What is Liquidity & LP (pool)

A liquidity pool is a pool of funds (in cryptocurrency) provided by liquidity providers to facilitate trading on decentralized exchanges (DEXs), especially DEXs using automated market makers (AMM). It is essentially a smart contract that allows users to trade cryptocurrencies without the need for an intermediary or centralized exchange.

What is a Decentralized Exchange? What is the Automated Market Maker? Please refer to the "What is DEX" and “What is AMM” chapters.

When you combine two cryptocurrencies into one pair in the AMM liquidity pool, you are essentially providing liquidity to the pool, which means you are allowing other traders to trade through the cryptocurrencies you provide. When a trader trades in the pool, they need to pay a fee to all liquidity providers, which is distributed to the liquidity providers in proportion to the contribution of the liquidity pool.

Become a Liquidity Provider

In Uniswap, when adding liquidity to an established pool, you need to put both tokens in the same ratio as there already is in the pool to make sure that the prices of both tokens don't change. Otherwise, there is an arbitrage opportunity that leads to impermanent loss.

After that, every transaction in this pool provides a transaction fee for all LPs, which is divided according to the share of contributed liquidity. 

You will also receive LP tokens after contributing liquidity. These tokens are similar to Certificate Deposits, representing your share of the liquidity pool. To retrieve deposited liquidity, plus any fees accrued, liquidity providers must “burn” their liquidity tokens. This effectively exchanges them for the liquidity provider’s rightful portion of the liquidity pool + trading fee allocation.

You may also interested in: “What is UniSwap”, "What is Curve".