A liquidity pool is a pairing of tokens in a smart contract that is used for swapping on decentralized exchanges (DEXs).
In traditional finance, liquidity is organized using a central limit order book where buyers and sellers create orders (trade) organized by price and demand.
The Uniswap Protocol takes a different approach, using an Automatic Market Maker (AMM) to replace the traditional order book method with a liquidity pool of two assets.
The Uniswap Protocol AMM determines prices for liquidity pools using the formula x * y = k. In this equation, x and y represent the quantities of the two tokens in the pool, while k remains a constant.
Prices are set based on the amounts of each token available in the pool. For more information, read this article.
Liquidity providers add tokens to a pool and in return receive UNI-V2 tokens or NFTs that represent their ownership of that liquidity. These providers earn fees from swaps that are routed through their pools, rewarding them for their contributions.
Evaluating the available liquidity in a pool before swapping is important. A pool with low liquidity can lead to suboptimal swap outcomes and potential losses.
To see information on available pools and tokens on the Uniswap Protocol, visit the Uniswap Explore page.