What is Liquity?

What is Liquity?

Liquity is a decentralized lending protocol built on Ethereum, allowing users to deposit ETH as collateral to obtain LUSD loans without paying interest, while a one-off borrowing/redemption fee is needed.

LUSD is a collateralized stablecoin pegged to the US dollar. By depositing and locking ETH as collateral in a smart contract, users can create an individual position called a “Trove” and get instant liquidity by minting LUSD.

Users who mint LUSD must maintain a minimal collateral ratio of 110%, otherwise, the smart contract will liquidate the locked ETH to repay the LUSD loan.

Any LUSD holder can exchange 1 LUSD for $1 worth of ETH. The redemption and liquidation mechanism ensures that there are sufficient LUSD reserves to maintain its minimum value of $1, and the 110% collateral ratio creates a price ceiling for LUSD.

LUSD uses an arbitrage mechanism to adjust the token supply in the market, and automatic inflation and deflation can further ensure that LUSD is pegged to the US dollar.

Liquity also provides earning services for LUSD deposits. Users who deposit LUSD into the Stability Pool through smart contracts can earn a portion of the borrowing fees, redemption fees, and liquidation fees paid by other users.

When there are no other users in the market to liquidate Trove positions with insufficient collateral ratios, depositors in the Stability Pool will act as final liquidators to repay LUSD debts and get the ETH collateral.

If the LUSD in the Stability Pool is insufficient to repay the debt, the liquidated LUSD debt and collateral will be redistributed to active borrowers. This serves as an insurance mechanism to maintain the integrity of the debt liquidation process.

The unique design of Liquity allows users to borrow at a low collateral ratio. It uses economic incentives to maintain the peg of LUSD without relying on community governance or the intervention of interest rates.

What are Stablecoins?

The price of cryptocurrencies such as Bitcoin and Ethereum may fluctuate violently. To solve this problem, stablecoins whose prices are pegged to fiat currencies are created to maintain a fixed exchange rate.

Stablecoins are a driving force of the DeFi ecosystem, as they improve liquidity between different cryptocurrency assets. Traders can convert high-risk cryptocurrencies into stablecoins to hedge risks or use stablecoins as a payment method.

There are three types of stablecoins: fiat-collateralized stablecoins, crypto-collateralized stablecoins, and algorithmic stablecoins.

Fiat-collateralized stablecoins are supported by fiat currencies and highly liquid assets. They typically have low price volatility but a high degree of centralization. Common examples of stablecoins include USDT, USDC, Paxos, and TrueUSD.

Crypto-collateralized stablecoins require corresponding cryptocurrency assets to be staked as collateral. For example, MakerDAO, Equilibrium, and Synthetix allow holders to lock up cryptocurrency to mint stablecoins, providing users with opportunities to gain more liquidity and value while maintaining their investments.

Algorithmic stablecoins rely solely on smart contracts to control the supply and price, making them susceptible to speculation and price fluctuations. For example, UST collapsed due to over-issuance. Other algorithmic stablecoins include USDD, FRAX, AMPL, and others.

Shortcomings of Lending Protocols

Generally, various lending protocols are confronted with common problems.

Firstly, there are high and unpredictable interest rates that are intended to regulate the token supply and maintain the peg of stablecoins. However, the interest rates may have no obvious effects in the short term, and over time, they can accrue and increase lending costs for users.

This means that short-term speculation and leveraged traders may not be affected significantly by the interest rates, but existing borrowers may be unable to repay their loans due to delayed reactions to the rising interest rates. For example, MakerDAO had an annual interest rate of over 20% in 2019.

Secondly, governance token holders can decide the important economic parameters of these borrowing projects, such as interest rates and utilization fees. However, on-chain governance has always been difficult due to shortcomings like low voting rates, inappropriate incentives, the control of governance rights by a few people, conflicts of interest, etc. These make the economic parameter settings more controversial. Therefore, it is difficult to ensure that the protocol can effectively perform its functions to serve the community and users.

Lending platforms usually require borrowers to over-collateralize, resulting in capital inefficiency. Borrowers are therefore forced to maintain a higher collateral ratio, which is derived from the inefficient liquidation mechanism, as the design of fixed-price collateral auctions cannot cope with sudden large-scale liquidations and price changes. A well-known event was Crypto’s Black Thursday in 2020, where even with MakerDAO’s collateral threshold set at 150%, the sudden collapse of cryptocurrencies caused the liquidation robots to fail to process bad debts, eventually leading to errors such as auctioning ETH at a price of $0.

The lack of direct arbitrage and hard peg mechanisms is another shortcoming of these lending protocols, as crypto-collateralized stablecoins typically cannot be redeemed at face value, nor can their prices be guaranteed to remain fixed. These types of systems typically rely on a soft peg mechanism to stabilize the exchange rate by controlling the amount borrowed in the market through variable fees (such as interest rates). Compared to fiat-collateralized stablecoins, crypto-collateralized stablecoins have higher price fluctuations.

The History of Liquity

Liquity was officially launched in April 2021, and founded by Robert Lauko and Rick Pardoe, with Michael Svoboda serving as the current CEO. Robert Lauko was a researcher at DFINITY, a startup developing the Internet Computer project, and began conceptualizing and prototyping Liquity in 2019. In 2020, he teamed up with Rick Pardoe, a Solidity developer with degrees in Physics and Economics, to form Liquity’s core team.

In September 2020, Liquity announced that it had raised $2.4 million in seed funding to support the team and protocol development. The round was led by Polychain Capital and attracted many angel investors, including a_capital, Lemniscap, 1kx, DFINITY Ecosystem Fund, Robot Ventures, and Tomahawk.VC. In early 2021, Liquity conducted two other funding rounds and raised a total of $8.4 million, with Pantera Capital joining in.

Source: Liquity website

Liquity’s vision is to establish a decentralized lending protocol for Ethereum. It is supported by immutable, governance-free smart contract algorithms so that even the founding team cannot make updates or modifications. It achieves full decentralization through a decentralized network of frontend operators.

In the cryptocurrency market crashes in May 2021 and May 2022, Liquity’s mechanism proved its validity, with its exchange rate remaining close to the $1 peg. In early 2023, due to the impact of government policies of various countries and the ever-changing market condition, several stablecoins, such as USDC, DAI, and BUSD, experienced depegging. Although the Liquity smart contract is no longer updated after its launch, its growing list of partners and ecosystem has triggered public attention to the importance of decentralized stablecoins in mitigating risk.

How Liquity Works

To summarize, the issuance of any collateralized stablecoin involves the following core concepts:

1. Collateralization

2. Minting

3. Redemption

4. Liquidation

5. Arbitrage

Stablecoins without collateral reserves may lose their redemption ability due to insolvency. The redemption mechanism can control the circulating currency supply to cause inflation and deflation, thus helping stabilize the exchange rate. Liquidation is meant to avoid the over-issuance of stablecoins caused by bad debts in the system. Arbitrage is crucial to maintaining a stable exchange rate between stablecoins and fiat currencies, allowing arbitrageurs to trade based on market mechanisms and economic incentives, thereby maintaining a fixed exchange rate between stablecoins and fiat currencies. The Liquity protocol has unique designs in various aspects to achieve interest-free borrowing and a stable exchange rate for LUSD.

Collateralization and Minting

Anyone can deposit and lock ETH as collateral in a vault called Trove to mint LUSD up to 90.91% of the USD value of the collateral.

In other words, the Trove must always maintain a minimum collateral ratio (MCR) of 110%, meaning the ratio of the collateral value to the LUSD debt must be above 110%.

The value of the collateral exceeds the LUSD debt in order to ensure the redeemability of LUSD. Users can borrow more LUSD at any time when the collateral ratio is above 110%, and if the collateralization ratio drops to near 110%, more collateral must be provided to mint more LUSD.

Liquity’s smart contract limits the minimum debt for creating a Trove to 2,000 LUSD, and when repaying, the debt must be settled below 2,000 LUSD to avoid low-collateral debts affecting the overall collateral ratio of the protocol.

To borrow from the Liquity protocol, borrowers are charged a one-off borrowing fee without paying interest. As long as there is a sufficient collateral ratio, users can borrow indefinitely. The borrowing fee is variable according to the borrowing activity and time of all users and will gradually decrease when there are no borrowers for a long time. The borrowing fee ranges from 0.5% to 5%.

Redemption

Liquity allows users with collateral held in their Troves to pay off their LUSD debts and redeem an equivalent value of ETH collateral. One LUSD can be redeemed for 1$ worth of ETH collateral.

A fully redeemed Trove means the debt has been paid off and will automatically close. The Liquity protocol does not allow any Trove to be left with a non-zero debt below 2,000 LUSD. It charges a one-off ETH fee for redemption, with the redemption fee rate dynamically adjusted based on the redemption frequency of all users. If there is no redemption for a long time, the fee rate will gradually decrease (the base rate is 0.5%).

The smart contract will first use the redeemed LUSD to repay the Trove with the lowest collateral ratio, which has the highest risk, and transfer the corresponding amount of ETH to the redeemer. Therefore, the redemption activity can increase the overall collateral ratio of the protocol and reduce systemic risk.

Image: Liquity whitepaper

Liquidation

To ensure that the circulating LUSD has sufficient collateral reserves, Troves whose collateral ratio falls below 110% will be liquidated and closed. When liquidation occurs, anyone can take ownership of the ETH collateral by repaying the LUSD debt on behalf of the borrower. There are three liquidation mechanisms in order of priority.

1. User-assisted liquidation

Liquidators provide LUSD liquidity into the Liquity protocol to get ETH collateral and receive a gas compensation (200 LUSD + 0.5% of the Trove’s ETH collateral) as a reward for this service.

1. Stability Pool liquidation

LUSD holders can deposit LUSD into Liquity’s Stability Pool to earn revenues (minting fees + liquidation fees). When there are no liquidators in the market to provide immediate liquidation services, the Stability Pool deposits will absorb LUSD debts and get ETH collateral. As ETH is over-collateralized, depositors in the Stability Pool can earn the difference from discounted ETH during liquidation. Additionally, depositors in the Stability Pool can earn LQTY tokens as rewards.

Technically, the deposited LUSD can be withdrawn from the Stability Pool at any time, but the deposit and withdrawal functions will be temporarily suspended when there are Troves that need liquidating in the system to ensure the debts are repaid smoothly.

In the following charts, let’s take the debt (the red bar) and collateral (the blue bar) to be liquidated as an example. If there is only $10,900 worth of ETH collateral and 10,000 LUSD debt in this Trove, the Stability Pool will destroy 10,000 LUSD to absorb the debt and obtain a value of $10,900 worth of ETH.

Source: Liquity whitepaper

1. The redistribution of undercollateralized Troves

The LUSD deposits in the Stability Pool may not be sufficient to offset all undercollateralized Troves, or the LUSD deposits may be depleted during the Stability Pool liquidation process, resulting in partial absorption of Troves’ debts.

In this case, the system will redistribute the remaining debts and collateral from the partially liquidated Trove as well as the remaining undercollateralized Troves to all existing positions. The redistribution of the collateral and debt is done in proportion to the recipient Trove’s collateral amount, with Troves having higher collateral ratios receiving more debt and collateral. This ensures that the system does not experience cascading liquidations.

Taking the following table as an example. If Trove D’s collateral ratio is insufficient and it must be liquidated, its debts will be redistributed to Troves A, B, and C in proportion to their collateral ratios.

After redistribution, the debt increase each Trove gets is:

A = 8,000 * 1.5 / (1.5 + 4 + 7) = 960 (LUSD)

B = 8,000 * 4 / (1.5 + 4 + 7) = 2,560 (LUSD)

C = 8,000 * 7 / (1.5 + 4 + 7) = 4,480 (LUSD)

After redistribution, the collateral increase each Trove gets is:

A = 4.3 * 1.5 / (1.5 + 4 + 7) = 0.52 (ETH)

B = 4.3 * 4 / (1.5 + 4 + 7) = 1.38 (ETH)

C = 4.3 * 7 / (1.5 + 4 + 7) = 2.41 (ETH)

Users of Trove D still keep all the LUSD they borrowed, but they still suffer an overall loss of about 10% due to the loss of ETH collateral.

It is important to note that debt redistribution will not increase the overall collateral ratio of the Liquity protocol, but will reduce the individual collateral ratio of other borrowing Troves, making it riskier for other users to be liquidated. When there is insufficient LUSD liquidity, everyone has to bear the risk of an individual’s bad debt. In this way, users are encouraged to repay proactively.

Recovery Mode

In extreme scenarios (for example, the price of the collateral collapses, there are no sufficient liquidators in the market, the Stability Pool is depleted, and continuous debt redistribution occurs), the Liquity protocol may still be undercollateralized, resulting in no reserves to back the circulating LUSD.

Assuming that a large number of Troves are closed due to debt redistribution and there is only one Trove with outstanding LUSD debt and ETH collateral. If the price of ETH continues to fall, the value of the collateral will be less than the LUSD debt, then the borrower will never repay the debt.

Considering these special scenarios, Liquity incorporates an early liquidation mechanism called Recovery Mode. When the total collateral ratio (TCR) falls below 150%, the Recovery Mode will be triggered to liquidate Troves with lower collateral ratios until the TCR is above 150%.

Different collateral ratios will cause different results as follows:

1. Trove’s collateral ratio < 100%: The Stability Pool is depleted; debt redistribution occurs.

2. 100% < Trove’s collateral ratio < 110%: Automatic liquidation.

3. 110% < Trove’s collateral ratio < TCR < 150%: Recovery Mode is triggered by early liquidation.

4. 150% < Trove’s collateral ratio: No liquidation possible.

The TCR depends on the total debt and collateral value of all users in the Liquity protocol. If other users’ debt increases but no more collateral is provided, the TCR will decrease, exposing all borrowers to the risk of early liquidation. Through this mechanism, unnecessary high-leverage borrowing is discouraged, thereby maintaining the solvency of Liquity.

Arbitrage

Liquity allows borrowers to redeem $1 worth of ETH collateral for 1 LUSD. When the price of LUSD falls below $1, borrowers (or liquidators) can engage in arbitrage directly.

For example, if the current price of LUSD is $0.8, repaying 1 LUSD loan will yield $1 worth of ETH, so you can get 1.25 LUSD for every LUSD you pay. Users will be strongly incentivized to repay LUSD loans → sell ETH → sell USD → buy LUSD.

This way, the circulating LUSD will be burned, causing a value appreciation pressure and pushing the price of LUSD back to its $1 peg, which is the hard price floor for LUSD.

Conversely, when the price of LUSD rises above $1.1, borrowers can also engage in arbitrage directly.

For example, if the current price of LUSD is $1.25, then for every $1.1 worth of ETH collateralized, you can get 1 LUSD loan. In other words, you can get 1.25 USD for paying 1.1 USD. Users will be strongly incentivized to sell USD → buy ETH → borrow → sell LUSD → buy USD.

This will increase the amount of circulating LUSD and create inflationary pressure, pushing the price of LUSD back to its $1 peg, which is the hard price ceiling for LUSD.

Image: Liquity blog

Advantages of Liquity

Compared with other collateralized stablecoin projects, Liquity has made many improvements in user experience and system security.

0% interest rate

Liquity only charges a one-off borrowing/redemption fee. Borrowers do not need to pay any interest.

110% collateral ratio and high leverage

Liquity’s efficient liquidation mechanism effectively lowers the collateral ratio threshold, allowing users to obtain more LUSD liquidity from the same value of ETH. Through several rounds of borrowing, it is possible to achieve leverage of up to 11x, while lending protocols that require collateral ratios above 150% can only achieve 3x leverage.

Censorship resistance and decentralization

LUSD is automatically issued through smart contracts, with no community administrators available. Even the development team has no right to modify the protocol. Numerous frontend operators can effectively resist the risk of censorship and help build a truly decentralized stablecoin.

Fully collateralized and directly redeemable

LUSD has sufficient reserves to be exchanged for the underlying ETH collateral of equal value at any time.

Fast liquidation

LUSD can be quickly used to settle Trove debts without going through the collateral auction process.

Adequate liquidity and low price fluctuations

Most lending protocols passively wait for liquidators to provide liquidity to repay debts. When there is insufficient liquidity or no liquidators willing to provide services, it will have a serious impact on the price of the collateral.

The Liquity Stability Pool has liquidity of its own, with LUSD depositors serving as the ultimate liquidity providers, which reduces the impact of liquidation on collateral prices.

Risk mitigation

Debt redistribution can avoid escalation of the impact of bad debts, and encourage users to repay to provide the necessary liquidity for the Liquity protocol. The Recovery Mode liquidates high-risk loans in advance to avoid a collapse of the protocol due to insolvency.

High-level stablecoin returns

In the volatile cryptocurrency market, liquidation is actually a very profitable activity. However, setting up liquidation robots on the blockchain requires high technical expertise and may even result in gas fee losses due to competition between various robots.

Statistics show that the average annual percentage yield (APY) of the LUSD Stability Pool has been as high as 32% since its launch, and even during the bear market, it generated a minimum yield of 3%. Its interest-free loans provide users with more earnings than most other borrowing platforms.

Limitations of Liquity

Borrowing threshold of 2,000 LUSD

The Liquity protocol uses the total collateral ratio (TCR) to decide whether to trigger the Recovery Mode to liquidate Troves with an insufficient collateral ratio in advance. Therefore, hackers can use a large number of small loans with low collateral ratios to launch dust attacks, and use the Recovery Mode to liquidate the large loans of other users for profit.

The Liquity Protocol set a minimum borrowing threshold of 2,000 LUSD, but this also poses limitations to the use of small loans.

Immutable smart contracts

The fact that the project team cannot modify smart contracts provides benefits and limitations to the protocol. Though this helps achieve decentralization and resistance to censorship, it also makes it impossible for LUSD to have any upgrades. To iterate, the team needs to create a new smart contract (LUSD V.2 version) and migrate the existing users.

Oracle vulnerabilities

In September 2022, when Ethereum executed The Merge, the Liquity team discovered a code problem with the pricing oracle. The Liquity protocol mainly uses Chainlink’s oracle for pricing, and only uses Tellor’s oracle when the Chainlink oracle fails. However, the fallback oracle Tellor detected a bug that may provide incorrect information, which was exploited by hackers to mint billions of LUSD tokens on the ETHW fork.

As the LUSD code cannot be updated, the team had to improve the pricing system of the Tellor oracle to prevent such issues. At present, no users have suffered substantial losses on the Ethereum blockchain due to the oracle vulnerability.

No governance mechanism

Liquity does not have a governance mechanism, which eliminates the industry’s doubts about human manipulation. But on the other hand, its potential for long-term development in the future is also limited.

LUSD long-term premium

Having undergone frequent volatility in the cryptocurrency market since its launch, LUSD was traded below $1 only a few times. As governments around the world announced their regulatory requirements on centralized stablecoins, the demand for the fully decentralized stablecoin LUSD has increased. Currently, a “resilience” premium of 0.3-3% is required to purchase LUSD.

Only supports ETH as collateral

The smart contract of LUSD cannot be upgraded. Currently, only ETH can be used as collateral since its launch, which makes it not as flexible as other lending protocols.

LQTY Token & Liquity Ecosystem

The LQTY token is the second token issued by the Liquity protocol, which can be used to earn fee revenue from the borrowing system and incentivize early adopters and frontend operators.

LQTY rewards are distributed to users and institutions that provide LUSD liquidity, including those who deposit LUSD into the Stability Pool, frontend operators who offer LUSD deposits, and liquidity providers of the LUSD/ETH Uniswap pool.

The maximum supply of the LQTY token is 100 million. Since the Liquity protocol has no governance, LQTY is not a governance token.

Users who stake LQTY can earn a portion of the fees generated from issuing loans and redeeming LUSD from the borrowing protocol. LQTY liquidity rewards are halved annually. Currently, most LQTY tokens have been put in circulation.

The genesis allocation of LQTY is as follows:

• 35.3% to the Liquity community
• 23.7% to team and advisors
• 33.9% to investors
• 6.1% to Liquity AG Endowment
• 1% to service providers

Image: Liquidity blog

Compared to most other stablecoins, LUSD’s market share is still relatively low. However, as of the time of writing, there are 17 different frontend operators that enable smoother use of the LUSD stablecoin, allowing LUSD to effectively resist censorship. Currently, there are over 10,000 individual wallet addresses holding LUSD.

In May 2022, LUSD successfully integrated with the payment service provider Mover, allowing residents of the 28 countries of the European Union and the UK, Norway, and Iceland to connect their non-custodial wallets (such as MetaMask, Coinbase Wallet, or any other wallets through WalletConnect) to the Mover web app and make electronic payments directly with LUSD.

Users applying for a Mover card need to go through a KYC process. Ordering the card costs €9, with an annual management fee of €15.

Currently, LUSD focuses on the development of liquidity yield strategies and cross-chain applications. Chicken Bond is a yield-generating protocol built on Liquity, allowing LUSD holders to purchase bonds or BLUSD tokens and earn higher returns than the Stability Pool. Chicken Bond has multiple automated sources of revenue, including Curve’s $LUSD liquidity pool. However, it should be noted that Chicken Bond is a premium financial derivative, and under certain conditions, the interest income may not offset premium losses.

Recently, the project team announced a plan to integrate with the Aztec Network and Optimism, as well as multiple DeFi projects, including PowerPool, GearBox, and Sonne Finance. Notably, LiquiFrens serves as Liquity’s bold attempt to address the problem of lacking community governance in Liquity, striving to promote the growth of users, liquidity, lending amount, and LUSD/LQTY trading through token rewards.

Conclusion

Liquity is a decentralized borrowing protocol built on Ethereum, allowing users to deposit their ETH as collateral into a Trove and borrow interest-free LUSD, a stablecoin pegged to the US dollar. Users can deposit LUSD into Liquity’s Stability Pool to earn income.

As long as the collateral ratio stays above 110%, users can borrow LUSD indefinitely, making it an excellent solution for users with long-term borrowing needs.

The high degree of decentralization and the existence of numerous frontend operators are two of Liquity’s advantages. Its stable reserves and liquidation mechanism have proven the effectiveness of Liquity’s smart contract code. When facing the severe situation of stablecoin collapses and regulatory challenges, LUSD stands out and catches much more attention from the market.

However, Liquidity will never be upgraded and lacks community governance, which has largely limited its development. The development team is currently working on a solution to get a tradeoff between full decentralization and human intervention, with the aim of further expanding Liquity’s applications and unlocking greater growth opportunities.