A liquidity pool is created by users who deposit funds into a smart contract. The funds can be in various cryptocurrencies and allow users to trade those cryptocurrencies on a decentralized exchange without the need for a traditional order book. When users trade against the liquidity pool, they receive the desired token while providing liquidity, which earns them a share of the trading fees. This model enables efficient trading in decentralized finance (DeFi) and incentivizes users to provide liquidity.