Concentrated Liquidity

What is concentrated liquidity and why do we need it?

Source: Finematics

Introduction

The defining idea of Uniswap V3 that pioneered a new generation of AMMs is concentrated liquidity: liquidity that is allocated within a custom price range. In earlier versions, so-called Constant Function Market Makers, liquidity was distributed uniformly along the price curve between 0 and infinity.

The previously uniform distribution allowed trading across the entire price interval (0, ∞) without any loss of liquidity. However, in many pools, the majority of the liquidity was never used.

Consider stablecoin pairs, where the relative price of the two assets stays relatively constant. The liquidity outside the typical price range of a stablecoin pair is rarely touched. For example, the V2 DAI/USDC pair utilizes ~0.50% of the total available capital for trading between $0.99 and $1.01, the price range in which LPs would expect to see the most volume - and consequently earn the most fees.

With V3, liquidity providers may concentrate their capital to smaller price intervals than (0, ∞). In a stablecoin/stablecoin pair, for example, an LP may choose to allocate capital solely to the 0.99 - 1.01 range. As a result, traders are offered deeper liquidity around the mid-price, and LPs earn more trading fees with their capital. We call liquidity concentrated to a finite interval a position. LPs may have many different positions per pool, creating individualized price curves that reflect the preferences of each LP.

Active Liquidity

As the price of an asset rises or falls, it may exit the price bounds that LPs have set in a position. When the price exits a position's interval, the position's liquidity is no longer active and no longer earns fees.

As price moves in one direction, LPs gain more of the one asset as swappers demand the other, until their entire liquidity consists of only one asset. (In V2, we don't typically see this behavior because LPs rarely reach the upper or lower bound of the price of two assets, i.e., 0 and ∞). If the price ever re-enters the interval, the liquidity becomes active again, and in-range LPs begin earning fees once more.

Importantly, LPs are free to create as many positions as they see fit, each with its own price interval. Concentrated liquidity serves as a mechanism to let the market decide what a sensible distribution of liquidity is, as rational LPs are incentivized to concentrate their liquidity while ensuring that their liquidity remains active.

Source: Uniswap's Gitbook