A Deep Dive into Liquity Protocol

Forward the Original Title ‘Liquity 探索：去中心化借贷协议的革新与机遇’

1. Project Introduction

Liquity is a decentralized lending protocol that allows users to borrow a stablecoin called LUSD (pegged to the US dollar) using Ethereum as collateral. It also introduces a fully redeemable stablecoin, LQTY. The protocol, designed by Robert Lauko, aims to offer a more capital efficient and lower risk alternative to existing systems like MakerDAO.

Unlike traditional systems that require substantial over-collateralization to issue stablecoins, Liquity can instantly liquidate risky loans and employs a unique redemption mechanism, minimizing management requirements and thus lowering collateral demands.

For borrowers seeking an efficient way to utilize their Ethereum assets, this makes it an attractive choice. The protocol allows using ETH as collateral to borrow LUSD (a stablecoin always pegged to the USD), with a three-tiered liquidation mechanism of stability pool - debt redistribution - recovery. Liquity only requires a minimum collateral rate of 110%, greatly enhancing capital utilization, while maintaining good stability of the protocol.

The main use cases of Liquity are as follows:

• Open trove: Borrow LUSD against ETH with a minimum collateral rate of 110%.
• Provide LUSD to the stability pool (SP) to earn liquidation profits and LQTY, the native incentive token of Liquity.
• Stake LQTY to earn fees paid by other users when borrowing or redeeming LUSD.
• Use LUSD to redeem ETH.

2. Core Mechanism

The Liquity protocol, through its unique design, provides an innovative stablecoin solution in the decentralized finance (DeFi) sector. Three key mechanisms — price stability mechanism, liquidation mechanism, and supply control mechanism — work together to maintain the system’s stability and efficiency.

Price Stability Mechanism

The price stability mechanism of Liquity aims to maintain the value of its stablecoin, LUSD, pegged 1:1 with the US dollar (USD). The core of this mechanism allows users to mint LUSD at any time at a price of 1 USD by collateralizing ETH, or redeem ETH at a price of 1 USD using LUSD. This mechanism creates a hard price peg, i.e., when the LUSD price is higher than 1 USD, users are incentivized to mint and sell LUSD for profit; when the LUSD price is less than 1 USD, users have the motive to buy LUSD and use it to repay debt, or to redeem it to get ETH. This two-way price adjustment mechanism forms a strong price stability feedback loop.

In fact, this stabilization mechanism is very effective. The figure below shows the LUSD/USDc price calculated based on Curve’s LUSD/3pool (Curve’s LUSD/3pool is currently the exchange with the largest liquidity of LUSD).

The price fluctuation of LUSD has remained between 0.97~1.03, and most of the time is between 0.99~1.02, which demonstrates the stability of LUSD.

Liquidation Mechanism

Liquity’s liquidation mechanism is designed to protect the system from the threat of excessive debt, ensuring debt repayment. When a borrower’s collateral rate falls below the minimum (110%), their position will be deemed over-indebted and trigger liquidation. Liquity adopts a unique instant liquidation process, which does not require traditional auctions. Initially, if there are sufficient funds in the stability pool (the pool provided by users with LUSD), these funds will be used to repay the debt, and the associated ETH collateral will be distributed proportionally to the participants in the stability pool. If the stability pool’s funds are insufficient to cover the debt, the system will redistribute the unpaid debt to other borrowers through a debt redistribution mechanism. This mechanism ensures the robustness of the system while reducing the need for on-chain auctions, decreasing the complexity and uncertainty of the liquidation process.

The stability pool is a core factor in Liquity’s 110% collateral rate and guarantee of stability. As stated in the project’s whitepaper: “Since the buyer agrees in advance, there’s no need to find a buyer to purchase collateral on the spot when the collateral position is insufficient. This advantage significantly reduces the collateral rate while maintaining high stability.”

Supply Control Mechanism

Liquity’s supply control mechanism aims to regulate the total supply of LUSD to maintain its price stability. This is mainly achieved by adjusting the minting fee and redemption fee, both of which are dynamically adjusted based on market conditions and the frequency of redemption activities. When redemption activity increases, the redemption fee will rise, making the redemption of LUSD less attractive, and vice versa. The minting fee is likewise adjusted based on redemption activity, aimed at encouraging or suppressing the minting of new LUSD to regulate market supply. In this way, Liquity attempts to balance the supply and demand of LUSD without a regular interest mechanism, through fee adjustments.

3. LQTY

LQTY is Liquity’s stablecoin, minted when borrowers deposit collateral, possibly in amounts much lower than required by other systems. This efficiency is due to Liquity’s innovative liquidation process and redemption mechanism, ensuring a price floor for LQTY, thereby promoting stability without governance intervention. The system aims to automatically handle liquidation through the stability pool, where LQTY tokens can be burned to clear debt, and under-collateralized loans are automatically redistributed among borrowers. This process not only aims to maintain system stability but also sets a lower collateralization threshold compared to competitors.

The following are the main features of LQTY and their impact on users and the entire Liquity system:

Distribution and Rewards

LQTY has a total supply of 100 million tokens, which are mainly distributed to users participating in the Liquity protocol in various ways. A prominent method of distribution is through stability pool rewards. Users deposit LUSD into the stability pool to assist the protocol in managing the liquidation process, and in return, they receive LQTY tokens. Additionally, users providing ETH/LUSD liquidity to Liquity can also earn LQTY rewards.

Value Capture Mechanism

LQTY’s value derives from its ability to capture a portion of the income from the Liquity protocol. When users open a lending position or execute a redemption operation with LUSD, they need to pay a certain fee, a portion of which is distributed to LQTY holders. This means that LQTY token holders can directly benefit from the operation of the protocol.

Risk and Rewards

One of the main risks faced by LQTY holders is market value fluctuation. The market price of LQTY is influenced by several factors, including protocol usage, ETH price, and overall DeFi market trends. However, by participating in protocol governance, the stability pool, and providing liquidity, users can actively influence the value of LQTY.

Governance Function

Although LQTY itself does not have direct governance rights, it is a key component of the Liquity protocol ecosystem and represents recognition of contributions to the protocol. The holding and distribution of LQTY reflect the degree of user contribution to the stability and liquidity of the protocol.

4. Business

Track:

Liquity falls under the Stablecoin - Decentralized Stablecoin track.

Stablecoins have the most network effect within the DeFi sector, and they’ve seen above-average growth in the last cycle.

Due to the convenience of settlement and its familiarity to the general public, stablecoins have replaced BTC/ETH as the base currency for spot trading, derivative products like perpetual contracts that are popular in the market, and the settlement currency for most project financing activities by project sides and venture capital institutions. This is reflected in the data, where the growth rate of stablecoin market cap exceeds the average growth rate of the crypto market, and its pullback amplitude is also smaller than the market average.

The positioning of stablecoins as the basic settlement currency of cryptocurrencies is already very solid in the minds of all market participants. Its market scale will at least develop in sync with the overall scale of cryptocurrencies, still having a huge development space.

Business products:

Below are the important events of the Liquity project since its creation, up to March 2023.

Chicken Bonds

The Chicken Bonds launched by Liquity is a scheme designed to incentivize Protocol Owned Liquidity (POL). The first product module is the Chicken Bonds for LUSD. The aim of Chicken Bonds is to help the protocol guide liquidity at the lowest possible cost while providing users with more robust capital protection.

The mechanism of Chicken Bonds is quite complicated and ingenious. Simply put, in Chicken Bonds, the LUSD is nominally divided into three pools (pending, reserve, permanent), but only the LUSD in one of the pools can enjoy the full benefits of all three pools (reserve). $blusd is used to represent a user’s share in this exclusive benefit pool.

Core Concept

bLUSD (Boosted LUSD): Through participation in the Chicken Bonds mechanism, users can obtain an enhanced version of LUSD, which has a value and potential income exceeding regular LUSD. bLUSD can represent a user’s share in the Chicken Bonds mechanism and can be redeemed back into LUSD at any time.

LUSD Bond NFT: When users purchase bonds using LUSD, they receive a non-fungible token (NFT) that represents their debt rights within the Chicken Bonds mechanism. This NFT can be exchanged for bLUSD according to a predetermined time-income curve.

Mechanism Workflow

Investment and Returns: After users purchase bonds using LUSD, these funds first enter the “Pending Bucket” and are then deposited into the Stability Pool via B.Protocol, earning LQTY rewards and ETH liquidation income. These rewards are automatically converted back into LUSD to achieve a compounding effect.

Options: Users holding an LUSD Bond NFT can choose to receive bLUSD (Chicken in) or cancel the bond (Chicken Out). The amount of bLUSD received increases over time, but at a gradually slowing rate. Users can pay a certain percentage fee to receive bLUSD early, but doing so will cause a portion of the LUSD to enter the “Permanent Bucket,” becoming owned by the protocol.

Liquidity and Revenue Distribution: The value and returns of bLUSD mainly come from the returns generated by all LUSD in the three pools (Pending, Reserve, Permanent). These returns are all distributed to the bLUSD holders within the Reserve Pool. Therefore, the yield rate of bLUSD is higher than simply depositing LUSD into the Stability Pool.

Competitive Advantages and Disadvantages

Advantages: Chicken Bonds provide an effective mechanism to incentivize POL, while providing users with earning potential that exceeds that of ordinary LUSD, increasing the appeal of the Liquity protocol.

Disadvantages: Since Chicken Bonds’ income mainly relies on the participation of new users, there is a certain degree of “Ponzi structure” characteristics, and its sustainability and stability may be challenged. In addition, most participants are at a loss after participating in Chicken Bonds, which may affect their long-term willingness to participate and the healthy development of the protocol.

In general, Chicken Bonds is an innovative mechanism designed by the Liquity protocol to incentivize the liquidity owned by the protocol and increase user participation. By providing earning potential that exceeds traditional LUSD, attracting users to participate and lock funds, it increases the stability and attractiveness of the Liquity protocol. However, its sustainability and impact on early adopters needs to be observed and evaluated over time.

5. Team/Collaboration/Financing

Team

Robert Lauko, founder and CEO, graduated from the University of Zurich with a doctorate in law and has many years of legal and lawyer experience. Before founding Liquity, he was an assistant researcher at Dfinity.

Rick Pardoe, co-founder and core developer, has a bachelor’s degree in physics and a master’s degree in economics. He started to develop in the blockchain field in 2017 and created the website ethdevs.com.

Kolten Bergeron, Head of Growth and former Ecosystem and Community Development Manager at Stellar Development Foundation. According to LinkedIn, there are currently 10 team members, most of whom are developers.

Advisor

Ashleigh Schap, who is also currently the head of growth at Uniswap, previously worked at MakerDAO.

Yulin Liu, a PhD in economics from the University of Zurich, was previously an economist at Dfinity and is currently an associate professor of economics at Huazhong University of Science and Technology. Dr. Liu has co-published numerous academic papers on cryptocurrency. Conducted the initial macroeconomic model simulation for Liquity, providing a basis for LUSD to maintain stability under ETH fluctuations.

Cedric Waldburger, who was Liquity’s original investor.

Investor

The pre-seed round was invested by Tomahawk.VC, where Cedric Waldburger is located, and the specific financing amount and financing time were not disclosed.

In September 2020, it completed a $2.4 million seed round led by Polychain Capital, with participation from a.capital, Lemniscap, 1kx, Dfinity Ecosystem Fund, Robot Ventures, Robert Leshner (Founder of Compound), and Alex Pack .

In March 2021, a Series A funding round worth $6 million was completed, led by Pantera Capital. Other investors included Nima Capital, Alameda Research, Greenfield One, IOSG Ventures, and AngelDAO, as well as angel investors Bo Shen, Meltem Demirors, David Hoffman, Calvin Liu, and George Lambeth. Previous investors such as Tomahawk.VC, 1kx, and Lemniscap also made additional investments.

6. Project Advantages/Disadvantages

Liquity is currently the leader in fully decentralized stablecoins, but in fact, LUSD’s competitors are not only fully decentralized stablecoins, but also “partially decentralized” stablecoins like DAI and FRAX, and centralized stablecoins like USDT, USDC, etc. Of course, the ones that directly compete with LUSD are decentralized stablecoins.

Liquity’s competitive advantages in the stablecoin market can be summarized as follows:

1. Fully Decentralization: As a completely decentralized stablecoin protocol, Liquity’s decentralized nature is one of its most significant competitive advantages. This makes LUSD immune to single points of failure or regulatory risks, providing greater security and censorship resistance. Especially in the context of increasing regulatory pressure on stablecoins, Liquity’s completely decentralized features are even more precious.

2. Excellent Mechanism Design: Liquity’s stability pool, debt redistribution, and recovery mode mechanisms are considered very advanced and efficient. These designs not only implement a fast and secure liquidation process, but also provide a natural use case through the stability pool, allowing LUSD to maintain price stability while maintaining high capital efficiency, even without a centralized guarantor.

3. No Governance Required, reducing human intervention: Liquity’s governance-free model means that its protocol parameters and updates are completely controlled by preset algorithms, reducing the risk of human error or manipulation that may occur in the governance process. This design improves the transparency and predictability of the protocol while also ensuring long-term stability and security.

4. Low-cost Lending Services: Liquity provides interest-free borrowing services, and borrowers only need to pay a one-time minting fee and redemption fee. This low-cost design attracts many users looking for efficient capital utilization, especially when the cryptocurrency market is highly volatile, allowing users to flexibly manage their assets.

5. Being Widely Forked: The Liquity protocol has been forked more times than any other stablecoin protocol, which proves the popularity of its mechanism design and the industry’s recognition of its innovation.

6. Experience the Market Test: Liquity has successfully experienced multiple violent fluctuations in the crypto market since its launch, which proves the resilience and effectiveness of its core mechanism. Especially during market declines, Liquity’s liquidation mechanism and price stability have been fully verified.

Of course, compared with other stablecoin projects, Liquity’s own protocol has many innovations, and some features are also controversial, which also brings certain competitive disadvantages to the protocol. Liquity’s competitive disadvantages in the stablecoin market mainly include:

1. Lack of Governance Mechanism Limits Use Case Expansion: Liquity’s lack of governance provides advantages in security and decentralization, but it also limits the protocol’s flexibility and adaptability to new changes. The lack of governance means that Liquity finds it hard to adjust protocol parameters or introduce new features to respond to market changes through governance, which may limit Liquity’s ability to expand use cases and quickly adapt to market needs.

2. Fee Structure: Liquity uses a model of charging a one-time fee at mint and redemption, rather than based on loan interest. This charging model may lead to unstable protocol income, and as the circulation of LUSD increases, it cannot continuously profit from the increased stablecoin scale, leading to a mismatch between risk and return.

3. Lack of Future Incentives: The main incentive for LQTY tokens is used for the stability pool, but as time goes by, the number of LQTYs reserved for stability pool incentives will decrease. In the future, Liquity faces the challenge of insufficient incentives, which may affect its ability to attract and retain users.

4. The Governance and Product Innovation Capabilities of Competitors: Compared to other stablecoin projects, such as MakerDAO and Frax Finance, Liquity’s lack of a governance mode may be at a disadvantage in terms of governance and product innovation. These competitors can adjust protocol parameters and introduce new products more flexibly through their governance model to respond to market changes and user needs.

5. Ability to Adapt to External Changes: Due to the lack of a governance model, Liquity may find it difficult to quickly adapt to changes in the external environment, such as changes in ETH’s collateral mechanism, which may limit its long-term competitiveness and the growth of its market share.

7. Conclusion

As a decentralized stablecoin issuance platform, the Liquity project demonstrates its unique innovation and market potential. By offering interest-free lending services collateralized by Ethereum, and introducing a series of innovative mechanisms such as the Stability Pool, debt redistribution, and recovery mode, Liquity not only optimizes capital efficiency, but also enhances the stability and security of the system.

Despite this, Liquity faces challenges posed by its no-governance model, a specific fee structure, and the potential lack of future incentives. These are critical aspects that the project needs to continuously monitor and address. To maintain a competitive edge and achieve long-term development, Liquity needs to further optimize its products and mechanisms, strengthen collaborations within and outside the industry, and consistently explore and respond to market changes.

In summary, with its decentralized features and innovative mechanisms, Liquity has established a strong competitive position in the stablecoin market. Looking forward, Liquity is expected to expand its business scope and market influence through its team’s professional capabilities, continuous technological innovation, and adjustments in its market strategy, bringing more value and possibilities to the cryptocurrency and decentralized finance sectors.

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