What Is a Self-Generating Liquidity Token and How Does It Work?

Liquidity tokens, also known as liquidity provider tokens (LP tokens), are a key feature of automated market makers (AMMs) and serve as an incentive that encourages the protocol's users to contribute liquidity to its pool. They can be described as "self-generating" since the protocol creates them and issues them to users who provide it with liquidity. The concept of LP tokens has transformed DeFi and opened up new opportunities like yield farming.

Liquidity is a fundamental concept that cuts across both DeFi tokens and platforms. It refers to the effortless conversion of one asset class to another. Decentralized exchanges and other DeFi protocols require liquidity to promote trading on their platforms. Liquidity tokens incentivize DeFi users to provide this liquidity and help enable the seamless exchange of tokens on the protocol.

How Do Self-Generating Liquidity Tokens Work?

DeFi protocols facilitate trading on their dApps through liquidity pools - a basket of various tokens. This liquidity pool is provided by the platform's users, who are rewarded with liquidity tokens. A liquidity token represents the liquidity provider's share of the pool. Before the creation of liquidity tokens, staking assets in DeFi had no other utility.

Traders could lock up their tokens on a DeFi protocol and could not do anything else with it. However, with LP tokens as rewards, staking now has additional merit since it can generate convertible assets in the form of LP tokens that users can sell or stake on decentralized exchanges (DEXs) for more rewards.

To get liquidity tokens/LP tokens, one needs to participate in a DeFi protocol or decentralized exchange that utilizes a liquidity pool. You can add liquidity to their pool by staking an equivalent token pair. For instance, if you provide liquidity for a DEX like Pancakeswap, you can contribute to their liquidity pool by staking an equivalent token pair of ETH/USDT. This means you are adding liquidity for Ethereum and the stablecoin, Tether.

After you have selected the number of tokens you wish to add to their pool, you can confirm the transaction on your wallet. With this, you will start receiving liquidity tokens and trading fees reward for your contribution.