In addition to representing equity, LP tokens can be used across multiple DeFi platforms in ways that can increase the value of the investment.
How do LP tokens gain value? They gain value as a core component of DeFi and contribute to the smooth operation of the DEX and AMM used by these DApps.
One primary source passive income for liquidity providers, it is the share of transaction fees earned by the liquidity pool relative to their investment share.
There are other use cases and revenue streams for LP tokens. Here is an overview of the main ones.
Collateral in the loan
Some cryptocurrency platforms, such as Aave, allow liquidity providers to use their LP tokens as collateral to secure a crypto loan. Cryptocurrency loans has become an essential part of DeFi, allowing borrowers to use their cryptocurrencies as collateral and lenders to earn interest from their borrowers.
LP tokens used as collateral is still an emerging trend and only a few platforms offer this service. Such a financial instrument is highly risky, and if a certain collateral ratio is not met, borrowers may lose their assets through liquidation.
Profitable management
Yield farming is the practice of depositing LP tokens into a yield farm or compounder to earn rewards. Investors can move their tokens manually using different protocols and get LP tokens when they deposit them on another platform.
Alternatively, they can use liquidity pools of protocols like Aave or Yearn.finance, which help liquidity providers earn compound interest more efficiently than humans.
Such a system allows users to share expensive transaction fees and use different compound strategies according to the effort and time they want to devote to this type of investment. One example of a compound strategy is borrowing cryptocurrency on a platform that pays interest and then reinvesting that interest back into the original cryptocurrency to potentially increase returns. Another example is using an algorithmic trading strategy automate buying and selling assets to generate profits that can be reinvested.
LP staking
Liquidity providers can stake their LP tokens to get additional profit. It occurs when users transfer their LP assets to an LP staking pool in exchange for new token rewards, just as a bank pays interest on savings account. It also incentivizes token holders to provide liquidity. Early stakers in the project can earn a very high annual percentage return (APY), which decreases as more LP tokens are staked into the pool.
Where to bet LP tokens
LP tokens work just like other tokens supported by a blockchain network. For example, tokens issued on an Ethereum-based platform such as Uniswap are ERC-20 tokens and can be staked like any other token of the same kind.
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