Diving into Liquidity Pools
0x1CC2
August 2nd, 2022

Liquidity pools are one of the core building blocks of decentralized finance. In order to work efficiently, exchanges need a pool of assets (liquidity) that facilitate trading two assets. 

Traditionally, this liquidity is provided by centralized exchanges using the order book model and a trusted intermediary. Decentralized exchanges (DEX) replace the order book model by using automated market makers (AMMs) which operate using smart contracts. Rather than executing trades by finding a trading pair using an order book, AMMs use liquidity pools for each asset in their smart contracts in order to execute trades. 

In order to work effectively, AMMs need pools of liquid assets. 

Uniswap is one of the leading DEX and one of the most powerful DeFi protocols. Since its inception as the first AMM, the Uniswap protocol has been creating efficient markets and allowing users to put their assets to work for them through the creation of liquidity pools. 

With Uniswap V1, users could create a liquidity pool for any token with an ETH base pair using a constant product formula. While this created liquidity or market depth for each asset, it was inefficient to switch between token pairs as everything had to be converted to ETH before trading. If a user wanted to trade the UNI for AAVE, they would need to swap UNI to ETH, then ETH to AAVE. 

Uniswap V2 introduced several new features and allowed multiple ERC20 token pairs, allowing liquidity providers to choose the token pairs that they wanted to allocate assets to. This innovation set the stage for exponential growth in AMM adoption and led to Uniswap being the most highly forked DeFi protocol. 

In Uniswap V2, liquidity is provided along a price curve with an even distribution across all price ranges. Although this provides market depth across all prices, it is not capital efficient. Since liquidity was spread thin across all prices from zero to infinity, market depth was often too thin and often resulted in high degrees of slippage as well as LPs only earning fees on a small portion of the portion of their assets where funds are being traded.  

Uniswap V3 created capital efficient markets by introducing concentrated liquidity. Concentrated liquidity allows LPs to set the price range in which they would provide liquidity, so rather than their capital being spread thin it can be directed to a narrower range of prices where there is more market activity. Concentrated liquidity also makes capital more efficient by providing more fees to LPs as well as increasing market depth. 

The introduction of concentrated liquidity allowed Uniswap to become the most flexible and efficient AMM ever and it also solved some of the problems that earlier liquidity pools created. 

  1. Low liquidity leads to slippage.
  2. Low yield for liquidity providers causes them to move their assets elsewhere.

Concentrated Liquidity Creates More Market Depth

Market depth is a measure of how deep the liquidity pools are for assets traded on a DEX. A deep liquidity pool not only supports larger transaction amounts, but also higher transaction volumes. Pools that have low liquidity or market depth end up either not executing or having high slippage, where the expected price of a trade is significantly different than the price at which it was executed. 

Concentrated liquidity provides greater depth because the assets liquidity providers allocate to the pools are concentrated within a narrow price range, rather than being spread out over the entire price curve. This means that concentrated liquidity creates more efficient capital markets and a better user experience because orders are executed more reliably and with less slippage. 

Research has shown that using concentrated liquidity, Uniswap V3 has been able to create deeper liquidity than many centralized exchanges. This means that not only are DEX optimized for permissionless trading, but for larger trades they offer price advantages compared to centralized exchanges. 

Alternatively, in order to create the same depth of liquidity as Uniswap V2, LPs need to allocate far less capital, meaning that their remaining capital can be distributed to other investments. 

Source: The Dominance of Uniswap V3 Liquidity
Source: The Dominance of Uniswap V3 Liquidity

Yield Farmers Want to Put Their Capital to Work

In order to create liquid markets, DEXs incentivize liquidity providers to deposit assets into pools in exchange for a percentage of the trading fees. 

Liquidity providers are investors that have capital that they want to work for them, so they seek out yield generating opportunities. Yield farmers are investors who use DeFi to maximize their returns on their investments, often moving from protocol to protocol in search of higher yields. 

Using concentrated liquidity, your money works harder for you.

Concentrated liquidity on Uniswap V3 opens up several advantages for LPs:

  1. Increased capital efficiency: By focusing liquidity on a narrow price range, LPs can create sufficient market depth with less of an investment, thus allowing them to increase their exposure to other assets and reduce their risk. 
  2. Higher returns on capital: Due to the increased capital efficiency, LPs can earn up to a higher yield on their investments. Research has shown that Uniswap V3 outperforms V2 by an average of 54%. A higher return on capital means that yield farmers are less likely to pull their capital for other yield farming opportunities. 
  3. Multiple fee tiers: V3 introduced multiple fee tiers based on varying degrees of risk: 0.05%, 0.3%, and 1%. The 0.05% fee tier is for lower volatility assets, while the higher fee tiers are more volatile and thus higher risk. 

A Word on Impermanent Loss

When liquidity providers put their capital into liquidity pools they are at risk of impermanent loss. Liquidity providers experience impermanent loss when the tokens they deposited into a pool lose value due to price volatility. 

The risk of impermanent loss is offset by the yield generated by the liquidity pool, so it would seem that pools that have a higher yield have less risk of impermanent loss. When Uniswap V3 first came out, many people believed that because they were more capital efficient and had higher returns that the risk of impermanent loss was also reduced, but that is not the case.  

Due to concentrated liquidity there is a greater risk of impermanent loss due to extreme price fluctuations. Providing liquidity to Uniswap V3 requires that LPs actively manage their positions to avoid impermanent loss. 

In the early days of DeFi, retail traders could put their assets to work for them by generating yield in liquidity pools. As the Uniswap protocol has developed and become more capital efficient, it has also made it more difficult for retail traders to participate in providing liquidity. 

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