Concentrated Liquidity
Understanding the Evolution: Uniswap V2 vs. Concentrated Liquidity.
As decentralized exchanges (DEXs) continue to evolve, so do the mechanisms that power them. One of the most notable upgrades in DeFi was the transition from Uniswap V2 to Uniswap V3, introducing the concept of Concentrated Liquidity.
Below, we break down the key differences between the two versions and explain why V3 is considered a major leap forward in capital efficiency and flexibility.
Uniswap V2 – The Constant Product AMM
Uniswap V2 uses a constant product formula (x * y = k) to facilitate trades. Liquidity providers (LPs) deposit equal values of two tokens into a pool and earn fees from trades.
Key Characteristics:
Liquidity is evenly distributed across the entire price curve (from 0 to ∞).
LPs earn fees on trades regardless of the price, but most liquidity is unused at any given moment.
Simple to use, but capital inefficient, since most of the capital isn’t actively used.
Example:
If an LP provides liquidity for ETH/USDC, they must be willing to support trades from ETH = $0 all the way to infinity. However, most trades happen within a narrow range—resulting in idle capital.
Uniswap V3 – Concentrated Liquidity
Uniswap V3 redefines how liquidity is deployed. Instead of spreading liquidity evenly across the entire price curve, LPs can concentrate their liquidity within specific price ranges.
Key Improvements:
Capital Efficiency: LPs can provide liquidity only within active trading ranges, allowing them to earn more fees with less capital.
Custom Ranges: LPs choose custom price ranges for their liquidity—offering precision and flexibility.
Multiple Positions: LPs can open multiple positions at different price ranges, essentially acting as a portfolio of strategies.
Example:
An LP who expects ETH to trade between $1,800 and $2,200 can provide liquidity only within that range. They earn higher fees and use their capital more efficiently, without committing funds to irrelevant price zones.
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