When you deposit tokens into a liquidity pool on a DEX, you receive an LP token in return. This LP token is a claim on your proportional share of the pool — if you put in 1 percent of the total, your LP tokens represent 1 percent of whatever the pool contains at any given moment, which includes the two underlying tokens at their current ratio plus any trading fees that have accumulated since your deposit. When you want to withdraw, you burn the LP token and the contract hands you back your share of the pool.
On Uniswap V2, LP tokens are fungible ERC-20 tokens, one unique token contract per pool. The ETH/USDC pool has its own LP token, the WBTC/ETH pool has a different one, and so on. Because they are standard ERC-20s, you can transfer them, hold them in any wallet, and — critically — deposit them into other DeFi protocols as collateral or as yield-earning positions. Uniswap V3, by contrast, issues LP positions as NFTs rather than fungible tokens, because each V3 position has its own unique price range and can’t be cleanly combined with other positions.
Why LP Tokens Matter for Composability
The fungible-token format of V2 LP tokens turned out to be one of DeFi’s most important design choices. It meant that LP positions themselves became a building block for other protocols. A yield aggregator could accept LP tokens as deposits and automatically compound the fees. A lending protocol could accept LP tokens as collateral for a loan. A staking contract could reward users for locking up LP tokens in exchange for additional governance tokens — this is the “liquidity mining” mechanism that kicked off DeFi summer in 2020.
The most famous use case is Curve/Convex, which built an entire ecosystem on top of Curve LP tokens. You deposit stablecoins into a Curve pool, get LP tokens back, deposit those LP tokens into Convex, earn CVX and CRV rewards on top of the base trading fees, and end up with a stacked yield that would not have been possible without the composability of fungible LP tokens. This layering — protocols building on top of other protocols’ tokens — is sometimes called “money legos”, and it is both DeFi’s most distinctive feature and a meaningful source of systemic risk when any of the underlying layers has a problem.
The Risk Picture
Holding LP tokens exposes you to the risks of everything underneath them: the price movements of the two underlying tokens, the smart contract risk of the pool contract, the risk of a bad debt from a liquidation cascade if the pool is used as oracle input elsewhere, and the risk of impermanent loss eroding your returns. If the pool is then deposited into another protocol, you stack on that protocol’s smart contract risk, its liquidation mechanics, and any additional token exposures from reward tokens.
This stacking is why DeFi has occasionally produced impressive-looking yields that turned out to be illusory once something upstream broke. Anchor on Terra was offering 20 percent yield on UST deposits using a chain of yield sources that unwound violently when UST lost its peg, and a lot of LP-token-like claims got wiped out along with it. The rule of thumb is that if you do not understand what is generating the yield on an LP position, you do not understand the risk, and the yield is coming from somewhere — usually from a token being inflated that you do not yet know you own.
The upside is that for the pools where things do work — blue-chip stable-stable pools, major L2 volume pools — LP tokens have been a reliable way to earn a small but consistent return on idle capital. They are not risk-free and they are not going to make anyone rich, but for someone who just wants to generate a few percent a year on stablecoins they were going to hold anyway, they have held up reasonably well across multiple cycles.