What is concentrated liquidity?

Concentrated liquidity is a way of supplying tokens to a decentralized exchange pool within a price range chosen by the provider. Older automated market makers spread every provider's funds evenly along all possible prices, from zero to infinity. Concentrated liquidity lets providers put their capital where trading actually happens. The basic pool model is explained in what an automated market maker is.

How does concentrated liquidity work?

Uniswap's documentation says the defining idea of v3 is liquidity allocated within a custom price range. In earlier versions, liquidity was spread uniformly, which meant most of it was never used. Its example is the v2 DAI/USDC pool, which used only about 0.50% of its total capital for trades between $0.99 and $1.01, where most volume takes place.

With concentrated liquidity, a provider in a stablecoin pair can put all of their funds in the 0.99 to 1.01 range. Traders get deeper liquidity around the market price, and providers can earn more fees with the same amount of capital. Each range a provider sets is called a position, and one provider can hold several positions in the same pool.

What happens when liquidity goes out of range?

Uniswap explains that as an asset's price rises or falls, it may leave the bounds of a position. When that happens, the position's liquidity is no longer active and stops earning fees. As the price moves in one direction, the provider gradually holds more of one token and less of the other, until the whole position is a single asset. If the price later returns to the range, the position becomes active again.

This is why concentrated positions often need more attention than older full-range ones. A narrow range earns more while the price stays inside it but goes idle sooner.

Is concentrated liquidity riskier?

Concentrating funds does not create a new type of risk, but it magnifies an existing one. Because a position converts into one token as the price moves through its range, the gap between providing liquidity and simply holding the tokens can grow faster, the effect described in what impermanent loss is. Fees earned may or may not make up for it.

Which exchanges use concentrated liquidity?

Uniswap v3 and v4 use it, and several other decentralized exchanges, such as SushiSwap and Raydium, offer concentrated liquidity pools of their own. Providers usually receive their position as a token or record that represents their share, similar to the LP tokens used in older pools.

This guide explains how the mechanism works and is not a recommendation to provide liquidity.