The simplest version of a DeFi liquidity pool contains two tokens in a smart contract to form a trading pair.
Let’s Ether (ETH) and USD Coin (USDC) as an example, and to make it simple, the price of ETH could be equal to 1,000 USDC. Liquidity providers contribute an equal value of ETH and USDC to the pool, so someone depositing 1 ETH should match it with 1,000 USDC.
The liquidity in the pool means that when someone wants to trade ETH for USDC, they can do so based on the money deposited, rather than waiting for a counterparty to come over to match their trade.
Liquidity providers are incentivized for their contribution with rewards. When they make a deposit, they receive a new token representing their stake called a pool chip. In this example, the pool token would be USDCETH.
The share of the trading fees paid by users using the pool to trade tokens is automatically divided among all liquidity providers in proportion to their stake size. So if the trading fee for the USDC ETH pool is 0.3% and a liquidity provider contributed 10% of the pool, they are entitled to 10% of 0.3% of the total value of all trades.
When a user wants to withdraw his bet in the liquidity pool, he burns his pool tokens and can withdraw his bet.