In order to understand the concept of concentrated liquidity pools, I encourage you to first read my last post where I explain how liquidity pools work in general. Once you know what a liquidity pool is, the present article will be easier to understand.
To explain concentrated liquidity pools, I will make a metaphor to illustrate the principle. Let's imagine you have a football field where the janitor runs a sprinkler to water the field. You try to collect as much water as possible by depositing bowls on this field. In this metaphor the water is the fees that are generated by the liquidity pool and the bowls is your capital that you have put as liquidity. The collected water in the bowls is your income.
With a normal liquidity pool, the repartition of your bowls would look like this. The bowls are equally distributed on the whole surface of the field.
Your bowls cover the whole field and some of them collect some water, others hardly anything and a majority nothing at all.
The next day, it's possible that the janitor puts the sprinkler in another place. This would mean that the market price has changed. Now other bowls collect water but still it's only a small percentage of your bowls that get wet.
The problem with a normal liquidity pool is that you need to provide bowls in every corner of the field from price 0 to infinity. Only a small part of your liquidity is actually collecting fees.
With concentrated liquidity pools, you have the option to define where you want to place your bowls. You can put them very close to the sprinkler and you will collect a maximum of water. This is much more efficient because you only need to put bowls where you expect to get some water.
Things look different, if the place of the sprinkler changes. Now maybe only a part of your bowls would collect water and if the sprinkler moves much further away, you wouldn't collect any water at all. That's what we call being out of range.
What is special about concentrated liquidity pools?
With concentrated liquidity pools, you have the option to limit the market range for which you want to provide liquidity. The more concentrated your range is, the bigger the return on your liquidity. The more concentrate the range, the bigger is the chance however also to be out of range.
What happens when you are out of range?
When you are out of range, you don't earn any fees at all. You will only have one of the two assets remaining and it is as if you would have this asset in you wallet. It will move in value with the market price. In such a situation you have the option to wait and hope that you get back in range and earn fees again or you can close the position and reset your range according to the new market conditions. This is called rebalancing.
With concentrated liquidity pools, you can provide liquidity exactly where you want according to your needs and your strategy.
What are the possibilities and the risks of concentrated liquidity pools?
The advantage of concentrated liquidity pools is that you can tailor the position according to your needs and your strategy. The usage of your liquidity position is much more efficient.
You can even create positions that are not 50/50 between the two paired tokens. It's possible to make a position out of range where you provide liquidity only in one token. As soon as the price comes into range, you collect fees.
There are also risks related to these pools. First of all you have to understand that when you get out of range, you don't earn any fees and you get only one of the two tokens. So you should always be willing to own both tokens when dealing with these pools.
If you get out of range and you want to rebalance your position around the market price, this generates network fees that have to be considered.
When should I rebalance?
There is no need to rebalance too often. It can be a good idea to wait a day or two and see whether you get back in range or not. If the prices diverge even more, nothing will have changed for you since you will have 100% of one of the tokens in any case.
In the next post I will speak about what things to consider when providing liquidity into such pools.
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