You are reading an excerpt from our free but shortened abridged report! While still packed with incredible research and data, for just $20/month you can upgrade to our FULL library of 50+ reports (including this one) and complete industry-leading analysis on the top crypto assets. 

Becoming a Premium member means enjoying all the perks of a Basic membership PLUS:

• Full-length CORE Reports: More technical, in-depth research, actionable insights, and potential market alpha for serious crypto users
• Early access to future CORE ratings: Being early is sometimes just as important as being right!
• Premium Member CORE+ Reports: Coverage on the top issues pertaining to crypto users like bridge security, layer two solutions, DeFi plays, and more
• CORE report Audio playback: Don’t want to read? No problem! Listen on the go.

AMMS

Automated Market Makers (AMMs) have gained substantial ground, capturing over 95% of the total volume of decentralized exchanges (DEXs). This dominance emanates from the core attributes of AMMs that uniquely position them in the face of alternative designs, such as traditional limit order books or Request For Quotations (RFQs).

AMMs, particularly of the Uniswap v2 style, are designed to function even in low liquidity conditions. They always provide a price, thereby maintaining a continuous marketplace. Moreover, AMMs inherently offer passive liquidity management. This removes the active management burden from liquidity providers (LPs), making it easy for anyone to function as an LP and earn fees, thus democratizing the process beyond the realm of traditional market makers.

Another notable advantage of AMMs lies in their computational efficiency. Compared to order-book exchanges, they require less computational and storage resources, thereby consuming less gas. Additionally, AMMs operate without gatekeepers, offering a stark contrast to traditional exchanges where high listing fees can often be prohibitive, and centralized exchanges reserve the right to delist tokens at will.

However, AMMs are not without their flaws. One of the major drawbacks of AMMs is high gas fees. Trading on-chain remains expensive. Though AMM pool fees (0.01–0.3%) are comparable to centralized exchange (CEX) spreads, gas fees can substantially inflate the cost of small trades (under $1000), even on L2s. 

Another issue with AMMs stems from a phenomenon known as loss-versus-rebalancing (LVR). Uniswap LPs, for instance, have often been found to be quite unprofitable due to LVR resulting from toxic flow. This is because AMMs, being passive entities, cannot independently adjust their prices to match real-time price movements on more active exchanges, like Coinbase. This mismatch creates opportunities for arbitrageurs, leading to losses for LPs. Unlike active market makers on limit order books who strive to adjust their quotes instantaneously as prices change, LPs on AMMs often end up selling at non-optimal prices to arbitrageurs, hence suffering losses versus the potential profits from rebalancing their assets at the current market price.

Furthermore, AMMs have vulnerabilities when it comes to value extraction. Traders can be subject to predatory practices such as frontrunning, sandwich attacks, or having their trades blocked, thereby resulting in unfavorable prices. Passive LPs, too, face the risk of more active LPs providing just-in-time liquidity to claim the majority of trading fees.

Uni v3: Progress?

The introduction of Uniswap v3 allowed liquidity providers to customize their pool and the price range for their liquidity.Concentrated liquidity represents a significant departure from traditional liquidity provision in AMMs. Instead of distributing assets evenly across the entire price range, LPs can concentrate their funds around specific price ranges within a liquidity pool. This targeted approach has several key advantages:

By focusing liquidity within specific price ranges, LPs can achieve greater capital efficiency. Traditional methods often result in large amounts of unused capital sitting outside the price ranges where most trading activity occurs. Concentrated liquidity addresses this inefficiency by aligning capital allocation with trading demand.

The Osmosis team, a prominent player in the DeFi space, has claimed that concentrated liquidity can provide an increase in capital efficiency of 100x to 300x. This remarkable improvement stems from the ability to cater to large trades even when the total liquidity is lower, as the allocation within the effective price range is more substantial.

Slippage refers to the difference between the expected price of a trade and the price at which it is executed. Concentrated liquidity helps in minimizing slippage by ensuring that sufficient liquidity is available within the price ranges where trading is most likely to occur. This enhances the trading experience by providing more predictable and stable pricing.

With the right strategy, LPs utilizing concentrated liquidity could earn bigger incentives. By aligning their capital with market demand, LPs can optimize their returns, making concentrated liquidity an attractive option for those seeking to maximize their earnings.

Uni v4

This trend of customization continued with v4 and its introduction of 'hooks,' user-defined contracts that execute at a predetermined point in a pool's lifecycle. Hooks present an attractive proposition as they allow the creation of concentrated liquidity pools with customizable execution.

This customization can be leveraged to enhance functionality or modify pool parameters. For instance, hooks can facilitate the execution of large orders over time, enable on-chain limit orders that fill at tick prices, or implement dynamic fees that shift with volatility. They also provide mechanisms to keep Miner Extractable Value (MEV) in-house for liquidity providers and offer alternative oracle implementations.

While no single functionality can alleviate all the challenges faced by AMMs, they equip us with the tools to design a more efficient system. For instance, a v4 liquidity pool could dynamically increase swap fees during periods of high volatility or safeguard itself using an external oracle to update prices faster, or even permit only certain addresses to trade with the pool.

Ambient offers a similar feature with its protocol gating and permissioned pools, albeit subject to protocol governance approval. In essence, liquidity can set specific trading terms with the market, thus shifting the power balance towards liquidity providers seeking a return on their investments.

Conclusion

Concentrated liquidity is more than just a novel concept; it represents a strategic innovation that could reshape the way liquidity is provided in AMMs. By allowing LPs to align their capital with market demand, it offers increased efficiency, reduced slippage, and the potential for enhanced returns.

As the market evolves, and prices such as OSMO shift to different ranges, we can expect users to adapt their strategies accordingly, further highlighting the dynamic and responsive nature of concentrated liquidity.

In a rapidly growing and ever-changing market, concentrated liquidity stands out as a thoughtful and effective response to the challenges of liquidity provision. It underscores the continuous innovation within the DeFi space and offers a glimpse into the future of decentralized trading.