Market marker mechanisms in Liquidity pools
It is no longer news that with the continuous growth of decentralized finance, liquidity pools have become indispensable. Before going further, let’s try to understand what liquidity, liquidity pool and who a liquidity provider is.
In simple terms, liquidity refers to the ease by which tokens can be swapped to other tokens.
A liquidity pool is a collection of funds locked in a smart contract. It is considered as the backbone of many decentralized exchanges. Liquidity pools enable users to buy and sell crypto on decentralized exchanges and other DeFi platforms without the need for centralized market makers.
Talking about a liquidity provider, also known as a market maker, is someone who provides their crypto assets to a platform to help with decentralization of trading. In return they are rewarded with fees generated by trades on that platform, which can be thought of as a form of passive income.
When it comes to liquidity pools, you have three options for a market marker mechanism
Automated market marker (AMM)
An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Assets are priced according to a pricing algorithm. The AMM follows the equation x*y = k. Where x and y are the amounts of each of the two tokens in the liquidity pool respectively, and k is a fixed constant. Here, liquidity added by liquidity providers are covered between the range of 0 and infinity.
Concentrated liquidity market marker (CLMM)
In concentrated liquidity market marker, liquidity providers are allowed to add liquidity in their specified price range resulting in what is called a concentrated liquidity position. LPs can open as many positions in the pool as they wish, thereby creating unique price curves aligned with their personal needs and preferences.
Proactive market marker (PMM)
The algorithm provides accurate market prices of assets to reduce spillage and temporary losses in trading. It checks the prices of assets allocating funds to proactively increase liquidity near the market price.
Why I like the concentrated liquidity market marker
Although AMMs have witnessed wide adoption, it features a major problem which is the low capital efficiency because liquidity is spread between zero and infinity. This implies that if the prices of the two assets involved are concentrated in a relatively small range (e.g., stablecoin swap), most of assets in the pool are not effectively contributed to the swap, resulting in high slippage and lower fee collected by LPs.
With concentrated liquidity, there is great improvement in capital efficiency, slippage is greatly reduced and liquidity providers get to earn more fees. This is all because a liquidity provider is allowed to concentrate liquidity in a specific target price range. Liquidity concentrated to a finite interval is called a position. LPs may have many different positions per pool, creating individualized price curves that reflect the preferences of each LP.