LP Token

An LP token (Liquidity Provider token) is a fungible digital asset minted by a decentralized exchange's smart contract when a user deposits an equal value of two assets into a liquidity pool. It acts as a verifiable, on-chain receipt for the user's contributed liquidity, with its quantity representing the provider's proportional share of the total pool. Holding an LP token grants the right to reclaim the underlying assets, plus a portion of the trading fees generated by the pool, at any time.

The primary function of an LP token is to enable non-custodial proof of ownership. When a liquidity provider decides to withdraw their funds—a process known as "burning" the LP tokens—they submit the tokens back to the pool's smart contract. The contract then calculates their current share of the pooled assets, including accrued fees, and returns the corresponding amounts. This mechanism allows providers to exit their position without needing a centralized intermediary to track their contribution.

Beyond simple redemption, LP tokens are themselves composable financial primitives. They can be staked in additional yield farming protocols to earn extra token rewards, used as collateral for borrowing in lending protocols, or even traded on secondary markets. This composability is a cornerstone of DeFi (Decentralized Finance), creating layered financial incentives. For example, a user might deposit ETH and USDC into a Uniswap V3 pool, receive UNI-V3 tokens, and then stake those tokens in a separate protocol to earn additional governance tokens.

The value of an LP token is intrinsically linked to the value of the assets in the pool, a concept known as impermanent loss. If the price ratio of the two deposited assets changes significantly compared to when they were deposited, the value of the LP token holding may differ from simply holding the original assets. This risk is offset by the accumulation of trading fees, which are automatically added to the pool's reserves, increasing the underlying value each LP token represents over time.

An LP token (Liquidity Provider token) is a fungible ERC-20 or similar standard token that acts as a receipt and proportional claim on the assets within a decentralized exchange (DEX) liquidity pool. When a user, known as a liquidity provider (LP), deposits an equal value of two tokens (e.g., ETH and USDC) into a pool, the AMM's smart contract mints and sends these tokens to the provider's wallet. The quantity of LP tokens minted represents the provider's exact share of the total pool. Holding these tokens is the sole proof of ownership and the right to reclaim a proportional share of the pooled assets, plus any accrued trading fees.

The primary function of LP tokens is to enable passive yield generation and pool participation. As traders execute swaps against the liquidity pool, they pay a fee (commonly 0.01% to 0.3%). This fee is automatically added to the pool's reserves, incrementally increasing the total value of the pool. Because an LP token represents a fixed percentage of the pool, its underlying value grows as fees accumulate. This mechanism allows LPs to earn a return on their deposited capital without active trading. Furthermore, LP tokens are often used as collateral in other DeFi protocols for lending, borrowing, or yield farming strategies, creating complex financial levers.

A critical concept for LPs is impermanent loss, which is not a fee but a result of divergence in asset prices. When the price ratio of the two deposited assets changes significantly after deposit, the value of the LP's share in the pool can become less than the value of simply holding the original assets. The LP token's value automatically rebalances to maintain the pool's constant product formula (x * y = k), often selling the outperforming asset to buy more of the underperforming one. This loss is 'impermanent' because it is only realized upon withdrawal; if prices return to their original ratio, the loss disappears, though accrued fees can offset it.

To withdraw their underlying assets, a liquidity provider must burn or redeem their LP tokens. By sending the LP tokens back to the pool's smart contract, the contract calculates the provider's current share of the total reserves and transfers the corresponding amounts of both pooled tokens back to the provider's wallet. This action also automatically claims any unclaimed trading fee rewards accrued during the deposit period, which are included in the returned amount. The process is permissionless and executed in a single transaction, dissolving the provider's claim on the pool.

LP tokens are foundational to DeFi composability. Protocols like Curve Finance issue them as crvTokens, while Uniswap V2 uses UNI-V2 tokens. These standardized tokens can be staked in gauge systems to earn additional protocol governance tokens (e.g., CRV, BAL) or to vote on pool incentives. This creates layered yield opportunities but also adds smart contract risk and protocol dependency. The security and value of an LP token are intrinsically tied to the integrity of the underlying AMM contract and the liquidity of its paired assets.

An LP token (Liquidity Provider token) is a fungible digital certificate minted when a user deposits an equal value of two assets into an AMM's liquidity pool, such as a Uniswap V2 pair. It is a proof-of-stake that quantifies the provider's proportional ownership of the pooled reserves. Holding the LP token entitles the provider to a share of the trading fees generated by the pool and is the sole mechanism for reclaiming the underlying assets.

The lifecycle begins with deposit and minting. When assets are supplied, the AMM's smart contract issues new LP tokens to the depositor's wallet. The number minted is calculated based on the deposited amount relative to the existing pool reserves. From this point, the token accrues value through continuous fee accumulation as trades execute against the pool. This process is often called yield farming or liquidity mining when LP tokens are further staked in a separate protocol to earn additional token rewards.

The final stage is redemption or burning. To withdraw their share of liquidity, a provider returns their LP tokens to the pool's smart contract. The contract then burns (destroys) the tokens and transfers the provider's proportionate share of both pooled assets back to their wallet, plus any accrued fees. The value received may differ from the initial deposit due to impermanent loss, a divergence in the price ratio of the two assets held in the pool.