Intro to Concentrated Liquidity
Last updated
Last updated
NovaDEX Concentrated Liquidity Market Maker (CLMM) pools offer liquidity providers the flexibility to designate a particular price range where their liquidity becomes active for trades within the pool. This differs from Automated Market Maker (AMM) pools with a constant product model, where liquidity is evenly distributed across a price curve ranging from 0 to infinity. For liquidity providers, the CLMM design enhances capital efficiency and leads to higher yield from trading fees. Meanwhile, for traders, CLMMs enhance liquidity depth near the current price, resulting in improved pricing and reduced price impact during swaps.
Although CLMMs offer the advantages of increased capital efficiency, it's essential to fully comprehend the consequences of impermanent loss and concentrated liquidity, as they are amplified by the design.
The design of CLMMs allows for more efficient capital allocation in the price range for market making. Nonetheless, users must remain vigilant and actively monitor their positions and market fluctuations to effectively reduce the risk of heightened impermanent loss.
Earlier implementations of AMMs (such as Uniswap v2) used the so-called XYK model, based on the x*y=k price curve
Decentralized exchange (DEX) liquidity pools disperse tokens across a price spectrum, enabling price discovery and adjusting token value based on supply and demand. Abundant liquidity minimizes slippage, whereas scarce liquidity triggers price fluctuations. When swapping $5,000 DAI for Token B with substantial liquidity, it has a minimal impact on the price. However, in the case of limited liquidity, a $5,000 USDC for Token B swap can drive up the price. Most tokens along the price curve remain underutilized, leading to inefficient allocation of capital for liquidity providers (LPs). Contributing liquidity to a first-generation automated market maker (AMM) yields fees proportionate to the tokens supplied but constrains liquidity for other DeFi services.
Boosting Capital Efficiency with Concentrated Liquidity Market Makers (CLMMs) empowers LPs to select precise price ranges for their token allocation, granting them greater control. These ranges are subdivided into ticks, ensuring equitable liquidity distribution. Tokens are held within their designated ticks until withdrawal, and fees are exclusively accrued within the chosen price range. CLMMs prioritize token supply close to the prevailing market value, leading to a significant enhancement in capital efficiency when compared to conventional AMMs. This technology empowers LPs to attain superior returns with fewer tokens, delivering advantages such as decreased slippage for traders and optimized liquidity allocation for project growth.
To sum up, the strategy of concentrating liquidity around the current price and adjusting positions in response to price fluctuations is a potent method for maximizing profits while mitigating the risk of asset devaluation. This approach is mutually beneficial for liquidity providers and traders, enabling LPs to strategically allocate capital and earn higher fees while furnishing traders with more substantial liquidity and reduced slippage.
