📕 BETTER THAN YESTERDAY WITH BSCSTATION #6: CLMMs
In the previous part, BSCStation provided knowledge about Automated Market Makers (AMMs). Today let's get on with Concentrated Liquidity Market Makers (CLMMs).
Decentralized exchanges are gaining momentum in the crypto space. A real game-changing feature that has come up recently is Concentrated Liquidity Market Maker.
What is Concentrated Liquidity Market Maker and how can it benefit liquidity providers and traders? Let’s get to the chase.
What are CLMMs?
The concentrated liquidity market maker (CLMM) is a next-generation automated market maker (AMM). CLMMs increase the capital efficiency of decentralized exchanges (DEX) and are an excellent source of yield for liquidity providers (LPs).
Сoncentrated liquidity is the liquidity allocated within a custom price range.
When liquidity was distributed evenly, one could trade their assets within the infinite interval (0,∞). However, with the concentrated liquidity mechanics, liquidity providers (LPs) can accumulate their capital to smaller price intervals than (0, ∞) which enables individualized price curves, higher capital efficiency and deeper liquidity for traders.
In a stablecoin/stablecoin pair, for example, an LP may choose to allocate capital solely to the 0.99 - 1.01 range. As a result, traders are offered deeper liquidity around the mid-price, and LPs earn more trading fees with their capital.
What Was Before CLMMs?
Earlier implementations of AMMs used the so-called XYK model, based on the x*y=k price curve. The idea was to maintain a constant balance within a liquidity pool so that the total value of one token would always equal the total value of the other token in the pool; regardless of their current price against each other.
With the XYK model, the liquidity in the pool is spread across all possible price ranges. As a result, the liquidity providers (LPs) are earning far smaller trading fee bonuses — which is their compensation for the risk they take. They also suffer from higher slippage, because the majority of their liquidity never gets used in pools of this type at all.
The New Model of Pooling Liquidity
Concentrated liquidity tries to boost capital efficiency, and to make up for the inadequacy of the original formula. Within the new model, liquidity can be allocated to a price interval, resulting in what is called a concentrated liquidity position. LPs can open as many positions in the pool as they wish, thereby creating unique price curves aligned with their personal needs and preferences.
How CLMMs Work?
When LPs provide liquidity on a CLMM, they can choose the price range where they would like their tokens allocated, for example, from $20-$30. This range is broken down into “ticks,” where liquidity is distributed equally.
For example, in the range of $20-$30, there could be a tick for $21 tokens, $22 tokens, and so on. The tokens remain supplied in these ticks until they are withdrawn, and an LP cannot receive fees if the market value of the tokens they’ve supplied moves outside their set range.
Tokens provided on a CLMM are not spread out across a massive price range and instead are supplied at or around the current market value of a token, so capital efficiency is increased exponentially compared to first-generation AMMs. With a CLMM, it no longer takes 1,000 tokens to supply 10 tokens at the current token price. For LPs, 10 tokens deposited in a CLMM can return the same yield as 1,000 tokens inefficiently deployed from zero to infinity.
Allocating liquidity more efficiently is a boon for LPs, traders, and projects. LPs can collect more fees earned with fewer tokens deposited (that can be used to earn yield elsewhere in DeFi), traders can experience less slippage, and projects can more efficiently realize deep liquidity for their tokens without having to deploy capital that could be used elsewhere for growth.
How To Configure Your Position and Provide Liquidity on CLMMs
The ability to choose a price range makes CLMMs similar to an order book. You get to choose the price range where you would like to provide liquidity, and you can also select what fees you’d like to receive as an LP.
Considerations When Providing Liquidity on CLMMs
A study performed half a year after the release of Uniswap V3, the first DEX to introduce the CLMM, found that less than half of the LPs using the CLMM were making a profit compared to holding tokens.
Providing a CLMM with liquidity can require a lot of active management if you want to keep your concentrated position tightly around the current price. This means you’ll have to close your position and set up a new range when prices move towards the boundaries of your current range, or you’ll experience IL and earn zero fees.
This can be incredibly expensive on Ethereum Virtual Machine chains (EVM) that face problems with scalability issues and high fees during high traffic periods.
Keeping your liquidity within a tightly concentrated range requires active participation in maintaining your position. Liquidity provided at a 1%-5% range has historically earned more fees than liquidity provided at more passive ranges.
One interesting feature of providing liquidity on a CLMM is that you can open multiple positions for the same token pair. Since you are not “throwing your tokens into the same big bag,” you can set positions at multiple ranges as a strategy to optimize your returns.
Now, you’re fully armed with one of the latest trends of decentralized exchanges. Despite the fact that concentrated liquidity has opened effective ways to asset capitalization for liquidity providers and traders, it carries certain disadvantages which you need to be aware of and which will be discussed in the next articles.
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Disclaimer: Cryptocurrency investment is subject to high market risk. BSCStation is not responsible for any of your trading losses. The statements made in this article are for educational purposes only and should not be considered financial advice or investment recommendation.