Concentrated Liquidity

Concentrated Liquidity is currently the most efficient method of market making that on-chain decentralized exchanges have access to. This was popularized when Uniswap released V3. To get an idea of what Uniswap V3 offers we can compare it to a more centralized, well-known liquidity scheme: A CEX Order Book.

As you can easily see in the CEX Order Book diagram above, the bids (buys) and asks (sells) are clearly shown, and the depth at which a market order would impact the median price is visually discernible. Interesting enough, the concentrated liquidity model, is represented visually as an inverse histogram of the order book.

The blue area shaded in represents the liquidity ranges summated between all users within the pool.

Concentrated liquidity positions have a defined range chosen by the liquidity provider. Each liquidity provider chooses the lower and upper bound at which their liquidity can be utilized.

This means that liquidity is concentrated into narrower price ranges, providing much deeper liquidity to the market than if that liquidity had to be spread across the full (0,∞) range (as required in previous models such as Uniswap V2).

For example, $100,000 of liquidity spread from 0 to ∞ is exponentially less efficient than $100,000 of liquidity with a defined range of ($1,000-$1,100). It is calculable that the same $100,000 of liquidity is now concentrated in a $100 price range, providing an efficient swapping experience. Concentrated liquidity provides the lowest slippage currently feasible within the DeFi space.