Concentrated Liquidity Pools (CLP)

TBA

Concentrated Liquidity is currently the most efficient and profitable market-making method available to on-chain decentralized exchanges. This approach gained significant attention and popularity with the release of Uniswap's UniV3 model.

To understand the advantages of UniV3, it can be compared to a more centralized and widely recognized liquidity mechanism: the order book system used by centralized exchanges (CEX).

In the CEX Order Book diagram presented above, the bid (buy) and ask (sell) orders are distinctly displayed, making it straightforward to observe how a market order would affect the median price. The depth of the order book, which indicates the volume of orders at various price levels, is also visually evident.

Notably, the concentrated liquidity model is depicted as an inverse histogram of the order book. To visualize this, one can imagine flipping the diagram upside down and inverting the colors. This representation provides a clear illustration of liquidity distribution in the market.

The blue shaded area represents the aggregated liquidity ranges contributed by all users within the liquidity provider (LP) pool for a specific fee tier, which will be discussed further.

To clearly explain the efficiency differences between the x*y=k model (used in Uniswap V2) and Uniswap V3's order book-style automated market maker (AMM), it is important to note that traditional LP positions in Uniswap V2 operate over an infinite range (0,∞). This highlights the unique approach of Uniswap V3, where liquidity can be concentrated within specified price ranges, enhancing capital efficiency.

This implies that each individual user in the pool must provide liquidity across all positive real numbers. Consequently, every trade must account for this distribution when the swapping algorithms are executed. For example, $100,000 of liquidity spread from 0 to ∞ is significantly less efficient than if the same amount were concentrated within a defined range, such as $1,000 to $1,100.

In the latter example, the $100,000 of liquidity is concentrated within a $100 price range, offering a highly efficient swapping experience. This concentration minimizes slippage, providing the lowest slippage currently achievable in the decentralized finance (DeFi) space.