Liquidity Pool
A smart contract holding reserves of two or more tokens that enables decentralized trading on an AMM.
What is Liquidity Pool?
A liquidity pool is a collection of cryptocurrency tokens locked in a smart contract that provides the liquidity needed for decentralized trading on automated market makers (AMMs). Rather than relying on buyers and sellers to be matched through an order book, traders swap tokens directly against the pool's reserves. Liquidity is supplied by liquidity providers (LPs), who deposit equal values of two tokens (such as ETH and USDC) and receive LP tokens in return representing their share of the pool. LPs earn a portion of the trading fees generated by swaps proportional to their pool share. The core risk of providing liquidity is impermanent loss: if the price ratio of the two tokens changes significantly relative to when liquidity was deposited, the LP's position is worth less than simply holding the tokens. Pool-based liquidity is the foundational primitive of DeFi trading and underpins most decentralized exchanges.
Example
A Uniswap v2 ETH/USDC pool holds $10 million in ETH and $10 million in USDC. A liquidity provider contributing $100,000 total (equal split) receives LP tokens representing a 0.5% share. When traders swap tokens, the 0.3% fee is distributed to all LPs proportionally. If ETH doubles in price after deposit, the LP's position — due to impermanent loss — grows less than $200,000 despite the ETH appreciation.
Source: Uniswap Protocol Documentation