Exploring Concentrated Liquidity Core DeFi Building Blocks

Introduction

Decentralized finance has grown beyond simple lending and borrowing. At the heart of many protocols lies a small set of primitives that enable anyone to trade or provide capital without a central authority. Automated Market Makers (AMMs) are the most visible of these primitives. They rely on smart contracts to keep markets open 24/7, using mathematical formulas to determine prices from on‑chain reserves.

When AMMs first appeared, the model was simple: a pool of two tokens that maintained a constant product invariant—an early design that laid the groundwork for modern AMMs. For a deeper look at this evolution, see From Basics to V3 The Evolution of AMM Liquidity Strategies.

This design worked well for early use cases but had a major inefficiency: capital was spread thinly across the entire price range. Even if the market moved only a few percent, a large portion of the LP’s capital sat idle, unable to generate fees.

Concentrated liquidity models, first popularized by Uniswap v3, address this shortcoming. A comprehensive exploration of these models can be found in Deep Dive Into Concentrated Liquidity Models V3 for Advanced AMM Design.

In this article we dissect the core building blocks that make concentrated liquidity possible, explain the mechanics that underlie them, and walk through how these primitives combine to form the backbone of modern DeFi protocols.

Core Building Blocks

Below are the essential components that enable a concentrated liquidity AMM to function. Each building block builds upon the others, creating a cohesive system that balances flexibility, security, and efficiency.

Liquidity Pools

At its most basic, a liquidity pool is a pair of tokens locked inside a smart contract. The contract stores the reserves, enforces the pricing invariant, and collects transaction fees—a process detailed in Automated Market Maker Mechanics Explained for DeFi Builders. The pool can be thought of as a digital bank account that always contains the two assets.

In a concentrated liquidity pool, the reserves are still tracked, but the pool now also keeps track of active ranges—intervals of price at which each LP’s liquidity is effective. The smart contract aggregates all active ranges to compute the overall price curve.

Position Ranges

Unlike the flat range of early AMMs, concentrated models allow each LP to specify a price interval for which they are willing to provide liquidity. Think of it as placing a limit order that only activates when the market price falls within that window. An LP can choose a narrow range around the current price, a wide range that spans many price levels, or even split their capital across multiple ranges.

Position ranges are defined by two price points: a lower bound and an upper bound. The pool records the amount of liquidity contributed to each bound, and the smart contract adjusts the effective reserves as the price moves through the range.

Tick Spacing

To manage price granularity, the protocol divides the continuous price axis into discrete ticks. Each tick represents a specific price point, and tick spacing determines the distance between adjacent ticks. Tick spacing is a design parameter that balances precision against gas cost. Finer tick spacing allows LPs to position liquidity more precisely but increases the amount of data the contract must store.

The smart contract stores liquidity per tick and updates it as trades move the price across ticks. The use of ticks also makes it easier to compute the amount of LP tokens earned in a given range.

Fee Tiers

Concentrated liquidity pools support multiple fee tiers, such as 0.05 %, 0.3 %, or 1 %—each tier influencing risk and reward. Learn more about fee tier dynamics in Navigating V3 Liquidity Models Core DeFi Concepts Explained.

The fee tier dictates how much a trader pays on each swap, and indirectly influences the risk profile for LPs. Higher fee tiers attract trades that generate more revenue per swap but expose LPs to higher impermanent loss if the price moves outside their chosen range.

The protocol stores the fee tier as part of the pool’s state and uses it to compute the exact fee amount for every trade.

Oracle Integration

The price of each asset pair can be derived from the pool’s own reserves (the on‑chain price) or from an external oracle. Some protocols provide an optional oracle integration that reports the price to other DeFi primitives—such as lending platforms or derivatives protocols—ensuring that downstream applications have access to the most up‑to‑date price data.

In concentrated liquidity models, the oracle must be aware of the current active range and the amount of liquidity at each price point to compute an accurate price that reflects the pool’s real‑time state.

Impermanent Loss Management

Impermanent loss (IL) arises when the price of the two tokens diverges during the time an LP’s capital is deposited, but V3 models can mitigate it. See Leveraging V3 Models to Optimize Automated Market Maker Performance for strategies that reduce IL. Concentrated liquidity mitigates IL by concentrating capital around the most probable price. LPs can also use dynamic strategies—such as re‑balancing ranges—to keep their positions profitable over time.

The protocol exposes metrics that let LPs monitor the effective price, the implied volatility, and the current IL of their position. Smart contracts can also provide incentives—for instance, liquidity mining rewards—to compensate for potential IL.

How Concentrated Liquidity Works

To understand the mechanics, it is helpful to walk through the life cycle of a single trade in a concentrated AMM. Suppose we have a pool of Token A and Token B, with an active LP who has provided liquidity between the price points 0.90 and 1.10 B per A.

1. Trade Initiation

A trader decides to swap 10 A for B. The pool first calculates the current spot price using the reserves. Because the pool’s active range includes the current price, the trade is eligible to use the LP’s liquidity.

2. Price Movement and Tick Crossing

The trade pushes the price upward. The smart contract steps through each tick from the current price toward the new price, adjusting the reserves according to the constant‑product formula x y = k. As the price crosses each tick, the pool updates the liquidity per tick state. Only the portion of the LP’s capital that lies within the new price range continues to provide liquidity.

3. Fee Allocation

The trader pays a fee equal to the configured fee tier times the amount swapped. The fee is added to the pool’s reserves and later distributed proportionally to LPs based on the amount of liquidity they provided in the relevant price range.

4. Liquidity Withdrawal (Optional)

If the trader wants to exit the pool, they can withdraw the assets by specifying the liquidity they want to remove. The contract calculates the current reserves at the present price and returns the appropriate amounts of A and B, along with any accrued fees.

5. LP’s Position Over Time

During this sequence, the LP’s capital may remain fully active if the price stays within their chosen range. If the price moves beyond the upper bound, the LP’s capital becomes inactive and is effectively locked in a passive position, reducing the risk of further IL.

Mathematical Foundations

Effective Price Calculations

The effective price of a token pair in a concentrated liquidity pool is calculated using the following formulas:

• Effective Price: Effective Price = (ReserveA / ReserveB) * (1 + (TickSpacing * TickCount))
• Price Impact: Price Impact = (New ReserveA / New ReserveB) - (ReserveA / ReserveB)

These formulas account for the dynamic nature of price movements within the specified tick ranges, ensuring that the price reflects the actual liquidity available at each point in the curve.

Tick-Based Liquidity Representation

• Tick Count: Represents the discrete number of price points within the active range.
• Liquidity Per Tick: Liquidity Per Tick = Total Liquidity / Tick Count
• Active Liquidity: Active Liquidity = Sum(Liquidity Per Tick)

These metrics allow protocol builders to query the depth of liquidity at any point on the price curve, facilitating advanced use cases such as automated market making, hedging strategies, and liquidity aggregation across multiple pools.

Example Protocols

• Uniswap v3: The flagship implementation of concentrated liquidity. For a step‑by‑step guide, see Mastering Concentrated Liquidity A Step‑by‑Step AMM Guide.
• Balancer v3: A flexible AMM that supports multiple token types and dynamic fee structures.
• SushiSwap: A popular AMM that has integrated V3 concepts to offer improved capital efficiency.

Conclusion

Concentrated liquidity represents a paradigm shift in how decentralized markets are engineered. By allowing liquidity providers to specify precise price ranges, the model transforms raw capital into high‑yielding, low‑slippage assets. The core building blocks—liquidity pools, position ranges, tick spacing, fee tiers, oracle integration, and impermanent loss management—combine to create a robust, modular architecture that can adapt to a wide array of use cases.

For traders, concentrated liquidity offers deeper markets and tighter spreads. For LPs, it delivers higher capital efficiency and the possibility of reduced impermanent loss. And for protocol builders, it provides a composable foundation that can be extended with advanced primitives, incentives, and governance mechanisms.

As DeFi continues to expand, the principles of concentrated liquidity will likely become the default standard for AMMs, shaping the next generation of decentralized financial products.