💧Concentrated Liquidity

Introduction: The central innovation of the latest version of a prominent DeFi AMM platform is the concept of concentrated liquidity. Unlike previous versions where liquidity was uniformly distributed across the entire price spectrum from 0 to infinity, this new approach allows for liquidity to be allocated within specific price ranges.

In the past, the uniform distribution meant that trading could occur across the entire price range without any loss of liquidity. However, it was observed that a large portion of this liquidity was seldom utilized. This was particularly evident in stablecoin pairs, where the relative price of the assets remains fairly constant. For instance, in the earlier version, a typical DAI/USDC pair might only use about 0.50% of the total capital for trades within the $0.99 to $1.01 range, despite this being the range where most trading volume and fee generation occurred.

With the new version, liquidity providers (LPs) can target their capital to narrower price intervals than the broad (0, ∞) range. For example, in a stablecoin-to-stablecoin pair, an LP might choose to allocate capital exclusively within the 0.99 to 1.01 range. This results in deeper liquidity around the mid-price, enabling LPs to earn more trading fees with their capital. We refer to liquidity concentrated within a finite interval as a position. LPs can establish multiple positions per pool, each reflecting their individual pricing preferences.

Active Liquidity: When the market price of an asset moves outside the bounds set by an LP's position, the liquidity in that position becomes inactive and stops earning fees. As the price shifts in one direction, LPs accumulate more of one asset and less of the other, until their position is entirely composed of a single asset. This contrasts with the previous version, where reaching the extreme price bounds of two assets was rare. If the price re-enters the set interval, the liquidity becomes active again, and LPs start earning fees.

LPs have the freedom to create multiple positions with distinct price intervals. Concentrated liquidity thus allows the market to determine an optimal distribution of liquidity, as rational LPs are incentivized to focus their liquidity in active ranges.

Ticks: To facilitate concentrated liquidity, the continuous price spectrum has been divided using ticks. Ticks are defined as boundaries between discrete price segments, with each tick representing a 0.01% (1 basis point) change in price. They serve as the limits for liquidity positions, with LPs selecting the lower and upper ticks to define their position's range.

As trades occur, the pool contract exchanges assets within the current tick interval until the next tick is reached, at which point it activates any dormant liquidity at the new tick. While each pool has a consistent number of underlying ticks, only some are active at any given time. The spacing of these ticks is linked to the swap fee tier, with lower fees allowing for more closely spaced active ticks and higher fees leading to wider spacing.

Inactive ticks do not affect transaction costs during swaps, but crossing an active tick increases the transaction cost due to the activation of liquidity in new positions associated with that tick. In scenarios where capital efficiency is crucial, like in stablecoin pairs, narrower tick spacing enhances the precision of liquidity provision and can reduce price impact, leading to better prices for stablecoin swaps.