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Key Takeaways

CLMMs allow liquidity providers to set specific price ranges for their assets instead of spreading them across all possible prices.

This model can offer better efficiency by concentrating funds where trading actually happens, meaning providers can earn more fees with the same amount of capital.

Unlike traditional models, CLMMs require users to watch the market more frequently. If the price leaves the custom set range, they stop earning fees.

While potential returns are higher, the risk of impermanent loss can also be greater if the market moves quickly against your position.

Introduction

In the early days of decentralized finance (DeFi), providing liquidity was mostly passive. You deposited your tokens into a liquidity pool, and the underlying smart contract spread your liquidity across every possible price. This model, known as the standard Automated Market Maker (AMM), was easy to use but not very efficient.

Imagine trying to sell water. In the standard AMM model, you would set up a shop on every single mile of a highway crossing the entire country, even in deserted areas where no one drives. Concentrated Liquidity Market Makers (CLMMs) changed this. They allow you to set up your "shops" only on the busy sections of the highway.

What Is Concentrated Liquidity?

In short, concentrated liquidity is liquidity that is allocated within a custom price range. In earlier versions of AMMs (like Uniswap V2), liquidity was distributed uniformly. This meant that a large portion of the assets in a pool was never actually used for trading, especially for stablecoin pairs where prices rarely move much.

With CLMMs (like Uniswap V3), you can choose to allocate your capital solely to a specific price interval. For example, providing liquidity for a stablecoin pair only between $0.99 and $1.01. This makes the liquidity "concentrated" around the current market price, where it’s most needed.

How Do CLMMs Work?

1. Ticks

To make custom ranges possible, CLMMs break down the price spectrum into small, distinct steps called ticks. You can think of ticks as the boundaries between different price areas. When you create a position, you choose a lower tick and an upper tick to serve as the borders for your liquidity.

2. Active liquidity

Your liquidity is only "active" when the current market price stays within the range you selected. As long as the price is inside your range, you earn trading fees.

However, if the price moves up or down and crosses your tick boundaries, your position becomes inactive. At this point, your liquidity is no longer earning fees.

3. Capital efficiency

The biggest benefit of CLMMs is capital efficiency. Because you aren't spreading your money across distant prices, you can provide less total capital to earn the same amount of fees as someone in a standard AMM.

For example, a user providing liquidity in a concentrated range might earn the same daily fees with $1,000 as a user in a traditional pool earns with $5,000, simply because the concentrated money is being utilized more effectively.

The Risks: It’s Not "Set and Forget"

While CLMMs offer better returns, they are more difficult to manage than standard AMMs.

Going out of range: If the price exits your chosen interval, your liquidity effectively converts into one of the two assets and sits idle. You stop earning fees until the price comes back or you manually move your position.

Impermanent loss: Because your liquidity is concentrated, the impact of price changes is amplified. If the market moves against you, you may experience impermanent loss much faster than in a standard pool.

Complexity: Standard AMM pools are easier to manage; you deposit and walk away. CLMMs require you to analyze the market and decide on a strategy. Some users even use game-theoretic strategies to optimize their positions, updating them frequently based on market movements.

Closing Thoughts

Concentrated Liquidity Market Makers have made DeFi markets deeper and more efficient. They allow traders to enjoy better prices and liquidity providers to earn higher yields on their assets. However, they transform liquidity provision from a passive income stream into an active investment strategy. If you are new to DeFi, consider starting with small amounts or simply stick to standard AMMs until you are comfortable with the concepts of CLMM ranges and ticks.

Further Reading

What Is an Automated Market Maker (AMM)?

Impermanent Loss Explained

What Are Liquidity Pools in DeFi?

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