Decentralized Reserve Stablecoins: A Historical Development and Model Analysis

At the end of July, Liquity, a leader in decentralized stablecoins, announced that its version 2 would introduce the risk-neutral “Delta Neutral Stablecoins.” Additionally, the newly financed Ethena Finance is also planning to hedge its reserve assets to achieve high capital efficiency in a decentralized manner. This article will provide an in-depth understanding of these stablecoin protocols that attempt to solve the impossible trinity.

The “Impossible Triangle” in the Cryptocurrency Stablecoin Domain

Illustration by: Mint Ventures

In the field of cryptocurrency stablecoins, there’s a persistent “impossible triangle,” meaning it’s challenging to simultaneously achieve price stability, decentralization, and capital efficiency.

Centralized stablecoins like USDT and USDC boast the best price stability and up to 100% capital efficiency on the blockchain. However, the centralization of these tokens poses inherent risks, as evidenced by the stoppage of BUSD’s new business due to regulatory impacts and the effects of the March 2023 SVB incident on USDC.

The surge in algorithmic stablecoins, which began in the second half of 2020, attempted to implement under-collateralization on a decentralized basis. Projects like Empty Set Dollar and Basis Cash quickly collapsed. Following this, Luna used the credit of its entire public chain as implicit collateral, not requiring over-collateralization for the minting of UST. This approach maintained a balance of decentralization, capital efficiency, and price stability for a considerable time (from 2020 to May 2022) but ultimately failed due to a credit collapse. Other under-collateralized token projects like Beanstalk emerged but failed to gain significant market attention. The difficulty in maintaining stable value anchors is a critical weakness of this type of token.

Another approach, starting with MakerDAO, involves over-collateralization of underlying decentralized assets, sacrificing some capital efficiency in hopes of achieving price stability. Currently, Liquity’s LUSD is the largest stablecoin fully backed by decentralized assets. However, to ensure the price stability of LUSD, Liquity maintains a relatively low capital efficiency, with the system’s collateralization ratio consistently above 250%. This means that every circulating LUSD is backed by more than 2.5 U.S. dollars’ worth of ETH. Synthetix’s sUSD takes an even more extreme approach, requiring a minimum collateralization ratio often exceeding 500% due to the higher volatility of its collateral, SNX. The lower capital efficiency limits the scalability and appeal of these stablecoins. Liquity aims to address the issue of low capital efficiency in its planned V2 update, while Synthetix plans to introduce other assets as collateral in its upcoming V3 update to reduce the minimum collateralization ratio.

Early versions of DAI (pre-2020) also suffered from low capital efficiency. Additionally, the high volatility of DAI’s collateral, ETH, led to significant price fluctuations. To address this, MakerDAO introduced a Price Stability Module (PSM) in 2020, allowing the generation of DAI using centralized stablecoins like USDC. This move partially sacrificed decentralization in favor of more stable price anchoring and higher capital efficiency, aiding DAI’s rapid growth alongside the overall development of DeFi. FRAX, launched at the end of 2020, also primarily uses centralized stablecoins as collateral. Currently, DAI and FRAX are the two largest stablecoins in the decentralized category, indicating the effectiveness of their strategies in meeting user needs, but also highlighting how maintaining decentralization can limit the scale of stablecoins.

However, there are stablecoins striving to achieve high capital efficiency and strong price stability while maintaining decentralization. These tokens aim to offer users stablecoins that:

• Are generated from decentralized assets (like ETH) to avoid censorship risks.
• Can be minted with one dollar’s worth of assets for one dollar of stablecoin without the need for over-collateralization, facilitating scalability.
• Maintain stablecoin value stability.

Ideally, this represents the most intuitively perfect type of decentralized stablecoin. We use the term “decentralized reserve protocol,” as named in Liquity V2, for this kind of stablecoin. It’s important to note that unlike traditional over-collateralized stablecoins, the assets used to generate these stablecoins become the property of the protocol and are no longer associated with the user. In other words, it’s more akin to an ETH-to-stablecoin swap operation. This type of stablecoin resembles centralized ones like USDT, where one dollar’s worth of assets can be exchanged for one dollar of stablecoin and vice versa. The difference lies in the fact that decentralized reserve protocols accept cryptocurrency assets.

Some might argue that since the collateral no longer belongs to the user, such stablecoins lack a leveraging function, potentially losing a major use case. However, stablecoins in our everyday lives, including centralized ones like USDT and USDC, do not offer leverage capabilities. Their core functions are as settlement tools, units of account, and stores of value. Leverage is a special feature of Collateralized Debt Position (CDP) type stablecoins, not a general use case for stablecoins.

The reason past stablecoin protocols have struggled to continuously provide such stablecoins is due to a seemingly simple but difficult problem to solve: cryptocurrency asset prices are highly volatile, so how can they guarantee redemption of the issued stablecoins with a 100% collateralization rate? From the perspective of the stablecoin protocol’s balance sheet, the user’s deposited collateral is an asset, and the issued stablecoins are liabilities. How can they ensure that assets always equal or exceed liabilities?

For example, if a user mints 2000 stablecoins by sending 1 ETH to the protocol when ETH is valued at 2000 U.S. dollars, how can the protocol guarantee that these 2000 stablecoins can be exchanged for assets worth 2000 U.S. dollars when ETH’s price drops to 1000 U.S. dollars?

In the development history of decentralized reserve protocols, there have been mainly two schools of thought to address this issue: using governance tokens as reserves and hedging the risk of reserve assets. Based on the method of risk hedging, these are further categorized into protocols where the protocol itself hedges the risk and those where the users hedge the risk. Let’s explore these approaches one by one.

Illustration by: Mint Ventures

Decentralized Reserve Protocol with Governance Tokens as Reserves

The first type of protocol involves using the governance tokens of the protocol itself as the “new collateral.” When the price of collateral assets plummets, the protocol mints more governance tokens to redeem stablecoins held by users. This can be referred to as a decentralized reserve protocol with governance tokens as reserves. In the example mentioned, when ETH drops from 2000U to 1000U, the decentralized reserve protocol using governance tokens employs ETH valued at 1000U and governance tokens valued at 1000U to redeem 2000 stablecoins held by users.

Protocols adopting this approach include Celo and Fei Protocol.

Celo

Launched in 2020, Celo is a stablecoin project. Previously operating as an independent Layer 1, Celo transitioned to the Ethereum ecosystem in July of this year following a proposal by its core team. The mechanism of Celo’s stablecoin is as follows:

Celo’s stablecoin is backed by a reserve pool consisting of a mix of assets. The reserve ratio (value of reserve assets divided by the value of circulating stablecoins) is well above 1, providing a fundamental floor to the intrinsic value of its stablecoins.

Unlike stablecoins created through over-collateralization, Celo’s stablecoins are obtained by sending Celo tokens to the official stability module, Mento. Users sending Celo tokens worth one dollar can receive one dollar’s worth of cUSD or other stablecoins. Conversely, sending one dollar’s worth of cUSD to Mento allows the user to reclaim one dollar’s worth of Celo. Under this mechanism, when the market price of cUSD falls below one dollar, there will be incentives for purchases of cUSD at a lower price to exchange for one dollar’s worth of Celo. Similarly, when cUSD exceeds one dollar, people will mint cUSD with Celo to sell, ensuring cUSD’s price doesn’t deviate too far from its pegged value due to the presence of arbitrageurs.

To ensure the adequacy of the reserve pool funds, three mechanisms will be employed: 1. When the reserve ratio falls below a threshold, Celo produced from block output will be added to the reserve pool to replenish capital; 2. A certain ratio of transfer fees can be collected to supplement capital (currently not in use); 3. A fixed stability fee is charged in the Mento trading module to supplement the reserve capital.

To enhance the security of the reserve funds, the asset portfolio is more diverse, currently including Celo, BTC, ETH, Dai, and the carbon credit token cMCO2. This approach is safer than using only the project token as collateral (similar to the Terra scheme, where Luna is the implicit collateral for its native stablecoin).

It is evident that Celo is somewhat similar to Luna, being an L1 centered around stablecoins. In terms of minting and redemption mechanisms, it also closely resembles Luna/UST. The key difference lies in how, when the entire system enters a potential state of insufficient collateral, Celo initially uses $CELO produced from block output as collateral for the protocol, to guarantee the redemption of its stablecoin cUSD.

Source: https://reserve.mento.org/

Currently, the total collateral in the Celo system amounts to $116 million, with $46 million worth of stablecoins issued, representing an over-collateralization rate of 254%. Despite this, for users who wish to use its stablecoin cUSD, they can always exchange 1U worth of CELO for 1 cUSD, demonstrating an excellent utilization of funds. However, considering the composition of the collateral, half of Celo’s collateral comes from the centralized USDC and the semi-centralized DAI, which means that Celo cannot be considered a fully decentralized stablecoin.

Currently, Celo ranks 16th in the decentralized stablecoin market size (14th if excluding the now Peg-less UST and flexUSD).

Source：https://defillama.com/stablecoins?backing=CRYPTOSTABLES&backing=ALGOSTABLES

Fei

In early 2021, Fei Protocol, which received $19 million in funding from institutions like A16Z and Coinbase, garnered widespread market attention due to its incorporation of the popular algorithmic stablecoin concept. During their initial coin offering in late March, the project attracted 639,000 ETH for minting the FEI stablecoin, resulting in a total of 1.3 billion FEI. This propelled FEI to become the second-largest decentralized stablecoin after DAI, which had a market cap of $3 billion at the time.

However, the demand for FEI was excessively met during its genesis phase, primarily driven by users seeking to acquire Fei Protocol’s governance token, TRIBE. This led to a severe oversupply of FEI, and without any practical use case for the newly launched stablecoin, its value remained below one dollar for an extended period. The market volatility in May further exacerbated the situation, as panic over the price drop prompted users to massively redeem their FEI, leading to a prolonged slump for the protocol.

Towards the end of 2021, Fei Protocol launched its Version 2, introducing several measures aimed at realigning the protocol’s trajectory. This included changes to its price stabilization mechanism. In V2, FEI could be directly minted using collateral like ETH, DAI, or LUSD at a 100% collateralization rate. Once the stablecoin was minted, the collateral was pooled into the Protocol Controlled Value (PCV). If the collateralization ratio (PCV over circulating FEI) exceeded 100%, indicating a healthy appreciation of the protocol’s assets, additional FEI would be issued to purchase TRIBE, thereby reducing the collateralization ratio. Conversely, if the ratio fell below 100%, implying a potential inability to fully redeem all FEI, TRIBE would be issued to buy FEI, thus boosting the collateralization ratio.

In this mechanism, the governance token TRIBE served as a contingency reserve for FEI, also reaping additional benefits during system growth. This was somewhat similar to the mechanism employed by the Float Protocol, which was launched alongside Fei V1. Unfortunately, the launch of Fei V2 coincided with the peak of the bull market, and following a continual decline in ETH prices, Fei suffered a hacker attack in April 2022, losing 80 million FEI. Ultimately, in August 2022, the development of the protocol was discontinued.

Decentralized reserve protocols using governance tokens as reserves fundamentally rely on diluting the rights of all governance token holders to ensure redemption of the stablecoin. In bull markets, as the scale of the stablecoin increases, the governance token typically rises in value, creating a positive feedback loop. However, during bear markets, the total market value of governance tokens can plummet alongside declining reserve assets. If more governance tokens need to be issued under such circumstances, their value might decrease further, leading to a death spiral. If the market value of the governance tokens falls below a certain ratio to the stablecoin, the protocol’s redemption promise loses credibility, hastening an exodus and spiraling the system into collapse. Surviving bear markets is crucial for such stablecoins. For instance, Celo’s survival in the current bear market is intimately tied to its overall “over-collateralized” state. This was largely due to Celo allocating a significant portion of its reserves to USDC/DAI and BTC/ETH during higher market valuations, allowing the protocol to maintain security even as the price of CELO plummeted from 10 to 0.5.

Decentralized Reserve Protocol for Hedging Reserve Asset Risk (Risk-Neutral Stablecoin Protocol)

The second type of protocol involves hedging the risks of crypto assets on the asset side of the protocol. In the event of a significant price drop in the collateral assets, this hedging generates profits to ensure that the stablecoin protocol’s assets can always cover its liabilities. We refer to this type of protocol as a Decentralized Reserve Protocol for Hedging Reserve Asset Risk, or a Risk-Neutral Stablecoin Protocol. In the example above, after receiving 1 ETH valued at 2000U, the protocol hedges the risk of this 1 ETH (such as opening a short position in an exchange). If ETH falls from 2000U to 1000U, the protocol uses the 1 ETH worth 1000U plus the 1000U profit from hedging to redeem the 2000 stablecoins held by users.

Specifically, depending on the hedging party, this is further divided into decentralized reserve protocols where the protocol itself hedges the risk, and those where users hedge the risk.

Decentralized Reserve Protocol for Hedging Protocol Risks

Stablecoin protocols adopting this approach include Pika Protocol V1, UXD Protocol, and the recently announced fundraising of Ethena.

Pika V1

Pika Protocol, currently deployed on the Optimism network, is a derivatives protocol. In its initial V1 version, Pika planned to launch a stablecoin, with hedging implemented through Bitmex’s Inverse Perpetual Contracts. Inverse Perpetual Contracts, also a Bitmex innovation, differ from the currently more popular “Linear Perpetual Contracts” that track coin prices in U (USD) denomination. Inverse contracts track prices denominated in U using coin denomination. An example of the earnings from an inverse perpetual contract is as follows:

A trader goes long 50,000 contracts of XBTUSD at a price of 10,000. A few days later, the price of the contract increases to 11,000. The trader’s profit will be: 50,000 1 (1/10,000 - 1/11,000) = 0.4545 XBT. If the price had dropped to 9,000 instead, the trader’s loss would be: 50,000 1 (1/10,000 - 1/9,000) = -0.5556 XBT. The loss is greater due to the inverse and non-linear nature of the contract. Conversely, if the trader was short, their profit would be greater if the price decreased than the loss if it increased.

Further analysis reveals that inverse perpetual contracts are a perfect match for decentralized reserve protocols that hedge against reserve asset risks. Take our previous example: suppose when ETH = 2000U, Pika Protocol, upon receiving 1 ETH from a user, uses 1 ETH as margin to short 2000 ETH inverse perpetual contracts on Bitmex. If the ETH price drops to 1000U, Pika Protocol’s earnings = 2000 1 (1/1000 - 1/2000) = 1 ETH = 1000U. This means when ETH’s price drops from 2000U to 1000U, Pika Protocol’s reserve changes from 1 ETH to 2 ETH, still effectively redeeming 2000 stablecoins held by users (excluding trading fees and funding rate costs). The product design of Pika Protocol V1 is exactly the same as the NUSD design mentioned by Bitmex founder Arthur Hayes in his blog, able to perfectly hedge long positions denominated in coins.

Unfortunately, for the majority of crypto investors who use USDT as their base, the inverse and non-linear earnings characteristics of inverse perpetual contracts (the relationship between the rise and fall of the native currency and the contract is not linear) are not easily understood by average users. In subsequent developments, the popularity of inverse perpetual contracts (coin-denominated perpetual contracts) fell far short of linear perpetual contracts (U-denominated perpetual contracts), with trading volumes of inverse contracts in mainstream exchanges being only about 20-25% of linear contracts. BitMex, affected by regulation, has gradually declined from a top-tier contract exchange to a current market share of less than 0.5%. Pika believed linear perpetual contracts could not meet their hedging needs, and with a relatively small market for inverse contracts, they abandoned the stablecoin business in their V2 version and officially transitioned to a derivatives exchange.

UXD

The UXD Protocol is a stablecoin protocol operating on the Solana network, launched in January 2022. In 2021, UXD secured a $3 million funding round led by Multicoin and raised $57 million in an Initial DEX Offering (IDO). In January of this year, UXD decided to branch out to the Ethereum ecosystem, launching on Arbitrum in April and planning subsequent launches on Optimism.

Initially, the UXD Protocol allowed users to deposit SOL, BTC, and ETH at a 1:1 value ratio to mint its stablecoin, UXD. The deposited collateral was hedged through short positions via the Solana-based lending and perpetual contract exchange, Mango Markets. The funds earned from these shorts contributed to the protocol’s income, while the costs were covered by the funds raised by the protocol. For a considerable period post-launch, the UXD Protocol operated smoothly, to the extent that it had to limit the issuance of UXD due to potential risks in its short positions on Mango Markets. However, after Mango Markets suffered a governance attack in October 2022, resulting in a loss of nearly $20 million for UXD, the protocol’s insurance fund balance of over $55 million ensured normal redemption. Although Mango Markets later reimbursed the funds, the incident, combined with the FTX crisis, led to a rapid outflow of capital from Solana, leaving UXD struggling to find suitable exchanges for hedging its long positions. Consequently, UXD now only supports USDC as collateral, which doesn’t require hedging, and allocates these USDC collaterals to various on-chain USDC vaults and Real World Assets (RWA). Following this, UXD expanded into the Ethereum ecosystem with its April launch on Arbitrum and planned launches on Optimism, continuously seeking appropriate on-chain hedging venues.

As of now, UXD has a circulation of $14.3 million and an insurance fund balance of $53.2 million. Source: UXD Dashboard.

source：https://dashboard.uxd.fi/

Furthermore, the recently announced Ethena Finance stablecoin protocol, which raised $6 million with Dragonfly leading the round and participation from centralized exchanges like Bybit, OKX, Deribit, Gemini, Huobi, also plans to use risk hedging for its reserve assets. Ethena’s funders include many second-tier derivative exchanges, which could benefit its collateral hedging. In addition, Ethena intends to collaborate with the decentralized derivatives protocol Synthetix, opening short positions as a liquidity provider and increasing use cases for its stablecoin USDe (allowing USDe as collateral in certain pools).

For decentralized reserve protocols hedging risk, the advantages are evident. By hedging the cryptographic assets of collaterals, these protocols can maintain a risk-neutral position, ensuring stablecoin redemption, ultimately achieving 100% capital efficiency on a decentralized basis (depending on the hedging venues). If the protocols can hedge their positions with high capital efficiency, the reserved collaterals can yield returns in various forms, in addition to the funding rates as protocol income. This flexibility allows the distribution of profits to stablecoin holders, creating yield-bearing stablecoins, or to governance token holders.

In fact, any stablecoin protocol’s governance token implicitly serves as a last-resort lender for its stablecoin. Stablecoin protocols that hedge reserve asset risk can also use their governance tokens as a redemption source in extreme scenarios. For stablecoin holders, this adds an extra layer of security compared to stablecoins backed solely by governance tokens. Moreover, from a mechanism perspective, the logic of hedging reserve asset risk is more coherent and theoretically unaffected by market cycles, eliminating the need to test the governance token’s resilience during bear markets.

However, there are several limitations to development:

• 1. Centralization risks in hedging venues. Currently, centralized exchanges still dominate the liquidity of perpetual contracts, and most decentralized derivatives exchanges are not designed to suit stablecoin protocols for hedging, inevitably leading to centralized risks. These risks can be categorized into two types: one is the inherent risks of centralized exchanges themselves; the other is due to the limited number of hedging venues, where a single venue inevitably occupies a significant proportion of the protocol’s hedging positions. A problem in any one of these venues can have a substantial impact on the protocol. An extreme example of this centralized risk is the UXD Protocol suffering losses and halting operations due to the attack on Mango Markets.
• 1. Limitations in the choice of hedging tools. The current mainstream linear perpetual contracts cannot perfectly hedge their long positions. Taking ETH as an example, what stablecoin protocols need is hedging through ETH-denominated short positions collateralized by ETH. However, the most traded linear perpetual contracts currently require USDT as collateral, and their short selling profit curves are based on USD denomination, which does not perfectly hedge the ETH positions. Even if stablecoin protocols manage to use ETH to obtain USDT through some form of lending, this increases operational costs and the difficulty of managing position risks, while also reducing capital efficiency. As we know from the example of the Pika Protocol, reverse perpetual contracts would be an ideal choice for decentralized reserve protocols trying to hedge the risk of reserve assets, but unfortunately, the market share of reverse perpetual contracts is not large enough.
• 1. Scale growth has inherent self-limitations. The growth in the scale of a protocol’s stablecoins means the need for a persistent and sufficient number of perpetual contract short positions for hedging. Aside from the complexity of obtaining enough short positions, the more short positions the protocol holds, the higher the liquidity requirements for the counterparty during liquidation, and the more likely it is for the funding rate to be negative, implying potentially higher hedging costs and operational difficulty. This might not be a significant issue for stablecoins of a few tens of millions of dollars, but for those looking to scale up to hundreds of millions or even billions of dollars, this issue will noticeably constrain their potential.
• 1. Operational risks. Regardless of the form of hedging, high-frequency operations such as opening positions, adjusting positions, and collateral management are involved. These processes inevitably require human intervention, creating significant operational and even moral hazards.

Decentralized Reserve Protocol for User Risk Hedging

Protocols adopting this approach include Angle Protocol V1 and Liquity V2.

Angle V1

Angle Protocol was launched on the Ethereum network in November 2021, having previously secured $5 million in funding led by a16z. For detailed insights into the design of Angle Protocol V1, readers can refer to earlier reports by Mint Ventures. Here, we provide a brief summary:

Similar to other decentralized reserve protocols, Angle, ideally, supports users in generating its stablecoin, agUSD, using ETH valued at 1U (though the first stablecoin they introduced was the Euro-pegged agEUR, the logic remains the same. For simplicity, we use the U.S. dollar stablecoin in our examples). What sets Angle apart is its target user base, which includes not just traditional stablecoin users but also perpetual contract traders, referred to by Angle as HA (Hedging Agency).

Taking our previous example, when ETH = 2000U, a user sends 1 ETH to Angle and mints 2000 U.S. dollar stablecoins. At this point, Angle opens a leveraged position worth 1 ETH for traders. Let’s assume an HA opens a 5x leveraged position with 0.2 ETH (worth 400U) as collateral. The protocol’s total collateral is then 1.2 ETH, valued at 2400U, while the liability side has 2000U in stablecoins.

When ETH rises to 2200U, the protocol only needs to retain enough ETH to redeem 2000U in stablecoins, i.e., 0.909 ETH. The remaining 0.291 ETH (worth 640U) can be withdrawn by the HA. Conversely, if ETH falls to 1800U, the protocol must retain 1.111 ETH to ensure redemption, reducing the HA’s margin position to 0.089 ETH (worth 160U).

Traders essentially go long on ETH in terms of coin value. When the price of ETH rises, they not only gain from the increase in ETH value but also from the “surplus” ETH in the protocol (in the above example, a 10% increase in ETH price yields a 60% profit for the trader). When ETH price drops, they bear both the decrease in ETH value and the drop in the protocol’s collateral ETH (a 10% ETH price drop results in a 60% loss for the trader). From Angle Protocol’s perspective, traders hedge the risk of collateral price drops, hence the name Hedging Agency. The traders’ leverage depends on the ratio of the protocol’s available hedging position (0.2 ETH in the above example) to the stablecoin position (1 ETH in the above example).

For perpetual contract traders, trading through Angle has certain advantages: 1) They don’t have to pay funding fees (usually paid from longs to shorts in centralized exchanges), and 2) Trade prices are directly executed at oracle prices without slippage. Angle aims to create a win-win situation for both stablecoin holders and perpetual contract traders: stablecoin holders benefit from high capital efficiency and decentralization, while contract traders enjoy a better trading experience. However, this is an ideal scenario. In reality, there may be no traders to open long positions. Angle introduces Standard Liquidity Providers (SLP) to provide additional collateral (stablecoins) for protocol security, automatically earning interest, transaction fees, and governance token $ANGLE rewards.

Unfortunately, Angle’s actual performance has been less than ideal. Despite the substantial $ANGLE rewards for traders, the protocol’s collateral has not been fully hedged most of the time. The main reason, in the author’s opinion, is that Angle failed to offer a product attractive enough for traders. With the decline in $ANGLE token price, the protocol’s Total Value Locked (TVL) also plummeted from 250 million U.S. dollars at launch to around 50 million U.S. dollars.

Angle稳定币的主要抵押物Source- USDC池的对冲率情况

Source：https://analytics.angle.money/core/EUR/USDC

_Source：https://defillama.com/prot_ocol/angle

In March 2023, Angle’s yield-generating reserve assets unfortunately fell victim to a hacking incident involving Euler. Although the hacker ultimately returned the corresponding assets, Angle suffered a significant setback. In May, Angle announced the termination of the aforementioned product, referred to as Angle Protocol V1, and introduced plans for Angle Protocol V2. The new protocol shifts to a traditional over-collateralization model and was launched at the beginning of August.

Liquity V2

Since its launch in March 2021, LUSD issued by Liquity has become the third-largest decentralized stablecoin in the market (behind DAI and FRAX) and the largest fully decentralized stablecoin. We published research reports in July 2021 and April 2023 respectively, discussing the mechanism of Liquity V1 and subsequent product updates and use case expansions. Interested readers can visit our website for more information.

The Liquity team believes that LUSD has achieved a good standard in terms of decentralization and price stability. However, in terms of capital efficiency, Liquity’s performance is relatively average. Since its launch, Liquity’s system collateralization ratio has been around 250%, meaning that each circulating LUSD requires ETH worth 2.5U as collateral.

Source：https://dune.com/liquity/liquity

On July 28, Liquity officially introduced the features of its V2, the core of which, besides supporting LSD as collateral, is to achieve high capital efficiency through delta-neutral hedging across the entire protocol.

Currently, Liquity has not publicly released detailed product documentation. Information about V2 mainly comes from the founder Robert Lauko’s speech at ETHCC, Liquity’s introductory articles, and discussions on Discord. The following content is based on these sources.

In terms of product logic, Liquity V2 is similar to Angle V1, aiming to introduce traders to engage in leveraged trading on Liquity, using their margin as supplementary collateral for the protocol, and hedging the overall protocol risk through these traders. For traders, Liquity offers attractive trading products.

Specifically, Liquity proposes two innovations. First is the so-called “principal-protected leveraged trading.” Liquity offers a leveraged trading product that protects the principal, where users can use this feature after paying a certain premium. This feature allows users to recover a certain amount of U even if ETH falls significantly. For example, when the ETH price is 1000U, and a user pays 12ETH (including 10ETH principal and 2ETH premium), they can get a 2x leveraged long position + downside protection of 10ETH. That is, when the ETH price doubles, the 2x leveraged long position becomes effective, and the user gains a total of 40ETH. If the ETH price falls, the purchased put option becomes effective, and the user can retrieve their original 10,000U (10*1000).

Source：https://www.liquity.org/blog/introducing-liquity-v2

This “principal protection” feature of Liquity’s product is a significant innovation over Angle, resembling a call option. Liquity believes this combination product will be attractive to traders, as the call option allows traders to gain leveraged profits when prices rise and ensure the principal when prices fall. From the protocol’s perspective, the premium paid by users can serve as a safety cushion: when the ETH price falls, Liquity can use this premium as additional collateral for stablecoin payouts; when the price rises, the increased value of the collateral can be shared with the contract traders as profit.

However, this mechanism has a clear issue. When traders want to close their positions and retrieve their ETH, Liquity faces a dilemma. Traders have the right to close their positions at any time, but if they do, the hedged proportion of Liquity’s overall protocol position decreases, weakening the protocol’s security. The same problem has occurred in Angle’s operation, with the system’s hedging rate consistently low and inadequate hedging of the overall protocol position by traders.

To address this, Liquity introduces a second innovation: a secondary market subsidized by the official. In Liquity V2, leveraged trading positions (NFTs) can be sold in the secondary market, in addition to being opened and closed like normal leveraged positions. For Liquity, the concern is traders closing their positions, as this reduces the protocol’s hedging ratio. If other traders are willing to buy these positions from the secondary market at a price higher than their current intrinsic value, it would be beneficial for the original traders, and Liquity can maintain the system’s hedging rate with relatively small subsidies, thereby enhancing the protocol’s security at a lower cost.

Source：https://www.liquity.org/blog/introducing-liquity-v2

For example, suppose Alice opened a position with 10 ETH when the price of ETH was 1000 U.S. dollars, and the premium was 2 ETH. This position corresponds to the value of 10 ETH being long plus principal protection. However, if the price of ETH falls to 800 U.S. dollars, the 12,000 U.S. dollars worth of ETH Alice invested can now only be exchanged back for 10 ETH (worth 8000 U.S. dollars). At this point, besides closing the position directly to obtain 10 ETH (8000 U.S. dollars), Alice could also sell this position on the secondary market at a price between 8000 and 12000 U.S. dollars. For Bob, who wants to buy Alice’s position, this act is somewhat akin to buying (8000 U.S. dollars plus a call option with a strike price of 1000 U.S. dollars) when ETH is at 800 U.S. dollars. This option is definitely valuable, so this also determines that the price of Alice’s position must be higher than 8000 U.S. dollars. For Liquity, as long as Bob purchases Alice’s position, the protocol’s collateralization ratio remains unchanged because the premium is still in the protocol’s pool of funds. If no one like Bob purchases Alice’s position for a while, Liquity will gradually increase the value of Alice’s position over time (the specific form is not specified, but, for example, lowering the strike price or increasing the number of call options can increase the value of this position), with the subsidy coming from the protocol’s premium pool (note that this would slightly reduce Liquity’s overall over-collateralization ratio). Liquity believes that not all positions require subsidies from the protocol, and the subsidies do not necessarily need to cover a large proportion of the income from these positions, so subsidizing the secondary market can effectively maintain the protocol’s hedge ratio.

In conclusion, these two innovations may still not completely solve the issue of liquidity shortages in extreme situations. Liquity also plans to use a standard liquidity provider mechanism similar to Angle’s as a last resort (a possible method is that the protocol may also allow users to deposit some V1 LUSD into the stability pool to support the redemption of V2 LUSD in extreme cases).

Liquity V2 is planned to launch in Q2 of 2024.

Overall, Liquity V2 has many similarities with Angle V1 but also makes targeted improvements based on the problems encountered by Angle: introducing the innovative “principal protection” and offering traders more attractive products; proposing “officially subsidized secondary markets” to protect the overall hedge ratio of the protocol.

However, fundamentally, Liquity V2 is still similar to the Angle Protocol, representing a stablecoin team’s attempt to cross over and create an innovative derivative product that supports its stablecoin business. While the Liquity team’s capability in the stablecoin domain has been proven, whether they can also design an outstanding derivative product, find a Product-Market Fit (PMF), and successfully promote it remains to be seen.

Conclusion

The prospect of a decentralized reserve protocol that achieves both decentralization and high capital efficiency while maintaining price stability is undoubtedly exciting. However, the intricacy and rationality of its mechanism design is just the first step for stablecoin protocols. What’s more critical is the expansion of stablecoin use cases. Currently, the overall progress in expanding the use cases of decentralized stablecoins is slow. The vast majority of these coins serve primarily as “mining tools,” and the incentives for mining are not inexhaustible.

To some extent, PayPal’s launch of PYUSD serves as a wake-up call for all cryptocurrency stablecoin projects. It signifies that prominent institutions in the web2 domain are entering the stablecoin arena, potentially leaving a limited time window for existing stablecoins. In fact, when discussing the centralized risks associated with custodial stablecoins, our concerns often revolve around the reliability of custodial and issuing institutions (Silicon Valley Bank is only the sixteenth largest bank in the U.S., and both Tether and Circle are merely “crypto-native” financial institutions). If major financial entities from the traditional sector, considered “too big to fail” like JP Morgan, were to issue their stablecoins, the state credit backing them could instantly undermine the position of Tether and Circle. This would significantly diminish the value of decentralization advocated by decentralized stablecoins: when centralized services are sufficiently stable and strong, people might not see the need for decentralization at all.

Until then, it is hoped that decentralized stablecoins can acquire enough use cases to reach a Schelling point—a situation where individuals naturally converge on a solution without communication. Although achieving this is challenging.

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