Concentrated Liquidity Guide📚

✨ Hello friends! In this guide, I'll illuminate everything you've been curious about regarding liquidity provision and, more importantly, teach you how to make money by providing concentrated liquidity. We'll start with the basics of liquidity provision, then delve into concentrated liquidity provision in detail. Get ready for a long tweet, let's begin!

1) What is liquidity provision? 💰⚖💰
Assuming everyone reading this guide is familiar with decentralized exchanges (DEXs) and their use, you know we can swap our tokens for other tokens on DEXs. The swaps are made possible by the liquidity pools for the assets being traded. Liquidity pools, containing two assets (or more if you're using Balancer), are filled by users adding their tokens, enabling others to swap their assets using these pools. Simply put, liquidity providers add their assets to liquidity pools, allowing others to swap. However, providing liquidity comes with its risks, which we'll address at the end.

2) What's in it for liquidity providers? 📈
Liquidity providers earn commission from the transactions conducted in their liquidity pool, usually around 0.3% in Uniswap v2 forks. With Uniswap, when adding concentrated liquidity, it's possible to set different commission rates for the assets added to the pool. Generally, pools like USDC/USDT or ETH/USDC might offer lower commission rates like 0.01%, while liquidity providers may prefer higher commissions in less stable coin pools. The reasoning is straightforward: users are more likely to swap with ETH, USDC, or USDT and avoid high-commission pools, whereas, for "exotic pairs" shown in Uniswap v3 screenshots with a 1% commission rate, higher commissions are preferable for liquidity providers in riskier coins, assuming that pools with lower commission rates will become more common as a token's volume and relative reliability increase.

3) Traditional DEXs vs. Concentrated Liquidity Provision (Uni v3 / Trader Joe / Meteora DLMM)
Now, we're reaching the crucial part. As the name "concentrated liquidity" suggests, you only add liquidity within a specific price range. This approach overcomes the inefficiency of providing liquidity in traditional DEXs (hereafter referred to as traditional dex), allowing you to use your liquidity more efficiently and earn more transaction fees (commission). Below, you'll see that traditional DEXs require you to add liquidity across an infinite price curve. In contrast, concentrated liquidity allows you to focus on a narrow range on this infinite curve.
I'll attach a simple explanatory image to help you understand how transaction fees are higher in this setup, using exaggerated examples for clarity. In traditional DEXs, every user adds liquidity across the same infinite price curve, earning transaction fees proportionate to their share of the pool's liquidity.

Example: If liquidity providers in a traditional DEX's pool collected $1000 in transaction fees over a certain period, and your share of the total liquidity in the pool was only 1%, you would earn $10.

(For clearer examples, I'll discuss everything using USDC pairs)

In concentrated liquidity, the situation differs because, as emphasized, this model allows each user to add liquidity within a desired range. The condition for earning transaction fees here is that swaps must use your liquidity. To earn transaction fees with concentrated liquidity, the market price of the asset added to the pool must fall within your specified range. If the price is outside your range, you won't earn transaction fees.

Example 2: You added concentrated liquidity to the ETH/USDC pool, and let's say the current price of 1 Ether is $2000. Your range was ($2900, $3000). In this case, since the market price is outside your range, you won't earn transaction fees.

Example 3: You added concentrated liquidity to the SOL/USDC pool, with the current price of 1 SOL at $100. Your range was ($90, $110). Here, you will continue to earn transaction fees until the SOL price moves out of your range.

If we've understood how concentrated liquidity works within price ranges, let's move on to how this system operates and its application methods. Let's assume the market price of Ethereum is $3000, and we've added liquidity in the range of ($2000, $4000). In this scenario, your liquidity would be as follows:

❗ Your chosen range ($2000, $4000) ❗

You would have added USDC in the ($2000, $3000) range and Ether in the ($3000, $4000) range. If the Ether price rises, users will buy the Ether you placed in the ($3000, $4000) range, giving you USDC in return. In the opposite scenario, if the Ether price falls, users will be selling their Ether for the USDC you placed in the ($2000, $3000) range. Simply put, adding liquidity in the ($2000, $4000) range means you're saying, "I want to sell my Ethers in the ($3000, $4000) range and buy Ether in the ($2000, $3000) range."
At the end of it all, if the Ether price rises above $4000, you would have sold all the Ether you added for liquidity, leaving you with USDC. Conversely, if the Ether price drops below $2000, you would end up buying Ether with all the USDC you added for liquidity, leaving you with Ether.

4) Concentrated Liquidity Strategies ♟🤔
Assuming we've grasped the core concept and conditions of providing concentrated liquidity, let's explore how you can practically use it. The flexibility offered by Trader Joe's liquidity book model allows for various strategies on TJ and Meteora. This possibility arises because, on TJ and Meteora, you can adjust where within the range your liquidity will concentrate.
Examples of what you can do include:

→ Single-sided liquidity addition: 🟡⚖❌
— Gradual buying: If you want to accumulate a specific token as its price falls, you can add only USDC below the market price to automatically purchase more as the price drops.
— Gradual selling: If you wish to gradually sell a token you hold as its price rises, placing it in a range above the market price allows you to sell the token incrementally, earning USDC as the price increases.

→ Double-sided liquidity addition: 🟡⚖🟡 This method typically aims at collecting transaction fees for yield and is slightly more complex to manage than single-sided strategies. It essentially combines the single-sided liquidity strategies but requires active management. On TJ and Meteora, you'll encounter three different distribution methods when adding double-sided liquidity:
👉🏻 Spot: Provides an even liquidity distribution across your chosen range. This strategy is applicable under most conditions and for most tokens.

👉🏻 Curve: Focuses most of your liquidity around the center of your chosen range, maximizing your efficiency. It's suitable for pairs with low volatility.

👉🏻 Bid Ask: Concentrates most of your liquidity at both ends of your selected range. Unlike other distributions, this can capture unusual movements or be used for highly volatile pairs.

5) Risks of Providing Liquidity
Firstly, the most obvious risk is that of smart contract vulnerabilities. If there are issues in the code of the protocols you use, they might not be apparent until a hack occurs. Then comes "Impermanent Loss (IL)," but before we delve into IL, it's crucial to remember that concentrated liquidity positions need to be thoughtfully crafted and actively monitored. If the price moves outside your range, not only will you not earn transaction fees, but you might also end up with a bunch of worthless tokens. Hence, never forget about your concentrated liquidity positions and always keep an eye on them.

The final topic is Impermanent Loss (IL) 🧨
Briefly, sometimes just holding onto your tokens can be more profitable than providing liquidity.

"Example: Frank, deposits 1 ETH and 100 DAI into a liquidity pool. In traditional DEXs, the deposited token pair must be of equal value, meaning at the time of deposit, 1 ETH's price was 100 DAI, making Victory's total deposit worth $200. If the pool had a total of 10 ETH and 1,000 DAI, Victory's share would be 10%, and let's call the total liquidity k. If ETH's price rises to 400 DAI, arbitrageurs will adjust the pool's ratio by adding DAI and removing ETH until the rate reflects the current price. Even if the pool's liquidity remains constant, its asset ratio changes. Now, thanks to arbitrageurs, the pool has 5 ETH and 2,000 DAI. If Victory decides to withdraw, they would end up with assets worth $400 in total: 0.5 ETH and 200 DAI. While the initial value of Victory's assets was $200, holding them in a wallet would have been more profitable since the 1 ETH and 100 DAI would now be worth $500, compared to the $400 worth of 0.5 ETH and 200 DAI they have after withdrawal. This situation is referred to as impermanent loss." (This quote is from an article on DeFi Introduction written by us at ITU Blockchain)

Thanks for reading.