How CLMMs Improve The DEX Landscape
Note: This article is not financial advice. Kamino Finance does not endorse any tokens or platforms mentioned in this article.
Overview:
- CLMMs increase the capital efficiency of decentralized trading.
- Both traders and LPs benefit from increased DEX efficiency.
- DEX volume can overtake CEX volume as UX improves.
The concentrated liquidity market maker (CLMM) is a game changer for decentralized finance (DeFi). The CLMM provides better returns for liquidity providers (LPs), deeper liquidity for traders, and is all-around more capital efficient than its predecessors.
In this article, we’ll explain why CLMMs could have such a powerful influence on the future of decentralized exchanges (DEXs). It’s possible to argue that the CLMM will be the next big thing driving trade in the future of DeFi, and Kamino will be there to help foster this shift.
How CLMMs Increase Capital Efficiency Compared with Traditional AMMs
The DeFi community has, for years, heavily relied on automated market makers (AMMs) to facilitate trade on DEXs. The problem is that traditional AMMs are astonishingly inefficient tools for supplying liquidity at a current price.
The root of this inefficiency is the invariant function x*y=k, which most DEX AMMs rely on, This invariant is called the constant product market maker (CPMM), and most of the tokens you deposit on a CPMM will never be used to fulfill a swap as it spreads token liquidity across a price range from zero to infinity.
For example, If you provide liquidity for a USDH/USDC pair on a traditional AMM, less than 1% of your tokens will be supplied around $0.999, $1.000, or $1.001. The rest of your tokens will lie dormant and unable to collect fees, ready to supply prices at less than a penny and more than a thousand dollars.
You’re missing out on other yield opportunities with these unused tokens, as most of your deposit is supplied at prices USDH will never touch. Instead, CLMMs break through this paradigm by concentrating tokens at probable price ranges rather than a broad swathe of “spray and pray” liquidity.
On a CLMM, LPs can choose what price range they want to provide liquidity. If this range is supplied at the price where traders are currently executing transactions, then more of an LP’s tokens facilitate swaps, and LPs collect more fees.
You can also provide liquidity for stable pairs at extremely narrow ranges, even at $0.999-$1.000, which means all the trades made at that price point will have a greater chance of interacting with your tokens and earning you fees.
An AMM Market Analogy
The difference between an AMM and a CLMM can be difficult to grasp, so let’s try a real-world analogy to explain how it works. For the sake of simplicity, we’ll substitute the DEX with a farmer’s market, and carrots will take the place of tokens.
Introducing the Farmers Market (AMM-style)
Imagine being the wholesaler who supplies carrots to a farmer’s market where there are 10 tables of vendors who must sell produce at $1-$10 a kilo, and prices per kilo rise by one dollar per table, moving from left to right.
The vendors selling produce at the $1 and $2 per kilo tables never make any carrot sales, because they won’t make money selling below market value. So they are constantly waiting for carrot prices to fall for it to make sense for them to vend your product.
On the other end of the market are vendors selling carrots for an exorbitantly high price, from around $7-$10 a kilo. They, too, rarely see any business, because no one wants to buy their overpriced carrots, but they keep them in stock just in case the price of carrots moons.
In the middle of this market, in the Goldilocks Zone, some vendors sell carrots at a reasonable price, usually between $4-$6 a kilo, depending on the season. These vendors attract business, and they help you move your carrot supply.
Supplying the Market (AMM-style)
Now, the batty thing about this market is you, as the carrot supplier, must provide an equal amount of carrots to each table. You brought 10 kilos, so you must give each table 1 kilo. It’s the same for your competitor, who brought 100–10 kilos of carrots to each table.
By the way, you supply these carrots 100% upfront and make no profits unless the vendors make sales. Your carrots are weighed and tossed in a basket with the other supplier’s carrots, and you receive payment proportional to the carrots you provided.
Since the current market value of a kilo of carrots is around $4, the table selling produce for $4 manages to sell 5 kilos for a total of $20. You have provided 10% of the supply, so you receive $2 at the end of the day.
Another Market and a Better Way (CLMM)
Since 90% of your carrot supply never had a chance to sell, you decide to try another market. This market also has 10 tables with prices ranging from $1-$10, and it also requires you to supply each table equally, but you can choose which tables and price points to supply.
You know that the market value of carrots is currently $4, but you think the price might rise through the day, so you also supply the $5 table. Therefore, you have now supplied 5 kilos of carrots at the $4 and $5 tables.
Your competitor brings 100 kilos again, but they feel the price of carrots might shift over time. They don’t want to return to the market to adjust their strategy, so they spread their supply between the $3-$7 tables, leaving 20 kilos at five different tables.
At the end of the day, the $4 table sells 5 kilos, but this time your share of the profit is 20%. So you make $4 this day, doubling your income by concentrating your supply.
Imagine a carrot connoisseur places a large order, wiping out the $4 table. The $5 table now has to help fulfill this order (scarcity demands a price rise), and you’re selling a lot of carrots.
If you supplied all 10 kilos of your carrots at the $4 table, you could increase your sales income by guaranteeing you helped fill this large order. On the other hand, you risk losing profit entirely if the market value of carrots rises or falls by a dollar, and you have no carrots at the $5 table.
How DEXs Could Compete with Centralized Exchanges
The tables from the previous analogy are known as “ticks” on a CLMM, and when you provide liquidity on a CLMM, you can choose the price ticks where you want to supply your tokens. By concentrating liquidity around certain ticks, LPs have a greater opportunity to capture fees, and traders gain access to deeper liquidity around current prices.
To go back to the carrot analogy, the “carrot whale” wouldn’t have to pay $5 a kilo to fulfill the rest of their order if they can find enough carrots supplied at the $4 table. In the same way, traders would rather access deep token liquidity at a predictable price range without moving the market, especially if they’re interested in making large trades.
If the DEX can increase its capital efficiency to challenge the efficiency of the centralized exchange (CEX), a host of traders who rely on CEXs to fulfill large orders could one day begin trading on a DEX. There are many reasons why users would prefer a DEX over a CEX, and increasing capital efficiency could be the last pain point that Kamino helps solve.
Overall, the CLMM improves the user experience of swapping tokens on a DEX for many traders by incentivizing LPs to concentrate their liquidity around a certain price, and Kamino ensures that this concentration remains balanced at an optimal price range.
On the other side of the equation, instead of spraying liquidity scattershot from zero to infinity on an AMM, LPs can earn more fees by providing concentrated liquidity where necessary, and in return, they are vastly improving the DEX landscape for the DeFi community.
