Uniswap V3 introduced the concept of concentrated liquidity in order to create capital efficient markets. Concentrated liquidity allows LPs to set the price range in which they would provide liquidity, so rather than their capital being spread thin across the entire constant price formula curve, 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 by using this design, Uniswap V3 has been able to create deeper liquidity than many centralized exchanges. This means that not only are DEXs 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.

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 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.