What is the Uniswap Liquidity Pool, and how does it work?

Each Uniswap smart contract, or pair, manages a liquidity pool

Uniswap liquidity pool is a trading venue for a pair of ERC20 tokens. When a pool contract is created, the balances of each token are in order for the pool to begin facilitating trades, someone must seed it with an initial deposit of each token. This first liquidity provider is the one who sets the initial price of the pool. They are incentivized to deposit an equal value of both tokens into the pool. 

Uniswap’s automated liquidity protocol is powered by a constant product formula and implemented in a system of non-upgradeable smart contracts on the Ethereum blockchain. It obviates the need for trusted intermediaries, prioritizing decentralization, censorship resistance, and security. Uniswap is open-source software licensed under the GPL.

Made up of reserves of two ERC-20 tokens.

Anyone can become a liquidity provider (LP) for a pool by depositing an equivalent value of each underlying token in return for pool tokens. These tokens track pro-rata LP shares of the total reserves and can be redeemed for the underlying assets at any time.

Pairs act as automated market makers, standing ready to accept one token for the other as long as the “constant product” formula is preserved. This formula, most simply expressed as x* y = k, states that trades must not change the product (k) of a pair’s reserve balances (x and y). Because remains unchanged from the reference frame of a trade, it is often referred to as the invariant. This formula has the desirable property that larger trades (relativeto reserves) execute at exponentially worse rates than smaller ones.

In practice, Uniswap applies a 0.30% fee to trades, which is added to reserves. As a result, each trade actually increases k. This functions as a payout to LPs, which is realized when they use their pool tokens to withdraw their portion of total reserves. In the future, this fee may be reduced to 0.25%, with the remaining 0.05% withheld as a protocol-wide charge.

Because the relative price of the two-pair assets can only be changed through trading, divergences between the Uniswap price and external prices create arbitrage opportunities. This mechanism ensures that Uniswap prices always trend toward the market-clearing price.