Copy of Liquidity Pools Starter Pack

AMM & DEX

Blockchain technology enables Decentralized Exchanges (DEXs), allowing users to trade assets directly without intermediaries. Traditional order books posed challenges on early blockchains due to high transaction volumes. The solution? Liquidity Pools where assets are pooled together and exchanged at a rate set by an on-chain formula. Originally introduced by Bancor, this concept was refined by Uniswap and other platforms, giving rise to the Automated Market Maker (AMM) model in use today.

Uniswap V3 Liquidity Pools

Kai Finance’s Leveraged LP Vaults use Uniswap V3 Liquidity Pools, an advancement that enables concentrated liquidity, allowing providers to focus their capital within a custom price range. Unlike earlier models, which spread liquidity uniformly across all price levels, Uniswap V3 lets users allocate funds only to relevant price intervals where trades are most likely to occur. This concentrated approach maximizes capital efficiency, enabling liquidity providers to earn more fees with less capital.

Price Range

Choosing a price range in Uniswap V3 pools is essential to maximizing returns. For instance, in a SUI-USDC pool with a current price of 2 USDC per SUI, a provider might select a narrow price range of 1.9 to 2.1 USDC. This allows them to capture trading fees as long as the price remains within these boundaries. Uniswap V3 further divides price ranges into ticks, or small intervals, that allow precise management of liquidity. As trades move between ticks, liquidity is activated or deactivated based on the current price, ensuring funds are used as efficiently as possible.

If the price moves outside the specified range, the position goes “out of range” and stops earning yield until it re-enters. This ability to focus liquidity at particular price levels is especially effective in pairs with predictable price behavior, like stablecoins.

Choosing a Price Range

Selecting the right price range depends on your market outlook and risk tolerance:

• Narrow Range: Concentrating liquidity within a tight range can yield higher fees, as capital is utilized more effectively. However, it also increases the likelihood of going out of range, especially in volatile markets.

• Broader Range: A wider range provides greater stability by keeping the position active longer but typically generates lower fees due to less concentrated liquidity.

Consider your strategy when setting a range: are you expecting price stability, or are you prepared for fluctuations? Stable asset pairs (e.g., USDC-USDT) generally benefit from narrow ranges due to their low volatility, while volatile pairs may require broader ranges to accommodate price swings.

Impermanent Loss

Impermanent loss occurs when the asset ratio in your position changes due to price fluctuations, leading to a temporary imbalance when compared to simply holding the tokens. For example, if SUI’s price rises in a SUI-USDC pool, a liquidity provider may withdraw with more USDC and less SUI than if they had held SUI alone. This imbalance arises as the pool continuously rebalances tokens within the chosen range to reflect market prices.

Out of Range Impact

If the price of an asset moves beyond your chosen range, the position goes out of range, halting fee generation but retaining the assets. For example, if the price exceeds the upper boundary, your position may hold mainly USDC, as the pool has “sold” SUI on the way up. Conversely, a drop below the range results in a position holding primarily SUI. This rebalancing contributes to impermanent loss, as the asset distribution diverges from a simple hold strategy.

Fortunately, if the price eventually returns to the original level, impermanent loss can be offset. Staying in active pools for extended periods allows accumulated fees to counterbalance shifts in asset ratios, potentially preserving or enhancing your position’s value.

Stable vs Volatile Pools

For pools with stable pairs, like USDC-USDT, where asset values remain closely aligned, impermanent loss is typically minimized, making them suitable for high-leverage strategies. Volatile pairs, such as SUI-USDC, carry a higher risk of impermanent loss due to significant price fluctuations. However, these pools often offer higher APYs to compensate for the increased risk, allowing providers to capture higher yields when managed strategically.