Concentrated Liquidity

The most widely adopted algorithm among DEX platforms in the DeFi space is the AMM (Automated Market Maker).

AMM operates on the classic constant product formula: x * y = k, where:

• x and y represent the liquidity of two tokens in a trading pair.

• k is a constant value.

This formula distributes assets evenly across the entire price curve, with liquidity provided by LPs (Liquidity Providers) spread over a broad range from 0 to ∞. The AMM model is implemented by several leading DEXs, including Uniswap V2, SushiSwap, Bancor, PancakeSwap, Raydium, and QuickSwap.

Challenges of Traditional AMM

While simple and effective, AMMs have inherent inefficiencies:

• A large portion of liquidity remains unused because prices rarely span the full range (0 to ∞).

• This leads to inefficient capital utilization, higher slippage, and reduced returns for LPs.

Emergence of Concentrated Liquidity

To address these issues, Concentrated Liquidity was introduced, notably by Uniswap V3 in March 2021. This model allows LPs to focus their capital within specific price ranges, greatly improving capital efficiency and enhancing yields.

Key features of Concentrated Liquidity include:

• Flexibility and Control: LPs can allocate capital to narrower price ranges, tailoring their exposure and potential earnings.

• Higher Yields: Concentrated liquidity can generate substantial, though variable, returns depending on the chosen price range.

How Liquidity Price Ranges Work

In CLMM pools, LPs select a price range to provide liquidity. Fees earned are proportional to the liquidity share within the active trading price range. LPs must actively manage their positions to keep the current price within their chosen range.

Key dynamics in price movements:

• If the price moves below the minimum range, the position will hold 100% of the base token.

• If the price moves above the maximum range, the position will convert entirely to the quote token.

• Outside the selected range, the position ceases to earn fees and is exposed to potential impermanent loss.

Unlike traditional AMMs, where liquidity is uniformly distributed, CLMMs intensify these dynamics within the selected range, enabling efficient capital use but requiring more active management from LPs.