PancakeSwap V2 vs V3: Key Differences in AMM, Liquidity, and LP Strategies

In the BNB Chain ecosystem, PancakeSwap is one of the most important decentralized exchanges (DEXs). When using PancakeSwap, many users notice that there are two main versions available: V2 and V3.

For newcomers to DeFi, the differences between these versions are often not immediately clear. Why are there two versions? Why does V3 require setting a price range? Why is adding liquidity more complicated in V3?

In reality, the difference between V2 and V3 is not just a UI upgrade—it represents a major evolution in Automated Market Maker (AMM) design. Understanding these differences not only helps users trade more effectively but also provides insight into how liquidity and market-making work in DeFi.

PancakeSwap V2: The Classic AMM Model

PancakeSwap V2 uses the classic Constant Product Automated Market Maker model, originally introduced by Uniswap V2. This model became the dominant design for early DeFi protocols because of its simplicity and reliability.

The entire system relies on a simple mathematical formula:

[x * y = k]

Where:

Parameter	Meaning
x	Amount of USDT in the pool
y	Amount of CiaoToolTest in the pool
k	Constant value maintained before and after trades

For example, a USDT / CiaoToolTest liquidity pool might contain:

Asset	Amount
USDT	100
CiaoToolTest	1,000,000

The market price would therefore be:

Which means:

1 USDT = 10,000 CiaoToolTest

When a user buys CiaoToolTest, the amount of CiaoToolTest in the pool decreases while the amount of USDT increases. To maintain the equation x * y=k, the protocol automatically adjusts the price. The larger the trade size, the more the price shifts—this phenomenon is known as slippage.

Liquidity Structure in V2

In V2, liquidity is distributed evenly across the entire theoretical price range—from 0 to infinity.

Liquidity Distribution (V2)

0 ---------------------------------------------------- ∞
|====================== Liquidity =====================|

This means LP funds technically support trades at any price. However, real market activity typically occurs near the current price, meaning a large portion of liquidity remains unused. As a result, capital efficiency in V2 is relatively low.

Adding Liquidity in V2

Adding liquidity in V2 is very straightforward. Users simply provide two assets according to the current market price ratio.

For example:

1 USDT = 10,000 CiaoToolTest

Liquidity must be provided in the same proportion:

Action	Assets Provided
Add Liquidity	1 USDT + 10,000 CiaoToolTest

After depositing the assets, the protocol issues LP Tokens, which represent your share of the liquidity pool. These LP tokens function like ownership shares—whenever trades occur in the pool, LPs earn a portion of the trading fees proportional to their holdings.

Create / Add Liquidity Example

1. Connect WalletEnter the private key that will be used to create/add liquidity.

   

2. Select the two tokens you want to add to the liquidity pool.

3. 

   Enter the liquidity amounts. (Note: Please calculate the appropriate token ratio before creating the liquidity pool.)

   

4. For the first operation, you will need to approve the contract to use your tokens.

5. After confirming everything is correct, click the “Start Transaction” button.

Removing Liquidity in V2

To withdraw liquidity, users simply return their LP tokens to the protocol. The tokens are burned, and the underlying assets are returned according to the current pool ratio.

LP Token
   ↓
Burn
   ↓
Receive USDT + CiaoToolTest

Remove V2 Liquidity Example

1. Connect WalletEnter the private key used to create/add liquidity.

   

2. Select the two tokens of the liquidity pool you want to remove liquidity from.

   

3. Choose the removal percentage.(Note: Please calculate the appropriate ratio before removing liquidity.)

   

4. For the first operation, you will need to approve the contract to use your tokens.

5. After confirming everything is correct, click the “Start Transaction” button.

   
   

Because prices may have changed during trading, the asset proportions you receive might differ from your original deposit. This effect is known as Impermanent Loss (IL).

Despite this risk, the V2 model remains very popular due to its simplicity and ease of use, making it ideal for beginners and smaller projects.

PancakeSwap V3: Concentrated Liquidity (CLAMM)

As DeFi markets matured, developers realized a key inefficiency in the V2 model: most liquidity in the pool was never actually used. Since trading activity typically occurs near the current market price, funds allocated to distant price ranges rarely participate in trades.

To address this issue, PancakeSwap introduced V3 in 2023, implementing the Concentrated Liquidity Automated Market Maker (CLAMM) model.

The key idea behind V3 is simple:

Liquidity providers can choose the specific price range where their capital is active.

For example, if the current price is:

1 USDT = 10,000 CiaoToolTest

An LP might set their liquidity range between:

9,000 – 11,000 CiaoToolTest

Visualization:

Liquidity Distribution (V3)

0 ---------------------------------------------------- ∞
           |========== LP Liquidity =========|
            9000       10000       11000

As long as the market price stays within this range, the liquidity participates in trades and earns fees. If the price moves outside the range, the liquidity becomes inactive.

By concentrating liquidity around the active trading zone, V3 significantly improves capital efficiency.

Liquidity Position Structure in V3

In V3, each liquidity deposit creates an independent Liquidity Position.

Each position contains:

Parameter	Description
Price Range	The active trading range for liquidity
Liquidity Amount	Amount of capital provided
Fee Tier	Trading fee level

PancakeSwap V3 supports multiple fee tiers:

Fee Tier

0.01%

0.05%

0.25%

1%

Different trading pairs use different fee levels depending on their volatility.

Why V3 Uses NFTs for Liquidity

In V2, all liquidity providers receive identical LP tokens.

However, in V3, each LP may choose:

• Different price ranges

• Different capital sizes

• Different fee tiers

Because each position is unique, the protocol represents liquidity positions as NFTs (Non-Fungible Tokens).

Each NFT records:

• Price range

• Liquidity amount

• Accumulated fees

This allows positions to be individually managed.

Adding Liquidity in V3

The process of adding liquidity in V3 is slightly more complex:

Select Trading Pair
USDT / CiaoToolTest
↓
Choose Fee Tier
↓
Set Price Range
↓
Deposit Assets
↓
Receive LP NFT

The most important step is setting the price range, as it determines whether your liquidity will be actively used.

Create / Add Liquidity Example (V3):

1. Connect Wallet: Enter the private key used to create/add liquidity.

   

2. Select the two tokens for the pool: When adding liquidity, you can enter the token pair addresses directly.

   

3. Choose Fee Tier: 0.01%, 0.05%, 0.25%, 1%.

   

   The LP fees in V3 differ from V2 and are no longer compounded. Transaction fees vary: V3 has four different fee tiers, which can reduce trading fees by up to 25×; in V2, each trade pays a fixed 0.25% fee. The default slippage for creating liquidity in V3 Swap is 1%.

4. Set Initial Price and Price Range:

   1. Range size determines returns (applies to both LP fees and CAKE rewards): narrower ranges generate higher returns but greater impermanent loss; wider ranges generate lower returns but smaller impermanent loss. Setting the full range behaves similarly to V2, with minimal returns.

   2. Outside the range: No earnings; the liquidity position becomes single-asset. You can remove and re-add liquidity or wait for the price to return within the range.

      

5. Enter liquidity amounts: Please calculate the appropriate token ratio before creating the liquidity.

   

6. For the first operation, you will need to approve the contract to use your tokens. After verifying everything, click “Start Transaction”.

Removing Liquidity in V3

Removing liquidity requires a few more steps compared to V2:

Close Position
↓
Withdraw Liquidity
↓
Collect Fees
↓
Receive USDT + CiaoToolTest

In practice, managing liquidity in V3 resembles actively managing a market-making strategy.

PancakeSwap V2 vs V3: Key Differences

• The fundamental difference can be summarized simply:

  V2: Liquidity is distributed across the entire price curve

  V3: Liquidity is concentrated within chosen price ranges

This leads to several important differences:

Feature	V2	V3
Liquidity Range	Full price range	Custom price range
Capital Efficiency	Low	High
LP Representation	LP Tokens	NFTs
Operational Complexity	Simple	More complex
Best For	Beginner LPs	Advanced liquidity providers

For casual users, V2 remains easier to understand and use. V3, however, offers significantly higher efficiency for liquidity providers who actively manage their positions.

Why Many Projects Prefer V3

As DeFi continues to evolve, more projects are choosing V3 liquidity pools when launching new tokens. The main reason is that V3 offers higher capital efficiency, allowing projects to achieve deeper liquidity with less capital.

Learn more: https://ciaotool.gitbook.io/ciaotool/evm-en

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FAQ

What is the difference between PancakeSwap V2 and V3?

PancakeSwap V2 uses a traditional AMM where liquidity is spread across all prices. PancakeSwap V3 allows liquidity providers to set specific price ranges, improving capital efficiency.

Why does PancakeSwap V3 require a price range?

Liquidity in V3 only works within the chosen price range. If the market price stays inside the range, the position earns trading fees.

Why are liquidity positions NFTs in V3?

Each V3 liquidity position has its own price range and liquidity amount. Because every position is unique, they are represented as NFTs.

Is PancakeSwap V3 better than V2?

V3 offers higher capital efficiency but requires more active management. V2 is simpler and easier for beginners.