Concentrated Liquidity

Concentrated Liquidity

Introduction

Rabbit Inu's primary innovation lies in enabling concentrated liquidity, allowing users to contribute their assets within specific price ranges. In the prevalent AMM protocols utilized by contemporary decentralized exchanges, liquidity is evenly spread across the entire price curve (0, ∞).

The conventional AMM liquidity distribution facilitates trading throughout the complete price interval from 0 to infinite with straightforward deployment. However, a substantial portion of liquidity in AMM pools remains untapped by actual transactions, representing a degree of inefficiency in the provision of liquidity. For instance, in stablecoin pairs where the trading price remains relatively constant, a significant portion of liquidity outside the regular price range is seldom utilized. In mainstream stablecoin trading pools based on AMM, less than 1% of total liquidity is actively employed, leaving the majority of available liquidity idle in the pools.

It is reasonable for liquidity providers (LPs) to desire the maximum utilization of their contributed liquidity to enhance fee earnings. This optimization can be achieved through concentrated liquidity. LPs have the ability to focus their liquidity within specified price ranges, aligning with the most active price intervals of a particular trading pair. As an illustration, an LP might choose to allocate all of their liquidity to the price range (0.995, 1.005) in a stablecoin trading pool. This strategic concentration allows LPs to maximize liquidity efficiency, participating in the most active transactions around the mid-price and consequently earning higher fees.

The introduction of liquidity concentration transforms the price interval of a user's liquidity from infinite to finite. The liquidity concentrated within a finite price interval is termed a "position" or "liquidity position." LPs can create multiple positions within the same pool by establishing different price ranges. This flexibility enables LPs to simulate diverse price curves, aligning with their custom strategies.

Active Liquidity

In the event that a user establishes a finite price range for a position, fluctuations in the asset price during market volatility may cause it to surpass the set range. In such instances, the liquidity within that specific position becomes inactive, ceasing to generate fees until the asset price re-enters the designated range.

If the price of a trading pair moves unidirectionally, liquidity providers will experience an increase or decrease in the quantity of one token within their positions. This indicates a higher demand for the other token from swappers. Upon reaching the upper or lower bounds of their positions, the entirety of their liquidity will consist of only one asset.

Upon re-entry into the specified range, the liquidity within the position becomes active once more, resuming the accrual of fees. An active position involves a liquidity composition of two tokens, as opposed to only one asset type.

Concentrated liquidity affords liquidity providers significant flexibility. They can create numerous liquidity positions with customized price bands as per their preferences and requirements. The underlying algorithm of concentrated liquidity outlines a mechanism that delegates the decision-making authority for liquidity distribution to the actual market. This is because most liquidity providers naturally focus their assets within the most active price ranges based on prevailing market trends, with the goal of maximizing transaction fee earnings.

Price Ticks

In an Automated Market Maker (AMM) model, the price exhibits continuity, but there's a notable distinction in a concentrated liquidity protocol. Within concentrated liquidity positions, prices are discrete, characterized by a partitioned price curve delineated by ticks. Each tick represents a distinct space, reflecting a 0.01% increase or decrease (equivalent to 1 basis point) in price at any point within the price space.

Ticks serve as demarcations for each liquidity position. Upon initiation, a liquidity position is defined by liquidity providers setting upper and lower price ticks.

With the execution of new swaps, the smart contract systematically utilizes available liquidity within the current tick interval. This involves a continual exchange of the outbound asset for the inbound one until the next price tick is reached. Upon reaching a new price tick, the pool contract promptly transitions, activating any dormant liquidity within the newly designated tick intervals.

While every trading pool within a concentrated liquidity protocol has an identical number of price ticks, only a subset of them function as active ticks in practical scenarios. The correlation between tick spacing and swap fee tier in a concentrated liquidity smart contract is noteworthy. Lower fee tiers result in closer proximity between adjacent active ticks, while a higher fee tier provides the pool with a wider tick space for potential active price ticks.

For trading pairs requiring heightened price granularity, such as stablecoin pairs, a relatively narrower tick space proves beneficial. This setup ensures a more moderate price impact during swapping, aligning with the specific needs of a stablecoin pool.