What does LP mean: a complete guide to liquidity tokens in DeFi

In Brief

When you deposit assets into a liquidity pool on a DeFi platform, the system issues you LP tokens. This is not just a reward — it is a digital receipt that confirms your share in the pool and allows you to later withdraw your funds plus the earned fees. But this is just the beginning: LP tokens can be used in much more creative ways.

Why is liquidity needed in crypto

Imagine: you want to sell a rare token, but finding a buyer is impossible. Your order just hangs in the air. This is the problem that liquidity pools solve.

On centralized exchanges, market makers and the order book create opportunities for trading. In the decentralized world, everything is different. Here, the automated market maker model (AMM) works: you deposit a pair of assets (for example, BNB and USDT), and other users can immediately swap one token for another. For each swap, the system charges a small fee — this fee goes to liquidity providers.

Bitcoin, for example, is traded everywhere and easily: it is a highly liquid asset. But small altcoins, especially new projects, often suffer from low liquidity. A liquidity pool solves this problem directly: you deposit assets, receive LP tokens, and the market begins to function.

How LP Tokens Work and Why They Are Important

When you deposit, say, 1 ETH and 2000 USDT into a pool on the Uniswap platform, the smart contract calculates your share in the pool and issues an equivalent amount of LP tokens. This is your access key.

LP tokens are stored in your wallet and represent your right to the underlying assets plus accrued fees. If you lose LP tokens, you lose access to your share of the pool. That is why their security is critical.

Most LP tokens are named after the pair: contributed CAKE and BNB in PancakeSwap – received CAKE-BNB LP. On Ethereum, they often use the ERC-20 standard.

It is interesting that unlike centralized exchanges (CeFi), where you simply receive a receipt, in DeFi your LP tokens are usually transferred and moved between wallets. But be careful: some platforms restrict this, so it's always worth checking the terms.

Where to Get LP Tokens: Step by Step

LP tokens are issued only to liquidity providers. It's easy to obtain them:

1. Go to the AMM platform: PancakeSwap, Uniswap, or any other DEX in your ecosystem.
2. Choose the asset pair you want to deposit
3. Contribute an equal value of both assets
4. Confirm the transaction on the blockchain
5. Receive LP tokens in the wallet

The system will automatically calculate what share you will have and issue the corresponding amount of tokens.

Important point: centralized exchanges usually do not issue LP tokens. Your liquidity there is stored on a trust basis in a custodial storage.

How LP tokens can be applied: four main ways

( Withdrawal of assets from the pool

The most obvious application: when you need money, you burn the LP tokens ) literally: you transfer them back to the contract ###, and the system returns both assets to you plus your share of the accumulated fees. No magic — pure mathematics.

( Transfer of ownership rights

Want to transfer your position in the pool to another person? Just send them LP tokens. They will be able to withdraw the assets under their address. This is convenient for complex investment schemes where multiple participants manage one pool. However, calculating the exact number of tokens in your position without a special calculator can be tricky.

) Using as collateral for a loan

This is where financial engineering begins. Some lending platforms ###, such as Aave or Compound, if they support LP tokens ###, accept them as collateral alongside regular tokens like ETH or BTC.

The logic is simple: LP tokens represent real assets, which means they have value. You deposit LP tokens as collateral and receive a loan, usually in a stablecoin or a top altcoin. If the collateral ratio falls below the required level, your collateral will be liquidated.

( Yield Farming: Boosting Profits

The most profitable, yet risky option. You take your LP tokens and deposit them into a yield farm — a special service that automatically:

• Earns fees from swaps in the pool
• Receives additional rewards from the platform
• Reinvests these rewards back into the pool
• Repeats the process several times a day

Result: your capital works more efficiently than if you just held LP tokens. However, high transaction fees are distributed among the farm users, and each reinvestment carries a risk.

Risks to Be Aware Of

The shine of LP tokens has a downside:

1. Loss of tokens = loss of everything If LP tokens are stolen or lost, your assets in the pool will disappear with them. This is irreversible.

2. Vulnerabilities of Smart Contracts If the liquidity pool is compromised, you will not be able to recover your deposit. The same applies to yield farms where you have transferred LP tokens. One bug — and everything can fall apart.

3. Unstable losses When asset prices in a pair diverge significantly, you lose money compared to simple holding. This is a mathematical consequence of how AMM pools operate.

4. Difficulty of Position Assessment Looking at the number of LP tokens, you won't understand how much they are worth in reality. You need to calculate the share in the pool, take into account the accumulated fees, and forecast impermanent losses. Due to this opacity, it's difficult to decide when to exit a position.

5. Opportunity Cost Risk Money in the liquidity pool is not the only way to use it. Perhaps a staking position or just holding would be better? It's a choice, and in DeFi, it costs money.

Practical advice

Before depositing assets, assess honestly:

• Your willingness to take risks with smart contracts
• The volatility of assets in the pair ) is higher volatility = higher unpredictable losses (
• The size of the platform's fees and the number of rewards
• Time horizon )short-term trading vs long-term holding###

LP tokens are not a passive income, but an active tool for experienced DeFi users. If you are a newcomer, start with small amounts and learn the mechanics in practice.