A liquidity pool is a smart contract that holds funds supplied by users, used to enable trading on a decentralized exchange.
Users deposit pairs of tokens into a pool. Traders swap against the pool, and a formula keeps the pool balanced and sets prices.
Liquidity providers earn a share of the trading fees generated by the pool, proportional to their contribution.
If the prices of the pooled tokens change relative to each other, providers can end up with less value than if they had simply held. This is called impermanent loss.
Besides impermanent loss, pools carry smart-contract risk and the risk of the underlying tokens losing value.
Liquidity pools are the engine of decentralized trading, but providing liquidity is not risk-free.