Understanding AMM Core Mechanics for Concentrated Liquidity V3

When you first dip your toes into the world of automated market makers, you’ll likely hear the same buzzword thrown around: AMM. It feels a bit like a secret club—an acronym that seems almost always to come with a promise of lightning‑fast profits. In reality, the mechanics are more like a quiet engine in a bicycle than a roaring jet. Today I want to walk through the core mechanics of the most recent generation of these engines, the concentrated‑liquidity, version 3 models, and show you how they differ from the first‑generation AMMs you may have seen. My goal isn’t to give you a crash course in code, but to help you feel comfortable with the concepts as you’d feel in a conversation over coffee.

What is an AMM, at its simplest?

An AMM is a recipe for how two assets trade against each other without a human market maker. Think of it as a digital vending machine. You put in a certain amount of one coin or token, and the machine gives you back a proportion of another. The proportion is decided by a mathematical formula that keeps the “product” of the two reserves constant (the so‑called constant‑product formula). This idea first appeared in the early days of decentralized exchange platforms, like Uniswap V1.

You might say, “That sounds simple enough. Why does it matter?” Two reasons:

1. Liquidity on a 24/7 basis – there is no need for a human to hop into a trading desk and decide the price. The machine updates itself immediately when people trade.
2. No order book, no hidden fees – trading happens against a pool that holds the assets. You pay a small fee each time, which gets split among those who have supplied liquidity.

In practice, everyone who wants to participate can become a liquidity provider (LP). They deposit two assets into a pool, receive LP tokens in return, and are then entitled to a share of the fees. It is how you, as an investor, can get a return on your assets just by holding them.

From V1 to V3 – why the shift?

In the first versions, liquidity was spread evenly across a huge price range, typically from zero to infinity. Imagine a bucket of water full of tokens, and everyone shares that bucket. The price adjusts as people withdraw or deposit – but the math is always the same regardless of what price range you set.

Then the designers had a breakthrough: concentrated liquidity. The idea is that you can choose a range around the current market price where you want your tokens to be active. If you set this range very narrow, your liquidity will be used more efficiently, and you’ll earn more fees relative to the amount you lock up. But be careful: if the price moves out of the window, you’ll be “stuck” – your tokens will just sit there, unearned.

This change made V3 a lot more attractive for LPs, but it also introduced a layer of complexity that can be intimidating. Below is a step‑by‑step explanation of how that mechanic works.

How a concentrated‑liquidity pool works (in plain terms)

Imagine your assets are two kinds of fruit – apples and oranges – and you’re the fruit stand owner. In the old model, you laid out apples and oranges across the entire shop floor. Every passerby could take a few, regardless of where they were. In the new model, you decide a small counter area where you keep your fruit.

1. Setting a range

You pick a price interval, say from €30 to €35 per unit. Only trades that hit a price within that interval will use your liquidity. Think of it as a “tight window” of pricing where you stay active.

2. Providing liquidity

When your range is tight, you can concentrate more of your tokens in that window. The fewer tokens you need to supply to maintain the same depth, the more capital you free elsewhere, theoretically earning you a higher fee share per unit of capital.

3. Automatic updates

The pool keeps adjusting: as spot prices rise or fall, the pool tracks where the current price lies. When it enters your window, your liquidity gets fully active. When it slides out, you’re idle until it comes back.

4. Fees

Every trade that takes place against the pool pulls a small portion (like 0.05 % on V3) of the asset out of the pool, which is then distributed to all active LPs proportionally to their share of the depth within the window.

The sweet spot? You own enough depth near the current price to capture plenty of trades, but you don’t want too many “inactive” LP tokens tied up.

Why the math is important

The underlying formula stays true to the constant‑product principle: reserveA × reserveB = k. For V3 the formula is adapted to handle the range concept, but the core remains the same. As you narrow your window, the density of your liquidity goes up, because you’re effectively buying the slope of the curve that matters most.

That means:

• Higher fee share – if you’re the only one in the region, every trade’s fee will be yours.
• Higher impermanent loss risk – if the price moves far enough from you, you could be left overexposed to the “wrong” asset.

So, the beauty is that you can keep a more efficient pool of capital, but the trade‑off is that you need to be comfortable with the risk that your tokens could move in price in a way that hurts you.

Managing the trade‑off: a real‑world example

Let’s say a token pair is priced at €50, and you decide to set a window from €48 to €52. You deposit €5 000 worth of each asset into the pool. Because your range is just €4 wide, you’re more “concentrated” than if you had set a window from €30 to €70.

If the price moves only to €49 or €51, your liquidity is fully used. If it goes beyond €52, your tokens become inactive. In practice, most trading pairs experience small daily swings, so that window works well.

If instead you set a range from €30 to €70, your €5 000 in each asset would cover a broader price space, but you’d be less efficient – the same trade would earn you a smaller fraction of the fee because you’d be competing with many other LPs spread out across that wide range.

Impermanent loss – what is it, and why does it matter?

When you become an LP, you’re exposed to the changes in relative value between the two assets. You’re not holding the assets in a portfolio that will grow or shrink with the market; instead, you’re a “passive owner” of a slice of the pool that can shift in value when the market moves.

Impermanent loss is the difference in value between:

1. Keeping the assets as a simple holding (say, €10 000 in each).
2. Storing them in the pool and later harvesting LP tokens.

If the pool price moves drastically, the pool’s composition will change, and you’ll receive more of one asset than the other. Because one asset may have become cheaper, your net value might be lower than if you’d simply held the two assets separately.

Two key points to remember:

• It’s “impermanent” – if the price returns to where it started, the loss disappears (although you may have lost some fees).
• In a concentrated‑liquidity setting, the risk is amplified – you’re essentially betting that the price will stay within your chosen window for the duration you stay invested.

How V3 mitigates or exacerbates impermanent loss?

The concentrated model can reduce the exposure to impermanent loss if you manage your window correctly. If you keep your LP tokens in place while staying within a tight range, the relative balance tends to stay fairly stable for the price movements you expect.

On the flip side, if you’re wrong about the price staying in that range, you might end up with a very asymmetric distribution of tokens at the end of your holding period, leading to a bigger loss than a broader‑range LP would have experienced.

One trick to mitigate this is to:

• Frequently re‑range your position as the market moves.
• Use tick spacing to keep your window reasonably tight but not excessively narrow.

Best practices for a cautious LP

1. Research the pair’s volatility – a stable pair (like USD stablecoins) is less risky. A highly volatile pair (like emerging‑market tokens) invites more impermanent loss.
2. Start small – test a concentration with a modest capital allocation. Treat it as a learning project.
3. Rebalance regularly – adjust your window when prices shift, or when you see the pool’s depth changing.
4. Keep the window wide if you’re unsure – a broader range gives you a safety net at the cost of fee efficiency.
5. Consider your time horizon – impermanent loss is more likely if you remain in a narrow window during turbulent periods.

A story from the field

I once worked with a small team that wanted to provide liquidity on a popular token pair. They chose a window where the price fluctuated around 5 % daily. After two months, the price had shifted by more than 15 %, and all their pool tokens were outside the active range. They had essentially left their assets idle, missing out on fees and suffering a loss because the pool’s token distribution had become skewed. The lesson? Even with concentrated liquidity, you have to respect the market’s tempo.

A few weeks later, a different firm used the same pool but set a window that stretched 12 % above and below the current price. Although they earned slightly less every trade, they stayed active the entire period and collected consistent fees, with minimal impermanent loss.

The moral: concentration is powerful but unforgiving. It’s not a “set it and forget it” tool.

The role of impermanent loss across V3 pools

In practice, impermanent loss only kills you if you’re not careful, and only if the pool diverges significantly from the baseline value of the assets. If you’re a very long‑term investor who will sit with your LP tokens for decades, impermanent loss becomes a less immediate worry, especially if the pair is stable or has a very low volatility.

For short‑horizon LPs, you want to combine concentrated liquidity with:

• Dynamic window adjustments
• Exit strategies
• Monitoring tools that alert you when the price moves close to your window’s boundary

The human factor: why you should stay skeptical

It’s tempting to fall into the hype that this AMM technology can replace a full-time job or that being an LP guarantees passive income. In reality, liquidity provision is a financial product that carries a complex risk–return profile. It’s not designed for the novice who likes to buy something, hold it, and never think about it again. Think of it as a garden you’re actively tending: you plant the seeds (your assets), water them regularly (re‑range windows), and prune when weeds grow (impermanent loss).

A quick illustration

Let’s put numbers to a simple scenario:

• Current price of Token X: €100 per Token Y.
• You decide on a range of €98–€102.
• You deposit €10 000 worth of each.
• Average daily trade volume on the pair is €50 000.

If all daily trades fall within your window, you’ll earn 0.05 % of the trades that happen against your liquidity share. Suppose you capture a 1 % share of the daily volume (because you’re the only LP in that narrow window). Then you earn €25 per day in fees.

Over a year, that’s about €9 125 in fees. If your LP position held a nominal value of €20 000 at the start, that’s a 45 % return. But what if the price moves to €103? Your LP tokens become inactive. The next time you recover them, they might have an imbalanced ratio of Token X to Token Y, potentially lowering your effective value. You need to monitor this.

Final actionable takeaway

Concentrated liquidity V3 can be a great tool if you:

• Understand the window concept – set a range that matches your view of the price movement.
• Balance efficiency vs. safety – keep your range tight enough for high fee density but wide enough to avoid being idle.
• Stay vigilant – adjust your range as markets move and keep an eye on the pool’s depth.

In plain terms: think of yourself as a gardener who plants a cluster of tomatoes next to a sunlit patch. If you plant them too close together and too narrowly, you’ll miss the light when the sun moves; if you spread them too thin, you’ll waste your seeds. Adjust the spacing based on how the sky changes, and you’ll see a bountiful harvest.*