Understanding Concentrated Liquidity

What is Concentrated Liquidity

Concentrated Liquidity Market Maker ("CLMM") pools represent an advancement in decentralized exchange technology, offering enhanced capital efficiency for liquidity providers and improved trading conditions for users.

Key Features of CLMM

Targeted Liquidity Provision

CLMMs allow liquidity providers to concentrate their assets within specific price ranges, unlike traditional Automated Market Maker ("AMM") pools. This focused approach enables more efficient capital deployment and potentially higher yields from trading fees.

Trading Conditions

Traders benefit from deeper liquidity around current market prices, resulting in better execution and reduced slippage.

Heightened Risk Awareness

While CLMMs offer increased efficiency, they also magnify the effects of impermanent loss. Liquidity providers must fully comprehend these implications and actively manage their positions.

How Price Ranges Function in CLMM

Selective Liquidity Allocation

Liquidity providers can select specific price ranges for their assets. Fees are earned proportionally to the share of liquidity at the current price.

Active Position Management

To optimize returns, liquidity providers should regularly monitor and adjust their positions to ensure they remain within active trading ranges.

Price Movement Implications:

• If the price moves below the minimum of a position's range, the position becomes 100% base token.

• If the price exceeds the maximum, the position converts to 100% quote token.

This mechanism accelerates the standard AMM behaviour within the selected price range, potentially leading to more pronounced effects on asset composition. Understanding these dynamics is crucial for effectively participating in and benefiting from CLMM pools.

Example:

Alice decides to provide liquidity to a SEI/USDC pool. She sets her price range from $0.80 to $1.20 per SEI, with the current SEI price at $1.00. Alice deposits an equivalent value of 1,000 SEI and 1,000 USDC.

Scenario 1: SEI Price Remains Within Range ($0.80 - $1.20)

If the price of SEI fluctuates between $0.90 and $1.10:

1. Alice's position remains active, containing a mix of SEI and USDC.

2. The exact ratio of SEI to USDC will change as the price moves within the range.

3. Alice continues to earn trading fees proportional to her share of liquidity at the current price.

4. She may experience some impermanent loss, but it's mitigated by the concentrated nature of her position.

5. Alice's returns are potentially higher due to the concentrated liquidity and active fee generation.

Scenario 2: SEI Price Moves Below Minimum Range ($0.80)

If the price of SEI drops to $0.70:

1. Alice's position becomes 100% SEI.

2. Her initial 1,000 USDC has been completely swapped for SEI.

3. Alice now holds approximately 2428 SEI (1000 original SEI + 1000 USDC worth of SEI at $0.70).

4. Alice is no longer earning trading fees as her liquidity is inactive.

5. She experiences impermanent loss due to the price movement.

Scenario 3: Price Moves Above Maximum Range ($1.20)

If the price of SEI rises to $1.30:

1. Alice's position converts to 100% USDC.

2. Her initial 1000 SEI has been entirely swapped for USDC.

3. Alice now holds approximately 2,300 USDC (1000 original USDC + 1000 SEI worth of USDC at $1.30).

4. Alice stops earning trading fees as her liquidity is outside the active range.

5. She experiences impermanent loss, though potentially less severe than in a traditional AMM pool.