Concentrated liquidity

In Defi, the term ‘concentrated liquidity’ mostly refers to a liquidity providing strategy in which Liquidity Providers (LPs) concentrate their liquidity within a specific price range. In some cases, it can refer to a situation in which a relatively small number of liquidity providers provide the majority of the liquidity for a particular asset or trading pair in a liquidity pool.  This article will walk you through both meanings, as well as a few extras.

Concentrated liquidity as a strategy

As mentioned above, the term concentrated liquidity can be understood in two ways. That being said, in most cases in DeFi, it is meant as a liquidity strategy that was first presented by Uniswap. In this strategy, LPs provide liquidity within a defined price range. Usually, the liquidity is distributed evenly, meaning that investors can trade their assets within an unlimited range. But by using concentrated liquidity, the liquidity can only be allocated into a specified price interval, which enables higher capital efficiency and deeper liquidity in that range.  This is best illustrated in the picture below.

The result of this specified and more focused liquidity is that the traders can choose from more liquidity in that range, while the LPs receive higher trading fees, which is beneficial for both parties.  LPs are able to create as many positions as they see fit, according to their needs and investing strategy. This actually influences the market itself, as people are in charge where most liquidity is located.

Concentrated liquidity also influences the profits of LPs as they need to think twice about in which range they should keep their liquidity. When they choose a very tight price range, they can increase their fee revenue. On the other hand, they can decrease it as well.

You can also check out this video on Uniswap to see how concentrated liquidity works.

Concentrated liquidity as an issue

In some cases, the term concentrated liquidity refers to a situation in which a relatively small number of LPs provide the majority of the liquidity for a particular asset or trading pair in a liquidity pool. This can occur on Decentralized Exchanges (DEXs) and other DeFi platforms, where liquidity is provided by LPs who deposit their assets into a smart contract. When liquidity is concentrated, it can lead to issues such as higher volatility in price movements, but as mentioned above, the term ‘concentrated liquidity’ refers in most cases to an investing strategy. Nevertheless, it is good to be informed about the two meanings of this term if you want to boost your DeFi knowledge.

PROs

• Concentrated liquidity allows investors and LPs to maximize their profits
• When using concentrated liquidity, you can stay ahead of your competition and increase your profits
• Concentrated liquidity enables faster and smoother execution of trades, as there is a higher probability of finding a counterparty willing to transact at your desired price

CONs

• Concentrated liquidity can be complex and difficult to implement for many LPs, which can result in higher transaction costs and a reduced pool of potential liquidity providers
• Concentrating liquidity within a specific price range may result in lower trading volumes and less liquidity outside of that range, which can negatively impact the overall performance of the liquidity pool

LPs should carefully evaluate the potential risks and returns associated with concentrated liquidity before implementing this strategy. Diversification of liquidity provision across multiple price ranges can help to reduce the risks associated with concentrated liquidity. Carefully evaluate the specific price range you want to target, based on market conditions and the overall liquidity of the asset. You want to make sure that there is sufficient demand for liquidity within that range, and that the range is not too narrow or wide. Monitor the performance of your liquidity provision regularly and adjust your strategy as needed, based on market conditions and performance metrics such as trading volume, trading fees, and impermanent loss.