An Intro to Concentrated Liquidity

Decentralized exchanges are gaining momentum in the crypto space. A real game-changing feature that has come up recently is concentrated liquidity. What is concentrated liquidity and how can it benefit liquidity providers and traders? Let’s get to the chase.

What is Concentrated Liquidity?

Сoncentrated liquidity is the liquidity allocated within a custom price range.

When liquidity was distributed evenly, one could trade their assets within the infinite interval (0,∞). With the concentrated liquidity mechanics, liquidity providers (LPs) can accumulate their capital to smaller price intervals than (0, ∞) which enables individualized price curves, higher capital efficiency and deeper liquidity for traders.

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.

What Was Before Concentrated Liquidity?

Earlier implementations of AMMs used the so-called XYK model, based on the x*y=k price curve. The idea was to maintain a constant balance within a liquidity pool so that the total value of one token would always equal the total value of the other token in the pool; regardless of their current price against each other.

With the XYK model, the liquidity in the pool is spread across all possible price ranges. As a result, the liquidity providers (LPs) are earning far smaller trading fee bonuses — which is their compensation for the risk they take. They also suffer from higher slippage, because the majority of their liquidity never gets used in pools of this type at all.

The New Model of Pooling Liquidity

Concentrated liquidity tries to boost capital efficiency, and to make up for the inadequacy of the original formula. Within the new model, liquidity can be allocated to a price interval, resulting in what is called a concentrated liquidity position. LPs can open as many positions in the pool as they wish, thereby creating unique price curves aligned with their personal needs and preferences.

How Concentrated Liquidity Works

When the price enters a certain range, the liquidity aggregated for that range starts collecting trading fees, with each LP receiving their slice of the fee pie, proportionally to their contribution to the total liquidity inside of that price range alone.

As the price moves up and down, liquidity from different LPs is used to execute the swaps. Consequently, users are making trades against the aggregated liquidity from all liquidity positions covering the current price, and there is no difference for those whose liquidity their swaps are utilizing.

There are a number of benefits and advantages that the new model of pooling liquidity offers both LPs and traders. Now, LPs can allocate their capital to the preferred price intervals, consolidating their funds to earn more fees and using liquidity more efficiently. At the same time, traders enjoy deeper liquidity when and where it’s needed most, as well as profiting greatly from reduced slippage.

How to Use Concentrated Liquidity?

One of the DEXs that supports concentrated liquidity allowing you to choose the price range is Algebra Finance. Let’s see how you can use concentrated liquidity positions on that DEX to capitalize on your assets to the maximum extent.

After you hop on the Algebra dApp, open the Pool section, and select a pair of tokens to participate in the pool with, you need to specify the price range, meaning the minimum and maximum prices that you expect your position to move within.

This gives you 2 choices:

1. provide liquidity across the full range, so you spread your assets thin with lower rates of return but no potential fall out of the range;
2. narrow your range according to the market’s state and development.

Most often users set an approximate range — ± 30% of the current price to hit the right price interval. Essentially, your capital is essentially multiplied when the price is within the range you’ve chosen. When the price falls out of those ranges, two major things happen: you stop earning fees, and your liquidity is turned into a single asset.

In case, you’ve never tried a concentrated liquidity position, you can easily start off on Algebra. With the user-friendly interface and comprehensive functionality, it will be a good fit both for beginners and seasoned crypto holders.

Now, you’re fully armed with one of the latest trends of decentralized exchanges. Despite the fact that concentrated liquidity has opened effective ways to asset capitalization for liquidity providers and traders, it carries certain disadvantages which you need to be aware of and which will be discussed right here in the next articles.

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