Explorer’s Manual: first steps into Concentrated Liquidity — the future of DeFi

The full article was originally published by TangleSwap on Medium. Read the full article here.

Explorer’s Manual: first steps into Concentrated Liquidity — the future of DeFi

Full control over your assets, maximum capital efficiency, endless possibilities.

Following last week’s enthralling one-year review of landmark milestones, today the crew is delighted to present a deep dive into the Concentrated Liquidity Market Maker (CLMM) algorithm that TangleSwap is uniquely bringing to the IOTA & Shimmer ecosystem.

Our pursuit to remain at the forefront of the rapidly evolving global Decentralized Finance (DeFi) market led our team to recognize concentrated liquidity as a vital element for success. Starting with this deep dive and an upcoming revamped TangleSwap documentation, we candidly commit to equipping our vibrant community with the tools and knowledge required to not just navigate but thrive in the modern DeFi landscape.

Join us on this easy-to-follow journey featuring a mock dialogue between an Explorer (E) and a Pilot (P) from the TangleSwap crew. Together, we will untangle the intricacies of Concentrated Liquidity, including:

  1. Why this innovation is widely regarded as the next step in the evolution of DeFi.
  2. How it significantly improves upon the conventional Automated Market Makers (AMM) Decentralized Exchange (DEX) architecture.

Now, grab your favourite cup of tea and prepare to take your first steps into the realm of Concentrated Liquidity. Let’s jump in!

Explorer — Wow, so much content to unpack from your Whitepaper! First off, weren’t TangleSwap algorithms initially based on traditional AMMs?

Pilot — You are right, that’s where our journey started. But before we dive deeper, let’s make sure that all our Explorers are fully up to date!

After two years of unwavering development, the team recently unveiled the TangleSwap Business Whitepaper, which highlights the seven trailblazing products at the heart of TangleSwap’s DeFi Hub. Among numerous other innovations, the transition from a conventional AMM DEX to a cutting-edge CLMM protocol is what inspired this second edition of our Explorer’s Manual.

Comparing the original product suite to our current offerings, it can be observed that, in line with our vision of empowering the IOTA community with the latest, most competitive DeFi tools, the crew made good use of the time leading up to the Shimmer EVM testnet by complete revamping our product palette and seamlessly integrating the latest DeFi breakthroughs alongside our own unique innovations.

E — And how does the TangleSwap algorithm differ from typical AMMs?

P — Not so fast! Let’s start with the basics. What is a liquidity pool, and how does a conventional AMM DEX use these?

Automated Market Makers

Liquidity Pools are at the very core of decentralized finance, acting as essential components that facilitate smooth and efficient asset exchange — tokens, NFTs — on platforms like TangleSwap. Unlike centralized exchanges (CEXs) that rely on order books to match buyers and sellers, these pools consist of two or more assets locked in a smart contract, creating a market for traders and enabling permissionless — i.e. publicly open — transactions. By pooling assets together, liquidity providers (LPs) can earn a share of trading fees generated by the protocol, thus incentivizing them to contribute to the ecosystem. This mechanism ensures that users can effortlessly trade their assets without relying on human intermediaries, fostering a more open, transparent, and empowering financial system for all participants.

Now, in traditional AMM DEXs, the fees earned by LPs depend on two primary factors:

  1. The global trading volume of the assets in the pool.
  2. The weight of their assets in the pool, determined by the total amount of tokens contributed with equivalent value. For example, 100 USDC ≠ 100 SMR, but rather 100 USDC = 600 SMR at a rate of 0.06 USDC/SMR.

As a result, in a conventional AMM, the liquidity provider’s initial exposure to a pool is always split into a 50/50% proportion of assets, irrespective of their preference. For instance, in our earlier example, an LP who is biased — i.e. more ‘bullish’ — towards SMR would still be required to convert 50% of their assets into USDC to participate in that specific liquidity pool.

Another noteworthy aspect of AMMs is that, due to the mathematical formula that determines the price of assets in a liquidity pool, LPs can only provide liquidity evenly across the entire price range from (0, ∞). This vast range from zero to infinity impacts the effective utilization of liquidity at any point in time, with most of the liquidity sitting idle at prices far from market expectations.

Continuing with our previous example, an LP participating in a SMR/USDC pool in a conventional AMM would have significant portions of their liquidity allocated to arbitrarily extreme price ranges such as <0.0000001 USDC/SMR or >100,000,000 USDC/SMR. While these prices may represent the user’s wildest dreams — or nightmares — the likelihood of these scenarios is unfathomably low. This is precisely the reason why traditional AMMs can be deemed capital inefficient, particularly when compared to CLMMs — the next generation of DEXs.

E — Got it! Then, why not let users choose the price range for their liquidity? This way, LPs could choose (0, ∞) or any other range that works better for them.

P — Well, you hit the nail on the head. That is precisely the groundbreaking innovation behind CLMMs, and it truly changes everything.

Concentrated Liquidity Market Makers

At their core, CLMMs build upon the foundations laid out by AMMs since 12018. However, one crucial difference offers significant advantages to all users, from traders to liquidity providers. Unlike traditional AMMs, which require liquidity providers to allocate their capital evenly across the entire price spectrum (from zero to infinity), CLMMs empower LPs to choose the exact price range where they want to provide liquidity. This innovation dramatically boosts the protocol’s capital efficiency and flexibility.

Notice how the same amount of liquidity is more efficiently used on a CLMM, providing significantly deeper *effective liquidity* for users to swap.

To grasp the practical implications of this feature, let’s break it down into three essential components:

1.By selecting an adequate price range for their liquidity, LPs can now deploy far more capital-efficient positions that earn higher fees (yield) with less liquidity (capital).

E — I’ve heard about incredible capital efficiencies ranging from slightly improved to as high as x4000 times better. Is this accurate, or is it just clickbait to attract attention?

P — Believe it or not, that figure is backed by data! While it does sound like a great headline, real-world research has validated these remarkable numbers. Let us delve into how this is even possible in the first place.

Capital efficiencies can reach up to x4000 in CLMMs simply because liquidity is not forcibly spread over all possible prices from zero to infinity. Instead, it can be strategically allocated within specific price ranges chosen by the user.

The inefficiency of distributing liquidity across the entire price curve becomes particularly evident in stablecoin pairs, though it is indeed applicable to any token pair. While stablecoin pairs typically see trading volume and fee generation concentrated roughly between the $0.99 and $1.01 USD range, in conventional AMMs a vast majority of liquidity is allocated outside that range. This leads to a majority of the LP position remaining perpetually idle and unproductive.

Now, let us examine the case for a CLMM. Imagine a user providing $100 USD in a stablecoin pair with a price range concentrated between $0.99 and $1.01 USD. In this scenario, the capital would be x200 times more effective, which means the $100 USD would have the same impact as $20,000 USD in a traditional, non-concentrated AMM. Narrow the range further to $0.999 and $1.001, and the capital efficiency skyrockets to x2000.

E — Amazing. But how does this affect traders who swap on the platform?

2. With liquidity being efficiently allocated, traders enjoy a remarkable increase in the depth of useful liquidity. This allows them to swap assets while reducing price impact and slippage to an absolute minimum.

E — Wait a second. Could you please explain how liquidity depth, price impact, and slippage affect users in real life?

P — Surely, let’s run through a quick overview and then see a practical example.

Liquidity depth refers to the amount of liquidity available for each side of a pair of assets. As explained above, AMMs distribute liquidity uniformly in a flat shape from (0, ∞), while CLMMs allow LPs to decide in which range(s) to allocate liquidity, which typically results in a shape that is centred around the current price to capture as much volume and fees as possible.

Illustrated homogeneous AMM liquidity distribution (left) vs. heterogeneous CLMM distribution (right).

Liquidity concentration and price impact are inversely correlated: the more concentrated the liquidity is around a certain price, the less impact a given trade has on said price when swapping tokens. Consequently, reduced price impact leads to less slippage, since the chances of any other user moving the price enough to affect your transaction before it’s executed are significantly diminished.

P — As you can see, it’s all connected.

E — Now it really makes sense, the algorithm is a win-win scenario for both LPs and traders! But you were mentioning a third key aspect, and I’m only counting two, which one is missing?

P — That’s right, last but not least:

3. The ability to choose a specific price range for providing liquidity unlocks a myriad of useful strategies. Users are no longer constrained solely to a 50/50% asset distribution — as in conventional AMMs — but instead, CLMMs now empower users to create asymmetric positions based on their individual preferences, such as 60/40% or 80/20% proportions of assets. This newfound flexibility allows for hedging, managing exposure to certain assets, using liquidity positions as limit orders, replicating options, and more. And of course, it also allows using the ‘full range’ — i.e. from (0, ∞) — configuration from a conventional AMM, if desired. Every TangleSwap user is free to tailor their strategy to their unique knowledge, experience, and vision.

E — I must say, I am truly impressed. Liquidity providers benefit from a remarkable increase in capital efficiency and revenue, along with the ability to create diverse, highly adaptive positions and strategies for every asset pair. Meanwhile, traders experience a substantial reduction in price impact and costs incurred. The advantages are indeed exceptional. However, there must be some drawbacks, correct?

P — Absolutely, it is paramount to consider both sides of the equation. Let’s go ahead!

With great power, comes (adjustable) great responsibility. The increased flexibility offered by concentrated liquidity means that, when deploying established — or new — strategies, one needs to consider a wider range of potential outcomes, depending on the input provided. It shall be noted that this applies to those individuals who are interested in actively optimizing the yield obtained from their positions; for passive or casual liquidity providers, it is always perfectly possible — as mentioned earlier — to simply provide liquidity in the ‘full range’ from zero to infinity. This strategy is sometimes called ‘set-and-forget’, because it generally requires little to no active management on the side of the LP.

E — So, will the introduction of CLMMs raise the bar for new users?

P — An analogy could be established with the widespread transition in the late 12000s from basic cell phones to smartphones. Making a phone call remained just as simple, but users who wanted to take full advantage of this novel technology needed to invest a minimum amount of time and effort into learning its features.

Decentralized finance is no different, and with CLMMs continuing to increasingly play a pivotal role in how the DeFi space evolves, taking the time to understand the core principles behind the future of finances is undoubtedly a worthwhile endeavour.

CLMM adoption over time. More stats on dune.com/mtitus6/Uniswap-V2V3-Comparison.

As we prepare for a long-awaited TangleSwap debut on the ShimmerEVM mainnet, we are committed to ensuring our Explorers are well-equipped to unlock the full potential of their liquidity positions. With numerous factors to consider, including exposure to impermanent loss, LPs aiming to strategically allocate their assets shall acquire an intimate understanding of the liquidity provision mechanisms. We highly recommend this excellent open-source resource: github.com/GammaStrategies/awesome-uniswap-v3.

Additionally, in the upcoming 3rd edition of our Explorer’s Manual series, we will provide an in-depth exploration of the most relevant advanced topics, empowering our community with the essential knowledge needed to thrive in the DeFi landscape of tomorrow. The TangleSwap crew firmly believes that concentrated liquidity is a revolutionary piece of infrastructure destined to fully reshape the landscape of decentralized exchanges.

Lastly, while today we have primarily focused on providing a beginner-friendly introduction to the overarching concepts behind concentrated liquidity, we would like to conclude with a brief summary of the numerous features that make TangleSwap unique (and we’d also like to remind readers that the full rationale behind these is detailed in our Whitepaper).

To achieve our ambition of becoming a globally utilized and recognized protocol, we shall not only leverage the exceptional technological prowess of the Shimmer and IOTA networks, but also keep a significant competitive edge against our top competitors: the major DEXs in leading global ecosystems, which are all using concentrated liquidity.

When compared to such competitors, TangleSwap is proud to have invested heavily in enhancing both the technology and the economics that provide the foundations for the protocol. A non-exhaustive list includes:

  • An Oracle Balancer to increase LP profitability and mitigate impermanent loss based on changing market conditions.
  • Our in-house decentralized reputation system: the Void Energy.
  • Tokenomics based on long-term sustainability and organic growth.
  • Fee discretization and NFT-based protocol utilities.
  • A groundbreaking ensemble of 6 (six) original DeFi applications, all of which are intimately connected to our CLMM core technology.
  • Intuitive user experience, e.g. incl. Pro/Lite mode for liquidity pools.
  • Numerous Shimmer-exclusive advantages, such as no Maximal Extractable Value, zero Layer-1 gas fees, extremely cheap Layer-2 gas, and a hyper-scalable base DLT architecture.

We sincerely hope that this edition of the Explorer’s Manual has captured your interest and left you eager for the upcoming in-depth exploration in the third edition. Despite facing numerous challenges over the past year, these obstacles have only served to fuel our drive for innovation, allowing us to lay a solid foundation in pursuit of our mission to become the ‘go-to’ DeFi solution and a flagship protocol for the IOTA & Shimmer ecosystem.

None of our achievements would have been possible without the fervent support of our dedicated Explorers.

With gratitude,
The Crew 🛸


Explorer’s Manual: first steps into Concentrated Liquidity — the future of DeFi was originally published in Explorer’s Manual on Medium, where people are continuing the conversation by highlighting and responding to this story.

Read the full Article

The full article was originally published by TangleSwap on Medium, where people are continuing the conversation by highlighting and responding to this story.

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