So if you were to contribute liquidity (in the shape of assets) to liquidity pools on these DEXs, you would be issued LP tokens. These tokens track your individual contributions to the overall liquidity pool and correspond in direct proportion to your share of liquidity in the overall pool.
The value of 1 LP token for a specific Liquidity Pool follows a simple formula:
Total Value of the Liquidity Pool / Circulating Supply of LP Tokens
For instance, if the total value of an ETH/USDT Liquidity Pool is $3 million and there are 1,000 ETH/USDT-LP tokens circulating, then each ETH/USDT-LP token would be worth $3,000 ( that is, $3,000,000 divided by 1,000).
As such, you can work out how many LP tokens you would get from the corresponding liquidity pool using the following formula:
Value of your contribution / Total Value of the
Liquidity pool * Circulating Supply of LP Tokens.For instance, if you provided $3,000 worth of ETH and USDT to an ETH/USDT Liquidity Pool, taking the total liquidity in the pool to $3 million, and there are 1,000 ETH/USDT-LP tokens in circulation, you would expect to receive:
3,000 divided by 3,000,000 multiplied by 1,000 = 1 ETH/USDT-LP token.
In other words, for providing 0.1% of the total liquidity in a Liquidity Pool, you would be issued 0.1% of the total LP tokens in circulation. You can easily see that your ownership share of LP tokens corresponds directly to your ownership share of the liquidity.
Holding LP tokens enables you, as a liquidity provider, to control how you want to lock your liquidity into the pool. As soon as you want to extract your contributed liquidity, you simple need to redeem your LP tokens on the corresponding liquidity pool. Once redeemed, you return your LP tokens and receive back your contributed liquidity (both assets, in equal dollar value, in the liquidity pool pair) plus your share of the commissions levied by the liquidity pool.
The relationship between LP tokens and the liquidity is almost always directly proportional, and this proportion is used to calculate:
- How much your share of the transaction fees or commission earned during the period you provide liquidity.
- How much liquidity (in the shape of assets) is returned to you when you decide to redeem your LP tokens for your contributed assets.
This commission is typically calculated at the same proportion of your contribution. For example, if you redeemed 1% of the total liquidity in the pool, you would also receive back 1% of any fees or commissions earned during the period you provided liquidity.
Today, there many other ways you can use LP tokens other than to provide liquidity to DEXs and earn commissions from that. Modern DEFI platforms even allow you to perform other financial transactions.
Two examples are farming and IDO qualification.
1. Farming LP Tokens
Some DEXs have a farming feature, which simply involves staking LP tokens to earn even more rewards. This encourages liquidity providers to ensure their liquidity is locked for longer in the pools. When staking LP tokens, you are usually given additional tokens – typically in the form of native DEX tokens. The longer you stake or lock, the more DEX tokens you get. For instance, if you stake LP tokens in PancakeSwap, the DEX rewards you with its own CAKE tokens, which you can sell or even further stake for additional revenue.
2. IDO qualification
Many DEXs also host what is called an initial DEX offering or IDO. These are new tokens created by companies to fundraise – very similar to initial coin offerings (ICOs) that were highly popular between 2016-2018.
In other words, IDO tokens are new tokens representing new companies that people can purchase as a form of investment. They hope that by buying these tokens, the companies issuing them can raise funds and build successful products that later cause their tokens to appreciate in price.
DEXs now also use LP tokens as a qualifying factor to access new IDOs they host. For example, to participate in an IDO, a DEX might require participants to also hold a certain number of LP tokens.
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