Understanding Concentrated Liquidity (Uni V3) with iZUMi Finance launch on Meter

iZUMi Finance just launched on Meter Network deploying its innovative Discretized-Liquidity-AMM(DL-AMM) model!

The DL-AMM model, which was upgraded from Uniswap V3’s concentrated liquidity model is an AMM mechanism that supports discrete liquidity on every price tick — liquidity can be precisely distributed on any fixed prices rather than a price range in Uniswap V3. Users can now place limit orders on iZUMi Finance in a non-custodial orderbook way, providing DEX users with a CEX-like trading experience

DL-AMM? Concentrated Liquidity Model? Price tick? Non-custodial Limit Order?

Being the first concentrated liquidity model deployed on Meter Network, Meter Community can have some of these questions.

In this blog, we will try to ELI5 the Concentrated Liquidity Model and open avenues to the Meter Community that ensure capital efficiency.

Uniswap V2 — Simple, Omnipresent but Capital Inefficient!

Uniswap opened the doors for Automated Market Making and Decentralized exchanges across the blockchain networks boosting on-chain liquidity management.

Liquidity Model/ Curve

The constant product model:

x * y = k

Implementation

Simple. Liquidity provided by all participants can be efficiently aggregated along the constant product curve. The LP tokens are also represented as ERC20 which are fungible.

User Interface

Simple, any user can add on-chain liquidity adhering to the constant product curve. Liquidity across all pairs is split 50–50 in value.

Expected Returns

Swap fees (fixed at 0.3%) and liquidity incentives.

Pitfall

Capital Inefficient — The constant product model (CPM) of (x * y = k) meant that liquidity spanned across the entire curve (0,∞) irrespective of range of trading or price action.

x>0 for all value of y

y>0 for all values of x

The model is also not intuitive for new retail users to determine returns and impact of impermanent loss.

Example

For pegged assets (stable coins, synthetic derivatives, liquid staking derivatives), this made the CPM highly inefficient as majority of liquidity along the constant product curve would rarely (if anytime) be used. Even for volatile assets (MTRG for e.g. has Upper Price = 6.26 and Lower Price = 1.27 between April 2022 to April 2023), liquidity beyond the volatile ranges remains unused.

Uniswap V3 — Capital efficient, gaining prominence but complex!

Key Innovation

The key innovation of Uniswap V3 is ‘Range-bound liquidity’ also called as ‘Concentrated Liquidity’ to increase capital efficiency of assets provided by users. A smaller asset base within the price range can achieve the same liquidity as Uniswap V2.

In addition, Uniswap V3 also introduced flexible fee structures that enable better price for users across the spectrum of assets (0.05% for low volatile stable/ pegged assets, 0.3% for medium volatility assets, 1% for high volatility assets)

Earlier efforts and liquidity Fragmentation

Prior attempts to address capital efficiency issue (Curve and YieldSpace) have involved building pools that use different functions (like CPM) to describe the relation between reserves.

The resultant design limited the application to a set of assets (stable and pegged assets for curve) as liquidity providers in a given pool have to adhere to the same curve formula.

DESIGN DETAILS:

What is Concentrated Liquidity

Concentrated Liquidity provides Liquidity providers (LPs) with the ability to concentrate their liquidity by “bounding” it within an arbitrary price range.

Ticks

Ticks represent the discreet boundaries of possible prices in a liquidity pool. Liquidity providers can provide liquidity in a range between any two ticks (which need not be adjacent).

By slicing the price range [0,∞] into numerous granular ticks, trading on V3 is highly similar to trading on order book exchanges, with only three differences:

1. The price range of each tick is predefined by the system instead of being proposed by users.
2. Trades that happen within a tick still follows the pricing function of the AMM, while the equation has to be updated once the price crosses the tick.
3. Orders can be executed with any price within the price range, instead of being fulfilled at the same one price on order book exchanges.

Fee Tiers

With V3, the swap fee is no longer locked at 0.30%. Rather, the fee tier for each pool (of which there can be multiple per asset pair) is set on initialization. The initially supported fee tiers are 0.05%, 0.30%, and 1%.

When a pool has multiple fee tiers, higher fee tier is chosen only when price impact is greater in lower fee tier.

For USDT/USDC Pair which has 0.05% and 0.3% fee tiers, the protocol will only evaluate 0.3% fee tier for swap when price impact is >0.3% in 0.05% fee tier.

Liquidity Certificates

Unlike the ERC-20 LP tokens that users receive on Uni V2, they receive a function ERC-721 NFT representing their position on Uniswap V3. As each position can be representative of different price range, the liquidity on Uni V3 is non-fungible.

Capital Efficiency of Uniswap V3

The Uniswap team defines the efficiency of Uni V3 corresponding to Uni V2 as below;

For USDT/USDC pair on Uniswap V3 with price range of (0.95,1.05) is 40.5 times more efficient than Uniswap V2 pair.

For trading within the price range (0.95,1.05), 200 USD worth of liquidity in Uni V3 earns as much fee revenue as 8093.75 USD worth of liquidity in Uni V2

Benefits to Liquidity Providers

Liquidity Strategies for Uniswap V3

Some Important points before we look at strategies:

1. Uni v3 liquidity positions have to balance capital efficiency and the time spent in-the-money. The relative time spent in the money can remain very close to 100% for large range factors and short timescales (<50 days).
2. LP returns are maximized for very narrow ranges. Smaller range also helps reduce impermanent loss
3. If the current price happens to be central to the targeted price range (current price = 4 when the price range is [2, 6]), it’s the exact same liquidity providing mechanism as the Uni V2: LPs provide liquidity in both tokens of the same value (= amount * price).
4. If the current price is not central to the price range, LPs still have to provide liquidity in both tokens, while the amount of each token depends on the distance between the current price and the price range
5. Be aware of amplified IL while taking large positions — you could lose position value really quickly, especially with double volume pairs during a damp
6. Holding a position for a long time and/or deploying to wider ranges reduce LP returns

The strategies will focus on MTRG/USDT pair.

Relevant Statistics:

Current Price (MTRG) — 4 USD

Price Variation (MTRG, April 2022 to April 2023) — 1.27 USD to 6.26 USD

Getting into Positions

Closing Positions

Dollar Cost Averaging or Profit Taking?

Reference Reads for more on Uniswap V3

1. Uniswap V3 Whitepaper: https://uniswap.org/whitepaper-v3.pdf

2. Uniswap Blog with V2/V3 Efficiency calculator: https://blog.uniswap.org/uniswap-v3

3. Understanding Liquidity Math for V3: https://atiselsts.github.io/pdfs/uniswap-v3-liquidity-math.pdf

4. Good V3 Primers:

https://twitter.com/0xOwenThurm/status/1645048975001817088

https://twitter.com/billionxdev/status/1520786591668531201

5. Understanding IL in V3:

https://twitter.com/BarryFried1/status/1565370856695599106

https://twitter.com/korpi87/status/1400963737578782724

6. Taking Liquidity Positions: https://twitter.com/guil_lambert/status/1564988757782265857

7. Understanding V2 vs V3 Efficiency: https://twitter.com/haydenzadams/status/1380217938867843072

8. iZUMi Finance: https://docs.izumi.finance/