🧠How do CLMMs Work?

What are Concentrated Pools?

Concentrated pools are at the heart of Concentrated Liquidity Market Makers (CLMMs) and represent a significant shift from traditional Automated Market Makers (AMMs). Unlike the latter, where liquidity is spread across a broad price range, concentrated pools enable Liquidity Providers (LPs) to allocate their capital within specified price bands. This strategy ensures that liquidity is heavily concentrated where it’s most needed, thereby potentially reducing slippage and improving trade execution. The operation of these pools is facilitated through smart contracts on the blockchain, which manage the liquidity, execute trades, and ensure that the LPs receive their share of the trading fees. The precise allocation of liquidity within certain price ranges allows for more effective capital utilization, aiming to provide better returns for LPs and a more favorable trading environment.

Role and Incentives for Liquidity Providers (LPs)

Liquidity Providers are the backbone of any decentralized exchange, and their role is even more pronounced in a CLMM. By providing liquidity within specified price ranges, they facilitate trading and earn a portion of the trading fees generated from the trades occurring within their chosen price bands. The concentrated liquidity model provides a more flexible and potentially lucrative incentive structure for LPs. Instead of earning a small fraction from a vast price range, LPs in a CLMM could earn more from the trades happening within their specified price ranges. This model encourages LPs to strategically allocate their capital where they anticipate more trading activity, aligning their incentives with the market dynamics. Moreover, the ability to choose the price ranges provides LPs with the autonomy to adjust their liquidity provision based on market conditions, making the CLMM model adaptive and potentially more rewarding. The innovation of concentrated pools in CLMMs represents a step towards a more capital-efficient and LP-centric decentralized trading environment.