Intro on Concentrated Liquidity

What is a CLMM?

A Concentrated Liquidity Market Maker (CLMM) enables liquidity providers (LPs) to allocate liquidity within a specific price range, differentiating it from traditional constant product Automated Market Makers (AMMs) that distribute liquidity along an infinite price curve. CLMM pools are designed for LPs to use their capital more efficiently, allowing them to earn higher yields from trading fees due to concentrated deployment at current price levels. This setup benefits traders by providing deeper liquidity around the prevailing market price, resulting in better execution prices and reduced price impact during trades.

However, while CLMMs offer improved capital efficiency, they also expose liquidity providers to increased impermanent loss. Understanding the risks associated with impermanent loss and concentrated liquidity is crucial due to the intensified effects within these specific price bands.

How do liquidity price ranges work?

In CLMM pools, LPs can choose a specific price range where they want to provide liquidity. Within this range, they earn fees based on their proportion of the liquidity present at the current price, motivating them to actively manage their positions to ensure that trading actively occurs within their selected range.

Should the market price exit the chosen range, the position will stop generating fees, and the LP might face substantial impermanent loss. Unlike in standard AMM pools where a price increase in a base token results from trading with a quote token, leading to a shift in token ratio, CLMMs operate similarly but within the confines of the chosen price range. For instance, if the market price falls below the minimum price of the position, the LP's holdings will convert entirely to the base token. Conversely, if the price rises above the maximum price, the position will be fully converted to the quote token.