A liquidity pool is a pool of cryptocurrency funds provided by liquidity providers to facilitate decentralized trading Trading on exchanges (DEX), especially DEXs that use the automated market maker model. It is essentially a smart contract that allows users to trade cryptocurrencies without the need for intermediaries or centralized exchanges.

What is a decentralized exchange? What is an automated market maker? Please refer to the "What is DEX" and "What is AMM" chapters.

When you combine two of your cryptocurrencies into an AMM liquidity pool, you are essentially providing liquidity to the pool, which means you allow other Traders trade in the cryptocurrencies you provide. When traders trade through this liquidity pool, they will pay a handling fee to all liquidity providers in the liquidity pool, and this fee will be distributed to the liquidity providers in proportion to their contribution to the liquidity pool.

Become a liquidity provider

In Uniswap, when adding liquidity to an established pool, the liquidity provider needs to combine the two tokens with those already in the pool. There are equal proportions of tokens put in to ensure that the price of both tokens does not change. Otherwise, arbitrage opportunities will arise, resulting in impermanent losses.

Each transaction in the pool then provides all LPs with a transaction fee, distributed according to their share of the liquidity contributed.

After depositing you will also receive LP equity tokens, which are similar to deposit certificates and represent your share in the liquidity pool. To retrieve deposited liquidity and any fees incurred, a liquidity provider must “burn” their LP stake tokens. This will effectively exchange it for the liquidity provider’s correct share of the liquidity pool and transaction fee distribution.

You may be interested in: "What is Uniswap", "What is Curve".