Liquidity and LP tokens
Liquidity pools (LP) are crowdsourced pools of tokens that are held in smart contracts. They are typically comprised of two tokens (e.g. LIF3 and FTM). The balance of these two tokens reflect the current market price, both in USD value and in token ratio with one another.
Due to the decentralized nature of Decentralized Exchanges (DEXes), anyone can add to these pools and provide liquidity. By adding the two tokens at the current market rate, liquidity-providing investors essentially buy a share of the pool, represented by LP receipt tokens (e.g. LIF3-FTM LP tokens).
Note: Since these tokens are representative of the whole pool, the underlying balance of the two assets is constantly changing, so what you put in is not necessarily what you will receive when withdrawing.
For every trade that runs through that liquidity pool, a portion of the fees is returned to the pool, where it is distributed amongst all the LP providers (proportional to each person's share of the pool) as incentive for providing liquidity. Thus, these representative LP tokens inherently appreciate with the swap fee accumulation, and they can be redeemed for the underlying assets at any time by withdrawing from the liquidity pool.
LP tokens are receipt tokens that:
- Represent an investor's deposit and share of the liquidity pool
- Allow investors to eventually withdraw their share of the tokens from the liquidity pool
(Note: don't transfer LP tokens to unknown wallets otherwise you risk losing all your deposited funds)
- Allow investors to earn swap fees from the DEX
Certain LP pairs are incentivized by DEXes to selectively deepen their liquidity. This means LP tokens can be staked in 'farms' for additional yield (typically in the form of house/native/DEX tokens). It promotes capital efficiency by utilizing the LP tokens, which otherwise may sit idle in the wallet.
Yield farming benefits for investors:
- Yield farming can be a lucrative way to earn trading fees or farming reward tokens
- Improve your assets' capital efficiency by utilizing idle LP tokens sitting in your wallet
- By yield farming, you are also supporting the DeFi ecosystem you are participating in