The New Liquidity Pool Default: What Is Concentrated Liquidity?

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%.

Cons of Concentrated Liquidity

While lucrative, Concentrated Liquidity positions require more effort to upkeep and there are multiple pitfalls that you have to watch out for.

Increased Oversight

As mentioned above, whenever your Concentrated Liquidity goes out of range, you will no longer be accruing fees. This means that Concentrated Liquidity positions require active monitoring as compared to the more passive XYK liquidity pools.

Here’s an example of what kind of oversight may be needed.

In the above example, the TIA/ETH liquidity position on Trader Joe is out of range. In order to fix this, you would have to first, remove your liquidity position, update your preferred liquidity provision range to current market prices and then redeposit the liquidity.

If you don’t adjust your liquidity position when it goes out of range, you won’t generate any yield. However, be cautious, as frequently updating the price ranges of your Concentrated Liquidity positions can be expensive. Balancing between the safety of a broader price range and the higher yields from a narrower range is often a complex choice.

Potentially Higher Impermanent Loss

In Concentrated Liquidity positions, whenever your position goes out of range, your liquidity becomes entirely denominated in one asset. For instance, in the example above, a previous 50/50 split of TIA/ETH has shifted entirely to ETH due to TIA’s relative price increase compared to ETH at the time of writing.

This differs from XYK pools, where your liquidity remains partially in both assets due to the infinite price range. As a result, impermanent loss can be more pronounced in Concentrated Liquidity pools compared to XYK pools.

Frequently Asked Questions

What Are Trading Bins?

The introduction of Concentrated Liquidity leads to the creation of the now widely used term “Trading Bins”. Concentrated Liquidity divides the previously continuous spectrum of price space into discrete segments, with Trading Bins representing the nominal boundaries for liquidity positions. While some DEXs simplify this by using straightforward price ranges such as in Ambient Finance, you might still come across the term Trading Bins in certain platforms.

On Meteora, you have many bin step options for any liquidity position: 

Essentially, a larger bin step corresponds to a wider price range, whereas a smaller bin step indicates a narrower price range. The specific calculations for bin steps can vary depending on the platform.

What Are Liquidity Shapes?

In addition to Concentrated Liquidity, some DEXs, like Trader Joe, offer you the ability to choose your liquidity distribution shape, where you can allocate different amounts of tokens at diverse price points. There are various reasons for you to choose other options but in general, a uniformly distributed shape, “Spot” in this case would suit the purposes of most liquidity providers. Read here to learn more about the niche cases of other liquidity shapes.

Why Is Shifting Price Ranges Costly?

Shifting price ranges can be costly due to the accumulation of transaction and swap fees. When your position goes out of range, it becomes entirely denominated in one asset. If you then want to rebalance your position to a 50/50 asset split, you'll need to swap half of your assets before redepositing them.

Here’s a typical process:

1. Remove TIA/ETH liquidity

2. Swap half of the ETH to TIA

3. Redeploy the liquidity

In addition to the swap fees incurred in step 2, you may also face price slippage during steps 1 and 3, which can further increase your costs. Therefore, it’s advisable to avoid frequently shifting price ranges.

How Often Should I Adjust Price Ranges?

This is largely dependent on your belief of current market prices, if you believe that prices will soon revert to previous levels. You might choose not to adjust your price range, as your position could return to being within range once prices drop.

Another consideration is the current yields of your liquidity position. If the yield you are able to obtain in the time before your position goes out of range is expected to be higher than the costs you incur while shifting price ranges, it may be worth it to adjust price ranges. Ultimately, some trial and error is expected here.

Conclusion

Concentrated Liquidity has become the preferred method for liquidity pools on many popular DEXs, including Uniswap, Ambient Finance, Thruster Finance, and others. Although it can be cumbersome, the focus on capital efficiency represents a significant advancement in DeFi, positioning it as the likely future direction for the space.