Concentrated Liquidity
In the evolving DeFi landscape, concentrated liquidity (CL) has emerged as a groundbreaking innovation, particularly influencing the mechanics of Automated Market Makers (AMMs) and liquidity provision. CL is a key feature in the deployment of Pearl v2. Any liquidity provider on Pearl should have a basic understanding of CL as it's now the dominant model in decentralized trading.
What is Concentrated Liquidity?
Concentrated liquidity is a massive step forward in the way liquidity is provided to AMMs. In traditional liquidity provision (Uniswap v2) liquidity was distributed uniformly along the price curve between 0 and infinity. This allowed for trading across the entire price interval (0, ∞) without any loss of liquidity. However, in many pools, the majority of the liquidity was never used.
Concentrated liquidity (Uniswap v3) allows LPs to allocate their capital to specific price intervals instead of the full (0, ∞) range. This targeted approach enhances capital efficiency and potentially increases fee generation for LPs.
Example: Stablecoin/Stablecoin Pair
Previously an LP would provide liquidity across the entire price price.
Now they have the choice to allocate capital within the 0.99 - 1.01 range. Traders now have deeper liquidity around the mid-price while LPs earn more trading fees with their capital.
Liquidity concentrated to a finite interval makes each new liquidity "position" non-fungible, now represented by an NFT instead of fungible ERC-20 LP tokens.
Key Features of Concentrated Liquidity
Provide Liquidity More Efficiently: By concentrating liquidity around the current price, LPs ensure that their capital is used more effectively in trades.
Earn Higher Returns: Because capital is used more efficiently, LPs now earn higher fees from trades that occur within their specified price range. (Note: Price movements may push trades outside an LPs range resulting in loss of fees and emissions)
Customize Risk and Reward: LPs can choose price ranges based on their risk appetite and market outlook. Narrow ranges can offer higher returns (due to more frequent trading within that range) but carry higher risk if prices move out of the range.
Improve Capital Efficiency: This approach allows for much greater capital efficiency, as less capital is needed to provide the same depth of liquidity within a specific price range.
Considerations and Risks
Active Liquidity and Rewards: To receive fees and emissions, provided liquidity must be in the active trading range for the pair. Liquidity on Pearl is provided in a band between distinct points on the asset's price range called "ticks." If a band is encompassed within the current price range of an asset then it is considered "active liquidity."
Impermanent Loss: The risk of impermanent loss can be heightened in concentrated liquidity setups. As price moves in one direction, LPs gain more of the one asset as swappers demand the other, until their entire liquidity consists of only one asset as price moves outside the LPs' chosen price ranges.
Active Management Requirement: LPs need to be more proactive in managing their positions, requiring a deeper understanding of market dynamics. Pearl offers users the option to utilize Trident, our proprietary Active Liquidity Manager (ALM).
Impermanent loss is a yield farming risk when one asset in a liquidity pool significantly outperforms the other, shifting their relative values and potentially causing losses for liquidity providers (LPs) compared to just holding the assets. Understanding and mitigating this risk is vital before engaging in yield farming.
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