except for being partially or completely decentralized. The digital wallets of each user on a cryptocurrency exchange are like their bank account. Therefore, one can also think about Liquidity Pools somewhat like savings accounts.
Traditionally, banks offer returns to their customer if they opt to open a savings account. It means that banks are trying to give benefits to consumers for putting their money in their accounts. The money is used by banks to provide liquidity and for other investment ventures.
On the other hand, crypto enterprises offer the chance for investors to stake their tokens in a Liquidity Pool. The staking could mean that investors have to pledge their cryptocurrencies for a given period to earn yields.
What are Automated Market Makers or AMM?
The Automated Market Makers are the digital versions of stock exchange market makers in the DeFi sector. The function of the AMMs is to maintain the prices of different cryptocurrencies within a crypto enterprise based on their supply and demand.
A person who is using more than one cryptocurrency exchange can notice that there are some minor price differences upon comparison for the same asset.
It happens on account of the AMM price projections and reflects the amount of a cryptocurrency reserve available within the Liquidity Pool of a DEX or CEX entity.
For an investor locking their cryptocurrency into a Liquidity Pool means that they have locked their reserves in a smart contract so that it can be used by other investors.
In return, the liquidity providers can earn a yield on their staked tokens. Automated Market Makers are like Liquidity Pool managers. Meanwhile, LPs operate in the same manner as companies convert cash reserves into debt or equities using loans.
The job of AMMs is to match the purchase and sell orders with each other while keeping a record of the Liquidity and it all happens within Liquidity Pools.
Top Liquidity Pool Providers in 2022
Most cryptocurrency exchanges are decentralized companies. Therefore, investors are always worried about finding sufficient liquidity to ensure the safety of their trading positions. Many decentralized trading forums leverage AMMs to make LPs automated and permissionless trading options for the benefit of their investors. Here are some of the most popular Liquidity Pools investors can use:
Uniswap
Uniswap allows investors to trade or exchange any ERC-20 tokens in a decentralized manner. The platform is open-sourced and it is open for any cryptocurrency investor who is willing to swap their DeFi tokens without charging a fee.
Curve
It is a decentralized LP built on the Ethereum network that is dedicated to stablecoins. The slippage on this platform is smaller in comparison to other LPs because stablecoins are inherently less volatile than crypto tokens and coins.
Balancer
Balancer is another noteworthy decentralized trading pool that offers unique options such as retail and collective pools. For both individual and group pooling options, there are different reward systems and incentives for the stakers in Balancer.
Advantages and Disadvantages of Liquidity Pools
Before moving on to learn about the Liquidity Pool Tokens, investors must learn about the pros and cons of Liquidity Pools.
Benefits of Liquidity Pools
Liquidity Pools allow the smallest DEX platforms to keep facilitating all their transactions in real time and using the current sports prices.
LPs are a great way for cryptocurrency investors to earn a passive income while they are holding on to long-term positions. This income can be seen as interest, yield, or staking rewards depending on the rules of the LP in question.
By incorporating LPs, decentralized networks and cryptocurrency exchanges can display smart contracts for security audit and transparency for their users.
Limitations of Liquidity Pools
The funds that are present in a Liquidity Pool are under the control of a small enterprise or group for example the management of the exchange. Such as system can go against the principles of decentralization.
LPs are often at risk for exploits and hacks that can result in massive losses for the stakers and liquidity providers.
There are some cases, where investors should beware of risks like rug pulls and exit scams when using an LP.
LP staking can expose the investor to the danger of impermanent loss. Meaning that while the cryptocurrency reserves are locked in an LP, the prices for that token can decline in the overall market and resulting in unrealized losses because investors are unable to take their stakes tokens out of the pool before the time limitation.
What is a Liquidity Pool Token (LPT)?
Liquidity Pool Tokens or LPTs are native-issued tokens that are used to govern and gain access to the services of the Liquidity Pool. In many ways, it can be said that they are like Utility Tokens that are specific to Liquidity Pools.
The LPTs can perform many functions related to the LP. It depends on the respective LP and how it has incentivized the LPT issuance and assigned which features for its users. In most cases, these LPTs are automatically issued from the LPs based on the smart contract triggers.
The owners of the LPTs are usually unable to buy or sell them in the spot markets but they can only earn them for participating in the LP and pledge them for LP incentives.
How do LPTs Work?
The simplest possible way to understand LPTs is that they are issued to investors who are staking their tokens in a Liquidity Pool. In some cases, these LPTs are issued as compensation or yield income and in other scenarios, these LPTs are used as a representation of other incentives related to an LP.
The LP present on a particular blockchain is often representative of the same token structure on the genesis blockchain. For example, all the decentralized Liquidity Pools on Ethereum issue LPTs that are compliant with the ERC-20 token standard.
The LPT issued by an LP can have unique names based on their issuers. However, they are based on two main crypto trading pairs. For example, Sushi Swap LPT is called SushiSwap Liquidity Provider or SLP token.
SLP is used for swaps between Ethereum and USDC, making ETH/USDC the main trading pair for SushiSwap.
Do LPTs have an Underlying Value?
There is an important question that arises for crypto investors that does LPTs have a trading value attached to them? The answer is not a simple yes or no. It is important to note that the value of an LPT is based on its importance for the functioning of an LP or DEX.
The cases, where AMMs cannot operate without LPTs, the value is higher. In other cases, LPTs can be used as record keepers for the total amount of yield earned and they need to be submitted in the LP to earn the yield and in such cases, the value can be lesser.
At the end of the day, some LPTs are standalone tokens and they are also traded on the spot markets in other cases they are limited to the internal functionality of an LP and only used to represent the yield income or other incentives.
Uses of Liquidity Pool Tokens
As mentioned before, there are no hard and fast rules attached to the functions of an LPT. Every Liquidity Pool sets the incentives and utility for its native LPT issuance at its discretion. Here are some important uses of LPTs or Liquidity Pool Tokens that are given as under:
Store of Value
The most common use of an LPT is to use it as a store of value currency. Some investors take out their cryptocurrency profits and convert them into stablecoins. This process ensures that the value of their profits does not disappear when there are spot price corrections for the given cryptocurrency.
However, sometimes stablecoins can be risky and they can crash to zero resulting in the decline of the total investment. Therefore, there are other options available for investors to keep their yields in the form of LPTs and treat it like a store of value.
Transfer of Liquidity
There is a very unique and interesting method of utilizing Liquidity Pool Tokens. In some cases, investors can use LPTs to transfer their liquidity stake to another investor. For example, when an investor has staked in Binance Liquidity, they will earn BNB LPTs.
The BNB LPT holder can transfer it to another user to transfer the ownership of their liquidity stake to other investors in exchange for other cryptocurrencies.
Loan Collateral
LPTs represent the number of cryptocurrencies an investor has under their ownership in addition to the total yield income they have earned. Therefore, some cryptocurrency lending platforms allow investors to use them as collateral for issuing new loans.
Therefore, investors who have LPTs can use them to represent the collateral to borrow stablecoins and other high-unit-price cryptocurrencies.
In case of a margin call, the lender can use the LPT present in the collateral to assume the ownership of the liquidity commit and its yield income.
Yield Compounding
Yield Farming is one of the most effective ways to generate multiple streams of income using LPTs. When an investor stakes their cryptocurrencies, they earn LPTs and yields. The returns from the cryptocurrencies are the first income stream while the LPT yield is the second one.
To add another layer of yield income, investors can take their LPTs and stake them back in other liquidity pools to earn yields on their LPTs, adding a third income stream.
In some cases, investors use the aforementioned manual yield farming method. On the other hand, investors can also render the services of Yield Compounders.
These services use the LPTs for each investor and earn yield rewards with them and then purchase more token pairs to compound the yield income by staking.
The compounding technique is considered more effective in comparison to manual yield farming. Because Compounding can decrease expenses and make compounding bets several times a day depending on its trading strategy.
IDOs
Most investors have heard about IPOs or Initial Public Offerings and their DeFi counterpart ICO or Initial Coin Offering. There is another type emerging from the same root called IDO or Initial DEX Offering.
IDOs are organized by decentralized exchanges to collect funds and issue token offerings for investors. The LPT owners who possess LPTs issued by a particular DEX could participate in the new IDOs related to the same decentralized protocol with their LPTs.
Risks Associated with LPTs
Here are some of the most noteworthy disadvantages of LPTs that every investor should know:
Theft
The entire cryptocurrency infrastructure and the decentralized sector is a digital plane. It means that it is vital for investors to beware of the risks of exploits, and hacks, and make sure to store their private keys securely.
In case of any type of external intrusion, the investors can lose their LPTs through theft or hack, they are bound to lose any claim over their liquidity stake and yield rewards. Another good method to prevent such loss is to lock LPTs in cold storage or offline wallets.
Smart Contract Lags
There are some cases, where the smart contract failure can result in the revocation of the yield income. The error in the smart contract functioning can expose the investors to not regain access to their liquidity based on their LPs.
In the same manner, smart contract failures can occur during yield compounding or yield farming. The best way to avoid such as scenario is to make sure that the DEX and LP you are using hold a credible technical audit that would prevent them from getting a technical error hit.
Value and Utility
In most cases, it is a difficult task to find the underlying value and the true functions of an LPT. There is no size-fit formula for LPTs. Each DEX and LP developer assigns functions and value to the LPTs based on their personal preferences and design.
Therefore, investors should do detailed research on the topic and learn about the use case for the LPT under different scenarios.
Hacks and Exploits
Another danger that hinders the value of LPTs is the danger of hacks and exploits. Some decentralized exchanges are routinely targeted by threat actors on account of their weak security.
Therefore, investors should read about the historical performance and stability of an LPT before becoming a liquidity provider.
Impermanent Losses
Impermanent Losses happen when the spot prices of a cryptocurrency locked in a Liquidity Pool drop suddenly. Under such circumstances, the investors are unable to sell their crypto reserves since they are locked in a smart contract.
Conclusion
Learning about Liquidity Pools and Liquidity Pool Tokens is a way for investors to elevate their trading income. Investors must always keep the risks and associated issues related to LPTs in mind. In this manner, they would be able to adopt preventive measures and reap multiplied income from their cryptocurrency reserves at the same time.