What exactly is an LP Token? A must-read for newbies.

Question

When it comes to DeFi Liquidity Mining, many people are left in the dark. In fact, the core idea can be summed up in one sentence: LP tokens are the “receipts” issued to you by the platform after you provide funds to the liquidity pool.

You deposit, and the platform gives you a note.

Imagine a scenario: Uniswap needs someone to provide ETH and USDC for traders, so it raises funds from you like a bank. You deposit 1 ETH + 1000 USDC, and the platform gives you an LP Token (for example, called “ETH-USDC LP”). This token is your “receipt” and “certificate.”

Why do we give you tokens? Because:

When traders use your funds for trading, they will pay transaction fees to the pool, and this money will ultimately be distributed to you.
This token can be redeemed anytime to cash out your ETH and USDC, and you can also take away the earned transaction fees.
This token can also do other things.

What Can LP Tokens Do? Three Main Uses

1. Transfer of Liquidity Ownership

You can transfer LP Tokens to others, which is equivalent to transferring your share in this liquidity pool. However, be aware that some platforms stipulate that once transferred, you will permanently lose liquidity, so make sure to ask clearly first.

2. Borrow Money

The Lend protocol will accept LP Tokens as collateral, allowing you to borrow stablecoins. For example, you can borrow USDC using “ETH-USDC LP”, provided that the margin rate meets the requirements; otherwise, it will be subject to forced liquidation.

3. Reinvest to Earn Compound Interest

This is the most commonly used method. Throw the LP Token into the “Liquidity Mining Aggregator” (like Yearn), and the system will automatically:

Harvest the trading fees you earn
Buy back new ETH and USDC
Re-deposit into the pool

A cycle happens several times a day, with interest compounding, and profits multiplying.

Risk Reminder: Don't Fall into the Trap

Smart Contract Bug: If there is an issue with the Uniswap contract, or if the mining aggregator where you put your LP Tokens is hacked, your money will be stuck.

Impermanent Loss: When the price of one coin goes up and the other goes down, the value of your LP Token will decrease accordingly. It's hard to calculate the actual value.

Opportunity Cost: Locking money in a liquidity pool may cause you to miss out on other more profitable opportunities.

Lost Tokens = Total Loss: Never put LP tokens in an unsafe place, as once lost, they cannot be recovered.

Core Recommendations

Providing liquidity sounds good, but don't be tempted by the profits to jump in. First, figure out: how much loss can you bear? How long can this money be idle without issues? Then decide whether to invest. The world of Decentralized Finance is full of tricks, take a closer look before acting.