A liquidity pool is a pool of funds provided by liquidity providers to facilitate the trading of certain assets in a decentralized exchange (DEX). In a DEX, liquidity is critical for trades to be executed quickly and at a fair price. Liquidity pools are needed to ensure that there are enough funds available for traders to buy or sell tokens in a DEX without facing large price slippage or waiting times for their trades to be executed. Without liquidity pools, trades may not be executed, or they may be executed at an unfavorable price, leading to a poor trading experience for users.
If you want to become a liquidity provider, you must deposit an equal value of two different tokens into the liquidity pool. In return, they receive liquidity provider tokens (LP tokens) that represent their share of the pool. In addition, liquidity providers earn passive income on their deposits through trading fees based on the percentage of the liquidity pool that they provide.
The introduction of liquidity pools was pioneered by the Ethereum-based trading system Bancor. However, liquidity pool was widely adopted in the crypto industry after Uniswap popularized them.
Learn more about the technology and how Uniswap works in the following article.