Chapter 5 - How does Concentrated Liquidity (CL) work

Uniswap V3 introduced the concept of tick based concentrated liquidity, which allows liquidity providers (LPs) to allocate capital more efficiently than in Uniswap V2.

Uniswap V2

Uniswap V2 (UniV2) and other Constant Product Market Makers (CPMMs) distribute liquidity uniformly across the entire price curve (0 to ∞). This means there will always be liquidity no matter how high volatility may be, however, the cost is that most of this capital sits unused.

Uniswap V3

Uniswap V3 (UniV3) concentrates liquidity by letting liquidity providers (LPs) use discrete price ticks to manage where liquidity is placed. Internally, each price range is a leveraged mini-pool with virtual reserves. V3 aggregates all the tick liquidity when executing trades. By placing liquidity in a range, LPs can allocate capital more efficiently rather than spreading it thinly. Within their range, LPs earn more fees for their liquidity than in UniV2. If the price goes out of range, LPs earn nothing since their liquidity is no longer active. UniV3 leverages V2 within specific price ranges to create virtual reserves that can support more trade activity and earn more fees. Since the liquidity is leveraged, there is a higher risk of Impermanent Loss (IL). The tighter the range, the higher the IL risk will be.