Uniswap V3: Concentrated Liquidity

Concentrated liquidity is really the defining idea of Uniswap V3. Simply put, it is the ability to specify a custom price range to allocate liquidity. In V2 and prior versions, liquidity was distributed evenly along the price curve between zero and infinity by default. This meant that the majority of the liquidity was never used.

For assets that trade tightly, such as stablecoin pairs, the pools generally use less than 1% of the total liquidity resulting in lower fees to LPs and a lower capital efficiency. Concentrated liquidity allows an LP to provide liquidity for a smaller range between (0,∞). For example, LPs could allocate liquidity to the price range of $.95 — $1.05 in a stablecoin pair, providing deeper liquidity which results in better price execution for the user and higher fees for the LP.

What effect does this have on the price curve? Instead of having one price curve from zero to infinity in which all LP funds are allocated, price curves will be an overlap of individualized price curves provided by each LP. Furthermore, each LP can have multiple price curves that specify separate custom ranges.

Interestingly, by adding liquidity to a price range entirely above or below market, an LP can essentially enter into a fee-earning limit order that executes along a smooth curve. Concentrated liquidity unlocks market-driven liquidity allocation in which rational LPs contribute to what a sensible distribution of liquidity should look like through a fee incentive rewarded from ensuring their liquidity stays active.

I’ll be explaining the concept of impermanent loss next week which is important to consider alongside concentrated liquidity.