The Local Package Directory is the cache where setup.exe stores the packages before they are installed.
The cache must not be the same folder as the Cygwin root.
Within the cache, a separate directory is created for each Cygwin mirror, which allows setup.exe to use multiple mirrors and custom packages.
After installing Cygwin, the cache is no longer necessary, but you may want to retain the packages as backups, for installing Cygwin to another system, or in case you need to reinstall a package.