Concentrated Liquidity
Uniswap v3 introduces the concept of concentrated liquidity, which is a departure from the earlier versions where liquidity was evenly spread across the entire price spectrum from 0 to infinity.
In the previous uniform distribution model, a significant portion of liquidity remained unused, especially in pairs with stablecoins where the relative price of the assets stayed relatively constant.
For instance, in Uniswap v2's DAI/USDC pair, only around 0.50% of the total available capital was utilized for trading in the narrow range between $0.99 and $1.01, which is where most trading activity occurred. The rest of the liquidity outside this range remained untouched.
Uniswap v3 addresses this inefficiency by allowing liquidity providers (LPs) to concentrate their capital within specific price intervals rather than distributing it uniformly across the entire price curve. In the example of a stablecoin/stablecoin pair, an LP can choose to allocate capital exclusively to a smaller price range, like 0.99 - 1.01. This focused approach provides deeper liquidity around the mid-price, where trading is most active, resulting in LPs earning more trading fees with their capital.
The term used for the concentrated liquidity within a finite interval is a "position." LPs can have multiple positions within a single pool, allowing them to customize their exposure to different price ranges. This flexibility enables LPs to tailor their strategies based on their preferences and expectations, creating individualized price curves for each LP.
In summary, Uniswap v3's concentrated liquidity model enhances capital efficiency by allowing LPs to optimize their positions and capture more fees in the price ranges where trading is most prevalent.
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