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What is a Liquidity Pool

A liquidity pool represents a pair of tokens that you can trade for one another. It is a necessary feature of an Automatic Market Maker (AMM) Decentralized Exchange (DEX). Liquidity is provided to the pool by anyone who'd like to capture some of the pool fees. To provide liquidity, a user must lock equal amounts of both tokens from a pair. When someone trades one token into the pool, they will receive an equal value of the other token, and the pool ratio will adjust. In this way, the price of a token is determined.

For example, a liquidity pool that has 100 ADA and 100 TEDY tokens will be a 1:1 ratio, and therefore 1 TEDY token will equal 1 ADA. If you sell 10 TEDY tokens for 10 ADA, the pool will adjust to 110 TEDY : 90 ADA. Now one TEDY is worth 0.82 ADA.

In this way, the liquidity pool will manage the price of a token, and always provide some tokens to be traded. Naturally, having more liquidity will mean more people can trade with the pool, having a smaller impact on the price.