LP Token: A Hidden Tool and Risk Guide in Decentralized Finance

Gentle reminder: The content is relatively long, so it is recommended to read it patiently. In the world of Decentralized Finance (DeFi), LP Tokens are the most common assets obtained by users participating in Liquidity Mining. These tokens essentially represent a certificate system, indicating your ownership share in the liquidity pool. Holding LP Tokens means you can withdraw the assets you deposited earlier at any time and receive all the earnings. However, the uses of these tokens go far beyond just withdrawing funds—they can also participate in yield farming, be used as collateral for lending, and even be transferred to others. It is important to note that once you transfer these tokens to others, the control over the original liquidity is also transferred.

Why is Liquidity So Important

Before understanding LP tokens, we need to understand the core role of Liquidity in the cryptocurrency market. Liquidity, simply put, is the ease of trading an asset—being able to quickly buy or sell an asset at a reasonable price without causing a significant impact on the market price.

Taking Bitcoin (BTC) as an example, it is the most liquid crypto asset on the market. Thousands of trading platforms around the world offer BTC trading, and regardless of how much you buy or sell, the price fluctuations are quite limited. However, not all tokens enjoy this convenience. Many emerging projects and DeFi protocols have relatively weak token liquidity, especially when they are only listed on a few exchanges.

Such a situation can cause practical problems: you may find it difficult to find a counterparty willing to take over the tokens you hold. Traditional finance uses market makers and order books to solve this problem, but Decentralized Finance adopts a different approach—liquidity pools (also known as automated market makers or AMMs).

In a liquidity pool, the paired two assets are stored in a smart contract, and the exchange price is automatically determined by the ratio of the two assets. Anyone who contributes a pair of tokens to the pool is called a liquidity provider, and they earn rewards through the fees collected each time a transaction occurs. Through this mechanism, DeFi users are both participants in the market and creators of the market.

How LP Tokens Work and Ownership Issues

When you deposit a pair of Tokens into the liquidity pool, the smart contract automatically issues LP Tokens to your wallet. These Tokens serve as a receipt that records your ownership proportion in the pool and are the only proof for you to withdraw your principal and accumulated fees in the future.

Since LP tokens represent ownership of real assets, it is crucial to safeguard these tokens. Once LP tokens are lost or stolen, all funds in that liquidity pool will also be irrecoverable. These tokens are typically stored in the wallet address used when creating the liquidity position.

It is worth mentioning that to have LP Tokens displayed correctly in your wallet, you may sometimes need to manually add the corresponding smart contract address. In most cases, LP Tokens in the DeFi ecosystem are transferable, meaning you can send them to other wallet addresses, and the recipient will gain control of the corresponding liquidity. However, not all platforms support this feature, and in certain cases, transferring LP Tokens may even lead to permanent asset loss.

Ways to Obtain LP Tokens

Only liquidity providers can obtain LP tokens. To own them, you need to deposit funds into a specific liquidity pool through DeFi applications (such as Uniswap or PancakeSwap).

This LP Token system is widely used across multiple public chains, various DeFi platforms, and automated market makers. It is important to note that LP tokens are usually not issued in the liquidity pools of centralized exchanges (CeFi)—your funds will be held in the exchange's custodial accounts.

The naming convention for LP tokens typically involves a combination of the symbols of the paired tokens. For example, depositing CAKE and BNB in PancakeSwap will yield a CAKE-BNB LP token that adheres to the BEP-20 standard; whereas on the Ethereum network, such tokens typically follow the ERC-20 standard.

The Diverse Use Cases of LP Tokens Ecosystem

Although LP tokens' most direct function is to prove ownership of liquidity, the composability of DeFi grants them multiple uses.

First Application: Transfer of Liquidity Ownership

The most direct way to use it is to transfer the LP Token to others. Although some LP Tokens are bound to specific wallet addresses, most can be freely transferred. For example, if a user sends BNB-wBNB LP Token, the recipient can withdraw the assets contained within. However, accurately calculating the specific asset quantity corresponding to one's LP Token is not an easy task and usually requires the use of DeFi calculation tools.

Second Application: Used as Collateral for Lending

Since LP tokens represent actual ownership of the underlying assets, many lending protocols consider them as valid collateral. You can use LP tokens for borrowing, typically to obtain stablecoins or other highly liquid assets. This borrowing must maintain an over-collateralization rate—if the value of the collateral falls below a specified ratio, the lender has the right to liquidate your LP tokens to recover the principal.

Third Application: Participate in Yield Farming

The most popular usage is to invest LP tokens into yield farming platforms. These platforms accept your LP tokens, use them to earn rewards, and then purchase more LP tokens. Periodically, the platform will reinvest the newly earned tokens back into the liquidity pool, allowing you to benefit from compound interest. While this can also be done manually, professional yield farming platforms are more efficient, as they can distribute high transaction fees among multiple users and perform multiple capital reallocations daily based on strategies.

Real Risks Faced by LP Tokens

Each asset comes with specific risks, and LP tokens are no exception:

Token Loss or Theft — Once the LP Token disappears from your control, all funds in the related liquidity pool will be permanently lost.

Smart Contract Vulnerabilities - If the smart contract of the liquidity pool has defects or is attacked, users may be unable to redeem the assets they deposited. This risk may also occur in yield platforms or lending services that receive LP Tokens.

Valuation Difficulty — It is difficult to determine the true value of LP Tokens just by looking at them. Coupled with complex factors such as impermanent loss and the need to calculate earned fee income, it becomes challenging for investors to accurately decide when to exit a position.

Opportunity Cost——Providing liquidity is just one of many investment options. Sometimes, other investment channels or asset utilizations may yield higher returns.

Summary Thoughts

The LP tokens obtained from participating in DeFi liquidity mining are certainly not just certificates waiting to be sold. When building a complete DeFi strategy, providing liquidity is only the starting point of the overall plan. Before deciding to further deploy your assets, it is essential to fully assess your investment goals and risk tolerance. This way, you can formulate the financial path that best suits you.