Understanding Concentrated Liquidity

Concentrated Liquidity pools are liquidity pools on decentralized exchanges (DEX) in which you have to allocate liquidity in a custom price range. You will have full control over the price range and you can adjust it anytime at will. Concentrated Liquidity pools are more capital efficient than traditional “XYK” liquidity pools and have the potential to generate greater yields.

Key Takeaways

• Concentrated Liquidity involves providing liquidity in a defined price range and requires active monitoring.
• Concentrated Liquidity pools have the potential to provide extremely high returns.
• Users have to be cautious of incurring too many fees when adjusting price ranges.

Is This a Concentrated Liquidity Pool?

If you’ve encountered terms like "Liquidity/Price Range", "Liquidity Shape” or “Trading Bins” it’s likely that you’re working with a Concentrated Liquidity pool. If those terms seems confusing to you, here’s a visual representation of what a Concentrated Liquidity pool might look like on Ambient Finance:

When providing liquidity in the example above for the ETH/USDC pair within a 10% range, your liquidity will only be active and generate trading fees if the market price of Ether falls between $2,304.03 and $2,815.25. In other words, if the market price of Ether moves more than 10% in either direction (up or down), your liquidity now becomes out of range and will cease to accrue fees.

Why Use Concentrated Liquidity

The concept of Concentrated Liquidity was first introduced by Uniswap V3 in March 2021 to tackle the capital inefficiencies inherent in traditional XYK liquidity pools. In those traditional pools, liquidity was spread uniformly across the entire price range from $0 to ∞. While this approach guaranteed liquidity at every price level regardless of market volatility, most of this liquidity went unused. With Concentrated Liquidity, liquidity providers can now focus their capital within narrower price ranges, enhancing capital efficiency and ultimately boosting their yields.

Concentrated Liquidity offers liquidity providers a high degree of flexibility and control over how they choose to allocate their capital. In doing so, they can sometimes experience very lucrative yields; however, they are highly variable because the yield depends on their choice of price ranges.

For example, on Ambient Finance, Concentrated Liquidity yields varies based on the price ranges chosen by each liquidity provider:

On the other hand, taking a look at the classic example of XYK-pools on Syncswap, all liquidity providers receive 8.94% yields.

Notice in the above examples, Concentrated Liquidity yields vary from 0.18% to 284.19%. This is because each liquidity position generates its own set of yield. Yield is no longer shared in a communal pool like in Syncswap’s XYK pools whereby all liquidity providers experience the same yield, 8.94%.