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Solution by V3 DEXs: Concentrated Liquidity

The core cause of low liquidity issue put in a single sentence is this: ‘while liquidity is provided to all price ranges from zero to infinity, swap activities take place selectively in particular price ranges.’ As a resolution to this, Uniswap suggested the concept of ‘concentrated liquidity’ when it launched V3. The idea behind it was to let LPs set the price ranges themselves and provide concentrated liquidity to those ranges. This activates the liquidity usage and enables more liquidity to be proactively utilized in actual swaps.

Improving Liquidity utilization rate by Adding Concentrated Liquidity

On V3-type DEXs, LPs set the price ranges they want to add liquidity to and provide concentrated liquidity exclusively to these ranges. Maybe below order-book type illustrations could help you understand better.
In this case, the liquidity added by LPs is added to the selected price range in a concentrated manner and not to any other price ranges. As LPs provide concentrated liquidity to price ranges where swaps actually take place, you can see how the liquidity utilization rate improves.
Compared to the V2-type, high liquidity utilization rate enabled by V3 has below advantages:
  • LPs can yield a greater swap fee income with the same amount of liquidity.
    • For instance, let’s say 1 BTC costs 40,000 USDT. If you choose to provide concentrated liquidity to the ‘30,000 USDT < 1 BTC < 50,000’ USDT price range, you may garner X 8.3 swap fee compared to V2-type transaction.
  • Greater swap liquidity allows traders to swap tokens with a lower price impact and slippage.
  • Higher liquidity utilization rate means more liquidity is utilized for swaps, facilitating the asset flow within the ecosystem.

NFT-type LP Position

In the V2-type liquidity provision model, all LPs add liquidity to an identical price range (zero to infinity) and provide A/B tokens at identical ratios at a particular point.
  • LP A who added $6,000 liquidity = provides 1 ETH and 3,000 USDT to the price range of zero to infinity
  • LP B who added $12,000 liquidity = provides 2 ETH and 6,000 USDT to the price range of zero to infinity
In the above V2-type liquidity provision, liquidity positions provided by individual LPs have a fungible relationship with one another. Therefore, V2-type LP tokens are issued in the form of ERC-20 standard FTs (Fungible Tokens).
However, in V3-type liquidity provision, LPs provide liquidity to different price ranges. As the LPs hold different positions, they get to provide A/B tokens at different ratios at a particular point.
  • LP A who added $6,000 liquidity to the 1,500 USDT < 1 ETH < 6,000 USDT price range = provides 1 ETH and 3,000 USDT
  • LP B who added $6,000 liquidity to the 2,000 USDT < 1 ETH < 4,000 USDT price range = provides 0.84 ETH and 3,468 USDT
In such a V3-type liquidity provision, liquidity positions provided by individual LPs have a non-fungible relationship with one another. Therefore, V3-type LP tokens are issued as ERC-721 NFTs (Non-Fungible Tokens).

Price Tick

In the V3-type liquidity provision, users provide different volumes of liquidity to varying price ranges. When a new liquidity position is provided, the liquidity pool provides its liquidity based on price ticks, or the boundaries between discrete price space areas.
Each price tick's liquidity is equivalent to the sum of all liquidity positions provided to the price range it (= each price tick) belongs to. When the prices change following a swap, the swap output (x*y=k) is calculated based on the liquidity volume of the price tick.
  • LPs provide different volumes of liquidity to varying price ranges.
    • LP A : Provides 3 liquidity to the price range of 3,000 – 3,400
    • LP B : Provides 2 liquidity to the price range of 3,100 – 3,600
    • LP C : Provides 1 liquidity to the price range of 3,200 – 3,500
  • The total liquidity volume of all LP positions included in each price range is used for the swaps.
    • 3,000~3,100 : LP A → liquidity: 3
    • 3,100~3,200 : LP A + LP B → liquidity: 5
    • 3,200~3,400 : LP A + LP B + LP C → liquidity: 6
    • 3,400~3,500 : LP B + LP C → liquidity: 3
    • 3,500~3,600 : LP B → liquidity: 2
  • If swap fees accrue within the price range that LPs added liquidity to, they will receive the fee proportionate to their liquidity share within that particular price range.