In a traditional liquidity pool, we know that the value of assets must be equal via the simple formula: x*y=k, where x and y represent the quantities of (usually) two tokens in a liquidity pool, and k is a constant.
In traditional AMMs, the user’s liquidity is spread across near-infinite price ranges to ensure trading can occur across all price ranges. While ground-breaking in the context of DeFi and blockchain innovation, it’s now considered a model that limits efficiency for the liquidity providers and traders that leverage the pool to swap assets.
Newer designs like concentrated liquidity allow users (liquidity providers) to more strategically allocate their funds across specified price ranges according to their preferences and investment strategies. This reduces trade slippage, increases capital efficiency, and allows customized risk preferences for liquidity providers.
The downside? Far more active investment management on behalf of the liquidity providers. Put simply, the liquidity providers face range selection risk and increased complexity when seeking ROI for their investments via concentrated liquidity models.
Actively monitoring — and adjusting — positions increases the fees a user experiences when using a DeFi protocol, too. If the user does not make a well-timed or strategic adjustment, they must repeat the process; incurring more fees and, potentially, impermanent loss. If they don’t update their positions, they risk less capital efficiency (lower ROI), or suffer from significant impermanent loss.
The fallout hurts liquidity providers and their faith in protocols.
It doesn’t take much effort to find irritated or confused (or both) liquidity providers on common communication channels Twitter (sorry, X) or protocol Discord communities. They often express frustrations at impermanent loss, UI / protocol confusion, lack of documentation, or complain about the increased complexities of newer protocol models.
In an effort to make DeFi more efficient, protocols risk alienating users. Proper data infrastructure and visual portfolio tools can make them happy and more profitable.