The concept of concentrated liquidity was first introduced by Uniswap v3. Its purpose is to enhance capital efficiency and address the limitations of the original x*y = k formula used in the standard automated market maker model.
Under the new model, liquidity can be concentrated within a specific price interval, creating what is known as a concentrated liquidity position.
Liquidity providers (LPs) have the flexibility to open multiple positions in the pool, enabling them to create unique price curves based on their market outlook using range orders.
Concentrating liquidity around the current price and adjusting custom positions based on price changes is an effective strategy that maximizes gains while minimizing exposure to the risk of asset devaluation.
The narrower the range for a concentrated liquidity position, the higher the fee revenue earned, and vice versa.
LPs still have the option to provide liquidity across the entire curve, but they will earn lower trading fees compared to selecting a smaller price range.
As the price fluctuates, liquidity from different LPs executes swaps. Users making trades are effectively trading against the aggregated liquidity from all liquidity positions covering the current price.
From the perspective of takers, the liquidity they consume in their swaps remains the same regardless of its source.
For more information, view our in-depth guide on liquidity pools.