Liquidity Token (LP Token)

A Liquidity Token (LP Token) is a blockchain-based token that represents a liquidity provider's share of a pooled asset reserve in a Decentralized Exchange (DEX). It is a receipt or proof of deposit, minted when a user contributes an equal value of two assets (e.g., ETH and USDC) to an Automated Market Maker (AMM) liquidity pool like Uniswap or Curve. Holding the LP token entitles the provider to a proportional share of the pool's trading fees and the right to reclaim their underlying assets, minus any impermanent loss, by burning the token.

The primary function of an LP token is to enable non-custodial ownership of pool shares. Unlike traditional finance, where a central entity records ownership, the LP token itself is the record. Its value is derived from the total value locked (TVL) in the underlying pool. As trades occur and fees accumulate, the value of the pool's assets changes, which is reflected in the exchange rate between the LP token and its underlying assets. This mechanism allows for the seamless transfer or use of liquidity positions across different DeFi protocols.

LP tokens are foundational to DeFi composability. They can be used as collateral for borrowing on lending platforms like Aave, deposited into yield aggregators to earn additional rewards, or staked in a protocol's governance system to earn emissions of a native token. For example, providing liquidity to a Uniswap V3 ETH/USDC pool yields UNI-V3-POS NFTs, a non-fungible variant of an LP token representing a specific price range, which can then be deposited elsewhere to compound returns.

The economics of providing liquidity are governed by the LP token. Providers earn a portion of all trading fees, typically ranging from 0.01% to 1% per trade, proportional to their share. However, they are exposed to impermanent loss—a divergence in asset prices that can make providing liquidity less profitable than simply holding the assets. The LP token's value automatically accounts for both accrued fees and this price divergence, representing the net position of the liquidity provider at any time.

Technically, LP tokens are often implemented as ERC-20 tokens (or ERC-721 for concentrated liquidity), with a smart contract that calculates each holder's share. When a user burns their LP tokens, the contract calculates their current proportional claim and transfers the corresponding amounts of the two underlying assets back to their wallet. This design ensures transparent, verifiable, and permissionless liquidity provision, forming the core infrastructure for decentralized trading and yield generation.

A Liquidity Provider (LP) Token is a blockchain-based receipt token minted by an Automated Market Maker (AMM) to represent a user's proportional share of a pooled liquidity reserve. When a user deposits assets into a liquidity pool—such as pairing ETH and USDC—the protocol mints and sends LP tokens to the depositor's wallet. These tokens are fungible and transferable, acting as both a claim on the underlying assets and a record of ownership. The quantity minted is calculated based on the depositor's contribution relative to the existing pool reserves, ensuring the token's value is directly pegged to the pool's total value.

The minting process is the first half of the cycle, initiated by a user's deposit transaction. The AMM's smart contract calculates the amount of LP tokens to issue using a formula like LP_tokens_minted = (deposit_amount / total_pool_supply) * existing_LP_token_supply. This ensures new tokens are issued without diluting the value of existing holders' shares. These tokens then accrue trading fees generated by the pool, which are automatically added to the underlying reserves, increasing the value each LP token represents. Holding the token is passive; fee accrual happens at the protocol level.

The burning process is the reverse operation, where a user redeems their LP tokens to withdraw their share of the pooled assets, plus any accumulated fees. By sending their LP tokens back to the pool's smart contract in a withdrawal transaction, the contract burns (permanently destroys) the tokens and releases the corresponding proportion of each asset in the pool to the user. The amount of each asset returned is calculated based on the current pool ratios, which may differ from the initial deposit due to price movements and accrued fees, resulting in impermanent loss.

This mint-and-burn cycle is fundamental to decentralized finance (DeFi) liquidity. It enables non-custodial, programmable ownership of pool shares. LP tokens themselves can often be used as collateral in other DeFi protocols for lending or yield farming, creating complex financial strategies. The entire mechanism is enforced by smart contract code, ensuring transparency and eliminating the need for a trusted intermediary to custody the assets or manage the ledger of ownership.

The value of an LP token is not a simple price but a direct claim on the underlying liquidity pool's reserves, calculated as the product of the quantities of the two paired assets. In a constant product AMM like Uniswap V2, the token's value is derived from the formula k = x * y, where x and y are the reserve balances. The total supply of LP tokens represents 100% ownership of the pool; therefore, the value of a single LP token is (value_of_x + value_of_y) / total_LP_token_supply. This value fluctuates with every trade, fee accrual, and impermanent loss within the pool.

LP tokens are non-fungible representations of a fungible position, minted and burned exclusively by the pool's smart contract. When a user adds liquidity, the contract mints new LP tokens proportional to their contribution to the reserves. Conversely, burning the tokens redeems the user's share. This mint/burn mechanism is governed by the contract's logic to maintain the invariant k. The tokens themselves are typically ERC-20 tokens on Ethereum or equivalent standards on other chains, enabling them to be transferred, staked in yield farms, or used as collateral in other DeFi protocols.

Smart contract interaction with LP tokens is central to DeFi composability. Protocols do not directly manage the underlying assets; they interact with the LP token contract. Key functions include mint() (deposit liquidity), burn() (withdraw liquidity), and sync() (update reserve balances). When a user stakes LP tokens in a yield farming contract, they are granting that contract temporary custody, allowing it to claim the trading fees accrued to that portion of the pool. This separation of custody (LP token) from the base assets enables complex, layered financial applications built on a foundation of programmable liquidity.