A liquidity pool is a collection of digital assets locked in a smart contract on a decentralized exchange (DEX) or automated market maker (AMM) platform. Liquidity pools enable users to trade digital assets without relying on traditional order books or matching individual buyers and sellers.

Liquidity pools serve two primary purposes: facilitating trades and providing liquidity. Traders can easily swap one asset for another within the pool, relying on the algorithm, which determines the exchange rate. The liquidity pool makes sure there are always enough assets for trading, even if there aren't immediate participants to trade with.

The prices of assets within a liquidity pool are calculated by algorithms or mathematical formulas that balance the relative supply and demand of the assets. This allows traders to execute transactions based on the prevailing prices determined by the pool.

Liquidity providers are incentivized by the liquidity pool through the opportunity to earn rewards. These rewards are in the form of transaction fees or a part of the trading fees generated by the platform. The amount of rewards received by liquidity providers is directly proportional to the liquidity they contribute to the pool.