Perks for Liquidity Providers
Last updated
Last updated
Concentrated liquidity enables liquidity providers (LPs) to focus their capital within targeted price ranges where trading is most likely to happen. This makes the provided liquidity more effective and better utilized. By concentrating liquidity in specific ranges, the same capital can facilitate larger trading volumes, resulting in a more efficient use of assets and higher returns for LPs.
Concentrated liquidity boosts capital efficiency up to 20x by placing liquidity within specific price ranges.
With the ability to concentrate liquidity in the most active trading zones, LPs can earn more fees than they would by spreading liquidity across the entire price spectrum. This flexibility encourages LPs to engage more strategically, positioning their liquidity where it can generate the highest returns.
Alice and Bob are providing liquidity to a TON/USDT pool. They each have $1 million in Toncoin and USDT. Alice invests her whole stash of tokens across the entire price range, which is 500,000 USDT and 100,000 TON at the price of Toncoin equaling 5 USDT.
Bob, on the other hand, takes a concentrated position, investing only 91,750 USDT and 18,350 TON (worth ~$183,500) within the price range of 2.5 to 7.5.
Despite the fact that Alice has deposited 5.44x as much capital as Bob, as long as the TON/USDT price stays within the 2.5 to 7.5 range, they are going to earn the same amount of fee rewards. Basically, it means that Bob’s capital is more efficient and can earn 5.44x more than Alice’s (per dollar deposited).
In case the price breaks out of this price range, Bob can no longer earn fees, and his funds will be converted to the less valuable token. At the same time, Alice’s liquidity, or liquidity on v2 DEXs, will be exposed to impermanent loss to a lesser extent. In this sense, we can imagine a full-range position on the decentralized exchange, with concentrated liquidity equal to the usual position on a v2 exchange. The smaller the range, the faster liquidity gets converted while the price moves. At the same time, choosing a concentrated position and taking on more risk of impermanent loss is remunerated fairly by increasing the LP effectiveness.
As in the worst-case scenario when one token loses all its value and its price falls to 0, both Alice and Bob will end up with the asset being worth nothing. However, Bob will lose only ~$183,500 (~16% of his capital), with Alice’s capital being gone in its entirety.
Liquidity providers (LPs) have the flexibility to manage their risk by selecting price ranges that align with their risk tolerance. For example, an aggressive LP may choose a narrower range near the current market price, which offers the potential for higher fee earnings but comes with increased risk if the price moves outside the range. Conversely, a more conservative LP might opt for a wider range, reducing the risk of being out of range while still earning steady fees.
