What Are Liquidity Provider Tokens (LP Tokens)?
Liquidity Decentralized Exchange (DEX) provider tokens, or LP tokens, are tokens issued to liquidity providers on decentralized exchanges (DEXs) that operate using automated market maker (AMM) protocols.
LP tokens serve the purpose of tracking individual contributions to the overall liquidity pool.
The provider’s number of LP tokens corresponds proportionally to their liquidity share in the pool.
Control and Redemption of LP Tokens
Holding LP tokens grants liquidity providers complete control over their locked liquidity.
Most liquidity pools allow providers to redeem their LP tokens at any time without interference, although some may impose a small penalty for early redemption.
The proportional share of a liquidity pool is used in two main cases:
- Determining the liquidity provider’s share of transaction fees accumulated during the liquidity provision period.
- Determining the amount of liquidity returned to liquidity providers from the liquidity pools when they choose to redeem their LP tokens.
LP tokens have many other emerging use cases:
- Staking LP tokens to earn additional rewards incentivizes liquidity providers to lock their liquidity into pools. This is sometimes referred to as “farming.”
- Using the value of LP tokens as a qualifying factor for accessing initial DEX offerings (IDOs).