Concentrated liquidity: how DeFi pools work
Who is suitable for this new way of interaction with the crypto market, and when it is profitable to use it
The use of concentrated liquidity was the developers' and community's answer to the problems of traditional pools: large impermanent losses and inefficient use of liquidity. When providing liquidity in classic pools, users spread it across the entire possible price range, while active trading actually takes place only within a fairly narrow price range.
Using concentrated liquidity pools, users can choose the minimum and maximum price value of a pair's assets, within which their liquidity will participate in trading and, accordingly, bring increased profit to the owner in the form of commissions.
The ratio of assets in the provided pair will change depending on which border of the range the price is closer to at the current moment.
When the price touches the lower boundary, liquidity will cease to be provided and both assets will be fully transferred to the most volatile asset whose price has fallen.
When the price touches the upper boundary, liquidity will also cease to be provided and both assets will be fully transferred to the least volatile asset whose price has changed less, compared to the asset that has risen in price.
For example, the user will provide liquidity for the ETH/USDC pair between $1,000 and $1,500. If the price of ETH falls below $1,000, all of the pair's liquidity will be transferred to ETH. If the price of ETH rises above $1,500, all the liquidity of the pair will be transferred to USDC.
Many projects are already working with concentrated liquidity: Orca, Tulip and Raydium on Solana, and to some extent the Earn section of the Wirex app works with the concept. The pioneer and leader of the technology is Uniswap V3.
Simulating situations - when is it profitable to use?
In some situations it will be more profitable to provide liquidity, and sometimes it will be more profitable to just buy an asset and wait for its growth. When the price falls, the difference between the two options will not be significant. If the price rises significantly and rapidly, it is advantageous to simply store the asset - by providing concentrated liquidity, users miss the growth phase of the asset after leaving the upper limit of the range.
The key to the profitability of concentrated liquidity positions is the length of time they stay within the specified price range. Even the fall in the price of the asset, that occurs after a long stay in the range, will be compensated by the commissions received. Therefore, by opening a concentrated liquidity position, users bet on the moderate volatility within the given range.
Are range orders the main or additional scenario of using the technology?
Due to the peculiarities of a pair's transition to a single asset on the range boundary, there are additional ways of using the technology that are not immediately obvious. You can use the Uniswap V3 interface to create buy and take profit orders. Range orders have a number of advantages in comparison with usual orders on centralized exchanges: practically zero risk of slippage, no influence of excessively large orders on the price in the moment and their visibility in the stock market, and of course additional profit from order execution in the form of commissions collected for the time in the range.
Let us give an example of using range orders in real situations to better understand their working principle.
User "A" wants to buy bitcoin at ~$15k, there will be a liquidity pair WBTC/USDC created for this task, the upper limit of the range will be set at $15.2k and the lower one at $15k. While the price is out of the range, the position will not be active. If the BTC price moves below the USDC range, the user will switch completely to WBTC. In addition to opening a long position, liquidity fees will also be received for all the time the price was inside the range.
Let's consider the second situation.
User B wants to fix the profit on ETH when the price reaches ~$1.7 thousand. For this purpose, there will be created a liquidity pair WETH/USDC, the lower border of the range will be set at $1.63 thousand and the upper one at $1.7 thousand. While the price is out of the range, the position will not be active. As soon as the ETH price is above the range, the user will execute his take profit order in its entirety by exiting the asset to the dollar, at the same time receiving commissions for providing liquidity for the time the price was inside the designated range.
In both of the above cases, immediately after exiting the ranges, the liquidity position can be turned off, leaving yourself the asset you initially desired. Re-entering the range will activate the liquidity position again, and the proportion of assets will begin to change again.
Which is better: concentrated or regular liquidity?
The use of concentrated liquidity is suitable for users who are willing to allocate extra time for active position management. For maximum efficiency, it is important to track the moments of entering and exiting ranges, to select the most "viable" price ranges based on technical analysis and, last but not least, to choose the networks with the highest trading volumes for the desired pair. In cases where you need to open a liquidity position and forget about it for a long time, it is more convenient to use classic pools.