Liquidity pools on Uniswap are the backbone of its decentralized trading system, allowing users to trade tokens without relying on traditional market makers. A liquidity pool is a collection of two tokens, locked in a smart contract, which traders can swap against. These pools are created by liquidity providers (LPs) who deposit equal values of both tokens into the pool, such as ETH and DAI.

In return for providing liquidity, LPs earn a portion of the trading fees generated when other users make trades on Uniswap. This fee typically amounts to 0.3% of each transaction and is distributed proportionally among all liquidity providers in the pool.

The liquidity pool model allows Uniswap to operate as an Automated Market Maker (AMM). Instead of matching buyers and sellers, Uniswap uses algorithms to price assets based on the ratio of tokens in the pool. As traders swap tokens, the ratio shifts, and the price adjusts accordingly, maintaining a balance in the pool.

However, providing liquidity also comes with risks, such as impermanent loss, which occurs when the value of deposited tokens changes in relation to each other. Despite this, liquidity pools have become an essential feature of decentralized finance (DeFi) by facilitating seamless and permissionless trading.