Liquidity Provider (LP) & LP Token

A liquidity provider, or LP, is anyone who deposits tokens into a liquidity pool to help power trading, lending, or other DeFi services. In return for their contribution, the LP earns a share of the fees generated by every transaction that passes through the pool. The more liquidity an LP provides, and the more active the pool is, the more they earn.

When you deposit into a pool, the smart contract gives you LP tokens — a special receipt that represents your proportional share of the pool. These tokens are not just a passive record; they are themselves tradeable assets. You can transfer them, use them as collateral in other protocols, or stake them to earn additional rewards. LP tokens are the key to the composability of DeFi, because they let your pooled assets do double duty: they stay in the pool earning fees while the LP token you hold can simultaneously be put to work elsewhere.

To withdraw your liquidity, you simply return your LP tokens to the smart contract. The contract burns them and sends back your share of the pool, including any fees accumulated since you deposited. The value of your LP tokens changes over time as the pool earns fees and as the underlying token prices shift. Understanding LP tokens is foundational to understanding how DeFi protocols stack on top of each other.

Example: You and nine friends each put $100 into a joint savings jar to lend to neighbors for a small fee. The jar gives each of you a paper receipt proportional to your share. Anyone holding a receipt can redeem it for their portion of the jar plus their share of the accumulated fees. You can even sell your receipt to someone else if you need cash before the group decides to close the jar.