Concentrated Liquidity Model
In order to increase the capital efficiency of the Constant Product Market Maker (CPMM) model, the concept of concentrated liquidity was introduced. The Concentrated Liquidity Market Maker model allows the liquidity providers to concentrate their liquidity by “bounding" it within a chosen price range.
When a liquidity provider opens a position, it only supports swaps that trade within its defined range. As seen in the figure below, without the need to cover for tail liquidity, the real reserve (orange curve and square) can reproduce the same effects as having a bigger pool with CPMM model (green curve and square, also known as virtual reserve) with a much lower amount of capital used.
Real reserve and virtual reserve.
With the CPMM model, liquidity providers provide liquidity to cover all possible price points (from 0 to infinity). On the other hand, a single position with the Concentrated Liquidity Market Maker model involves a defined price range. As such, the total liquidity a pair of tokens is actually a collection of different positions, as seen in the figure below.
It is also important to note that every liquidity provider enjoys the same rate of return with the CPMM model. With the Concentrated Liquidity Market Maker model, different positions with different defined price ranges have different rates of return.
Difference in liquidity shapes between CPMM and Concentrated Liquidity Market Maker models.
With the Concentrated Liquidity Market Maker model, liquidity providers can supply liquidity to different pools with different fee-tiers under the same pair of tokens (e.g. 0.01%, 0.05%, 0.30%, and 1.00%). DEXs offer multiple fee-tiers because it could motivate the liquidity providers to supply liquidities in a comprehensive way to make sure trades can still be processed even in times of extreme price fluctuations or in extreme trading volume.
This mechanism facilitates a new market equilibrium between farming rewards and swap fees. While liquidity providers consider risk-weighted returns when choosing the fee tier to provide liquidity, the swap is conducted after taking in the factors of both swap fees and slippage across different fee-tier pools by an automated mechanism.
Market trends show that certain types of assets gravitate towards specific fee-tiers. Low-volatility assets, such as stablecoin-stablecoin pairs, are more likely to congregate in the lowest fee-tiers. This is because these assets pose very low price risk for liquidity providers, while traders want to pursue an execution price as close to 1:1 as possible.
On the other hand, more exotic assets or ones traded rarely would naturally gravitate towards higher fee-tiers — as liquidity providers are motivated to offset the cost risk of holding these assets for the duration of their positions.
In the future, we will deep dive into the introduction of dynamic fee applied in the Concentrated Liquidity Market Maker model.