Liquidity pools, in essence, are pools of tokens that are locked in a smart contract. They are used to facilitate trading by providing liquidity and are extensively used by some of the decentralized exchanges (DEX).
If you're familiar with any standard crypto exchanges like Coinbase or Binance you may have seen that their trading is based on the order book model. This is also the way traditional stock exchanges such as NYSE or Nasdaq work.
In this order book model buyers and sellers come together and place their orders. Buyers a.k.a. "bidders" try to buy a certain asset for the lowest price possible whereas sellers try to sell the same asset for as high as possible.
For trades to happen, both buyers and sellers have to converge on the price. This can happen by either a buyer bidding higher or a seller lowering their price.
But what if there is no one willing to place their orders at a fair price level? What if there are not enough coins that you want to buy? This is where market makers come to play.
In essence, market makers are entities that facilitate trading by always willing to buy or sell a particular asset. By doing that they provide liquidity, so the users can always trade and they don't have to wait for another counterparty to show up.
Okay, so why can't we just reproduce something like this in decentralized finance?
The answer is we can. It would just be really slow, expensive and pretty much always result in poor user experience.