Evolution of Liquidity Provision in DeFi

You want to swap from currency A to currency B, how do you do that?

You go to the bank. What if there’s no bank? You go ask your friend. Imagine if your friends come together and pool all their money for you and others to be able to exchange freely, but in turn they take a fee for their services. That’s what a liquidity pool is — a pool of tokens A and B secured and guarded by Smart Contracts.

AMM(Automated Market Market)

An automated market maker is the most typical LP currently, pioneered by Uniswap V1 and used in Uniswap v2 and it’s forks. In this case you provide liquidity over the whole range.

IImagine the Y-axis as amount of money supplied and X-asis as the asset price

A poorly drawn representation of an AMM

As you can see the liquidity is evenly distributed. This makes it easy for people to start supplying liquidity and earning fees — you deposit your money into the smart contract and are good to go. But there can be a number of drawbacks associated with this:

1. Impermanentl loss(IL) — imagine you have 100 tokens A worth 100$ and 100 tokens B worth 100$. You supply them into the pool.
   Someone swaps 90 tokens B for 90 tokens A. You have 190B and 10A in your pool.
   An hour after that Elon Musk tweets about token A and its price grows to 10$ instead of 1$. You have 190(B) * 1 + 10(A) * 10 = 390$.
   But you could’ve had 100 * 10 + 100 * 1 = 1100$ if you haven’t provided liquidity in the first place. Of course you earned some fees, but those are much less than the ~700$ you gave up because of LP.
2. Low capital efficiency — since your liquidity is spread out from 0$ to infinity, you can’t “concentrate” your liquidity in the current price range. In other words with an AMM you can’t specify how much liquidity and where you want to provide, so some of your liquidity remains never used. For example a tighter range makes sense for stablecoins — on V2 DAI/USDC pair it reserves just ~0.50% of capital for trading between $0.99 and $1.01 , the price range in which LPs would expect to see the most volume and consequently earn the most fees. So with a an AMM your capital efficiency is low as well
3. Higher slippage — as liquidity is spread out, there’s less of it in the current price, so slippage experienced by traders is higher as well.
4. Inability to bet on the market sentiment — Let’s say you do ETH — USDT LP(liquidity provision) and think ETH will go take a dip and then go up, then there’s no sense for you to supply liquidity during the dip, as you’ll be experiencing more IL — people will buy ETH for a “discounted” USDT price. Then as ETH goes back up you might end up with 70%(or other arbitrary number) of USDT in your LP and only 30% ETH, while the most profitable outcome would be having 100% ETH or at least 50% USDT 50% ETH.

CLMM

Concentrated Liquidity market maker is exactly what is sounds like — it allows you to specify at what range and how much liquidity(tokens) to provide. Instead of distributing your tokens over an (almost) infinite range, you can “concentrate” your liquidity so it has the highest demand.

Poorly drawn represenation of CLMM

Uniswap V3 were the first to implement this https://blog.uniswap.org/uniswap-v3.

CLMM provide up to 4000x higher capital efficiency relative to Uniswap V2, lower slippage for traders, and less IL.

However on volatile asset pairs it comes with one serious downside

You always have to manage your liquidity or your capital efficiency becomes 0

If it’s a stablecoin pair(USDC — DAI), you can supply your liquidity to a 0.99–1.01$ dollar range and forget about it. But what if it’s USDC — ETH, or ETH — UNI, etc.? For those volatile assets prices can change quite frequently so you have two options

1. Spread your liquidity over a bigger range decreasing capital efficiency
2. Actively manage your liquidity decreasing your free time and social life(lol)

Actively managing your liquidity allows you to bet on the market sentiment, only supplying liquidity when the price goes up and minimizing IL

Courtesy of Maverick protocol

Same can be applied for betting on a bearish market

Courtesy of Maverick protocol

But actively managing your LP is also quite gas inefficient as you have to rebalance often, and hard to get right manually since prices fluctuate often.

So how do you solve this?

Managed Liquidity CLMM

Next step of the evolution is a managed liquidity CLMM — it has the same UX as an AMM, where you just deposit your money and earn yeilds, paired with the same capital efficiency an CLMM has. It uses Smart Contracts, price oracles and custom strategies to automatically rebalance and swap your liquidity.

Strategies which different protocols have are(see pictures above):

• “Bull mode” — only providing liquidity when price goes up, allowing you to bet on the market reducing your IL
• “Bear mode” — only providing liquidiy when price goes down, allowing you to bet on the market reducing your IL.
• “Mixed” — providing liquditiy all the time, automatically rebalancing and adjusting the range, best for mixed market conditions.

Within Mixed some sub strategies can be disected(mostly taking inspiration from Kamino)

• “Volatile — Volatile” When LPing for 2 volatile assets which don’t follow each others movement
• “Bluechip Volatile — Bluechip Volatile” when LPing for 2(or one) bluechip assets. Here protocols can hypothetically rely on mean reversion to rebalance more accurately
• “Stable — Volatile” When LPing for a stablecoin and a volatile asset
• “Stablecoin” — strategy with the tightest range
• “LST” — also a strategy with a tight range

Some protocols have their own pools, while the majority of them just routes their liquidity to established DEXes, like Kamino does with Meteor and Orca(2 of the biggest DEXes on Solana).

Managed Liquidity CLMM protocols are well on their way to becoming a liquidity layer for ecosystems, with most of the DEX LP volume passing through them. Because it’s just stupidly(in a good way) good:

1. It’s beneficial for the DEXes — Managed Liquidity protocols reduce the entry threshold to DeFi increasing user adoption. Managed Liquidity protocols and DEXs aren’t competitors, but partners.
2. It’s a no-brainer for the user — increased capital effiency, less IL, pools from different DEXs aggregated in one place.
3. It’s good for ecosystem wide liquidity — Managed Liquidity protocols reduce slippage so traders have an easier time, and increase TVL along with utilization, which are important parameters to the investors.

For example, Kamino Finance — a managed liquidity protocol has higher TVL than any DEX on the market, as it supporting LPing into almost any of them.

Kamino on the 3rd place in DeFiLlama

Newer protocols like Maverick or Kodiak have successfully raised(Kodiak raise, Maverick raise) and attracted a large user base. Kodiak, for example, is really driving the notion of becoming a one-stop liquidity hub for Berachain. Just like Twitter(X) is trying to become a super app, Kodiak has a managed and non-managed CLMM, full-range AMM, Incentive Layer and a Token Deployer factory. This underpins the fact how

Managed Liquity CLMM are becoming the user facing interface, and regular DEXes are becoming a more behind-the-curtain tech.

Further reading

• An amazing series on the math behind uniswap(good luck trying to digest it, since I couldn’t)
• Uniswap V3 release announcement
• Kamino Finance docs
• Maverick docs

Hope you enjoyed this article!Wanna build some cool stuff together — reach out and book a call