A liquidity pool is a collection of cryptocurrency tokens locked in a smart contract to facilitate trading, lending, or other decentralized finance (DeFi) functions without relying on traditional market makers. Users known as liquidity providers (LPs) deposit token pairs—such as ETH and USDC—into the pool, enabling others to trade between them directly on a decentralized exchange (DEX).
In return, LPs earn a share of the transaction fees and, in some cases, additional rewards or yield-farming incentives. The pool’s pricing is managed algorithmically by an automated market maker (AMM), which adjusts token ratios based on supply and demand. Liquidity pools are a core mechanism of DeFi, ensuring continuous market liquidity, reducing price slippage, and allowing decentralized trading to function efficiently.