# 48 | Liquity + a Glimpse of (My) Future
Code <OR> Conduct
The DeFi movement has bootstrapped one of the most fascinating infrastructural revolutions that value management has experienced over the last fifty years. While this has been enough to keep many of us busy for more than two years now, it is clear for some that it is not the case anymore. With money flowing en masse right into the DeFi pipes from the outside world, information transparency and computational efficiency was enough to transform minuscule design advantages into massive rewards for builders and investors. But things have changed. With governments now disorderly focused on getting cash away from the economic game, there isn’t much coming into the DeFi pipes that provide triple-digit returns to those spotting the best-functioning infrastructure. Infrastructure went back being just what it is: infrastructure.
Ultra-fast web connectivity, when entirely directed to the exchange of cat videos, won’t do too good to the growth in productivity and living standards. Virtually distributed computers merely used to swap jpegs of monkeys won’t do much more either. It doesn’t matter how much we try to convince ourselves of the contrary. Even useful experimentation won’t be so useful without a more extended application. In my opinion, the time has come for us to take the cannon and direct it to areas that, although coordinating value in planetary sizes, are still run with medieval sophistication. Someone will need to lift the traditional wholesale financial system from the dark ages, and I hope to be among those brave ones.
Liquity: the Missing Stable
Over the months that are quickly becoming years we, here on DR, have dissected several stablecoin constructs—trying to understand their philosophical grounding and pragmatic execution. Maker’s $DAI, obviously, but also Terra’s $UST—that many seem to have forgotten, as well as $RAI, $FRAX, $FEI, $MIM, and $agEUR. Not all of them spun out of original ideas. The one missing, more for exhaustion than anything else, was Liquity’s $LUSD. I believe it is about time, before abandoning for a while the territory of stablecoin farming and dedicating myself to the convergence of infrastructural and governance innovation, that I overcome my carelessness.
Liquity is a governance-minimised, decentralised, minter of a sovereign, dollar-pegged, stable—$LUSD.
The core of Liquity’s engine is a well-trodded design choice in the land of decentralised stables—yet with important nuances. Like Maker, Liquity allows users to draw a loan in sovereign hard-pegged currency ($LUSD) in exchange for posting collateral. Like Maker, loans are secured by over-collateralisation. Unlike Maker, Liquity narrows the collateral window to $ETH only, and opts for a different design to protect the protocol against bad losses. I have synthesised the key logical phases below.
Opening a Trove → $ETH is deposited into a Trove by users, and the protocol calculates the available maximum debt, in $LUSD form, based on a set of governance-controlled parameters: Minimum Collateral Ratio—at 110%, and Minimum Debt—at 2,000.
Drawing $LUSD → Users can decide to draw $LUSD, up to the maximum debt calculated, paying a one-off (algorithmically-calculated) Borrowing Fee—currently at 0.5%, as well as a Liquidation Reserve—at 200:
Liquidation Reserve is required to cover expected transaction costs following liquidation and will be paid back to the borrower at closing in case of no liquidation occurring
Borrowing Fee is dynamically calculated within a 0.5-5.0% range, in normal times, with such number being used as a monetary lever to support the peg of $LUSD against its reference asset—the dollar
Repaying $LUSD → In order to (partially or fully) close a collateralised debt position, borrowers simply repay $LUSD into the Trove they have opened.
Bad debt liquidation → The effective collateral ratio of each Trove moves dynamically based on the price of the underlying ($ETH) and the outstanding debt. In case such number would fall below the Minimum Collateral Ratio—MCR, the Trove would be cancelled (meaning that the borrower would stop accessing underlying collateral) and the collateral transferred to a protocol-controlled Stability Pool to be distributed across Stability Providers. This means that depositors would suffer a loss (proportional to their share of the Stability Pool) in order to absorb a similar share of the bad debt, while benefiting from the economic value of the collateral absorbed. We can look at the example below for simplicity.
In the example above, the Liquity system starts in the following conditions:
1 active Trove with 1,500 $LUSD outstanding, secured by $1ETH as collateral—and a Minimum Collateral Ratio of 110%
A Stability Pool containing 10,000 $LUSD, 50% of which is provided by 1 depositor
Let’s assume, for example, that $ETH oracle price would fall to $1,575, causing the collateralisation ratio to fall to 105%—i.e. below the MCR. As a consequence, the Trove is closed → 1,500 out of the 10,000 $LUSD in the Stability Pool are used to cover the Trove debt → $ETH is repossessed by the Stability Pool → and distributed pro rata to the Stability Providers. From the perspective of the single Stability Provider responsible for 50% of the Pool, this means losing 50% of 1,500—or $750, but gaining 50% of 1 $ETH—or $788 at current oracle prices. The Provider would have a gain of $38, or exactly 5% of the burned Pool’s assets. The Stability Pool following the liquidation would contain residual 8,500 $LUSD.
Stability Providers are also incentivised through $LQTY, the protocol’s secondary token. $LQTY is not a governance token, but rather a utility token that allows owners to capture a share of the revenues generated by the protocol. Stakers of $LQTY will receive a portion of the fees in $LUSD and $ETH—current staking APR gravitates around 5%.
Redistribution mechanism → Rather than triggering auctions, the margin call immediately activates a backstop; this is a strong mechanism but as strong as the funds that are in the backstop. It is, however, extremely capital inefficient for stakers. Still, Liquity could find itself with insufficient funds in the Stability Pool to cover bad debt. This could happen in case the over-collateralisation is not sufficient to protect against a sudden crash in the value of the underlying collateral. It goes without saying that this risk could be mitigated by increasing significantly the MCR—but more on this later. In such case, uncovered debt and collateral would be redistributed across all open and well-performing Troves—in proportion to the recipient Trove’s collateral amount.
Recovery mode → Liquity has a systemic emergency valve called Recovery Mode. When systemic collateral falls below 150%, every Trove below that threshold can be liquidated. For reference, the current systemic collateralisation ratio is 236%—and hit its lowest point at c. 180% at the beginning of the summer. During Recovery Mode Borrowing Fee is set to 0% to encourage borrowing. Liquity’s idea is that, given that it’s the sum of all borrowing Troves that provides rebalancing ability for debt deb, when the communal protection buffer goes below a certain point something should be done about that. I think it is interesting to recap the capital protection flow.
Redeeming $LUSD → Loan redemption is where Liquity allows for further risk mutualisation across borrowers during normal times. Let me explain. When $LUSD is redeemed—by anyone, a similar (i.e. oracle-calculated, the oracle in question is Chainlink) amount of $ETH is provided to the redeemer from the Trove with the lowest collateralisation/ highest leverage ratio. If you happen to be the borrower operating the riskiest Trove your outstanding debt will be reduced by the redeemed amount. The protocol, in other words, intends to de-risk first the riskiest borrowers—which is a rational decision given that borrowers pay fees only at the drawing down stage and higher interest rates aren’t charged to higher risk Troves. Importantly, redemptions are subject to a Redemption Fee, also algorithmically calculated—but more on this later.
A so-called stablecoin is ultimately as good as its peg, and stabilisation mechanisms is where things get interesting for crypto-dollars. Liquity intends to peg $LUSD to the American dollar, and tries to do so through both hard (flooring and capping) and soft (rates) pegging mechanisms.
Flooring & capping → $LUSD can be redeemed for $1 of (oracle-priced) $ETH. This means that if there’s $LUSD trading below $1 level, arbitrageurs should be incentivised to purchase and use it to redeem $ETH to be immediately sold into the market—limiting downward pressure. This would work, obviously, as long as there is enough $ETH in the system to justify the $LUSD outstanding. Interestingly, the Minimum Collateral Ratio causes price capping for $LUSD as well, since when the value of $LUSD exceeds that relative value (e.g. 110% * $1.0 = $1.1) borrowers could make a profit by drawing as much as possible from their Troves (depositing $ETH) and selling that in the open market with same-block profit.
Rates → Rates are intended to adjust inflows and outflows of $LUSD. Borrowing and Redemption Fees are dynamically calculated by applying a spread around a Base Rate. Such a Base Rate keeps decaying if nothing happens—i.e. incentivising market to interact with the protocol during excessively quiet times, and is increased proportionally with redemption intensity. The intention of the dynamic rate is to stimulate lethargic activity and limit over-exuberance.
By looking at on-chain data, we can see how $LUSD has not been entirely successful in keeping its peg against the dollar. Liquity’s version of the dollar has been consistently trading at 2-3% premium over other stables recently (see Dune) across most DEXs. On Curve’s LUSD+3Crv pool, $LUSD is only c. $5.5m (or 9.7%) of the float, with users able to swap c. 1.3 $DAI/ $USDC/ $USDT for each $LUSD foregone. TVL and volumes, however, are negligible. The picture on Uniswap isn’t very different.
If You Build It, They Will Come
In hindsight everything seems obvious, but it’s good to benefit from diachronic perspectives at times. Liquity, as many other projects in DeFi, has been focused on sorting out incentive-compatible frameworks, without worrying too much about the usability and attractiveness of its own product. $LUSD float has been going down constantly since early summer, and after having rapidly reached ATH > $1.5b, it is now stable at c. $170m. The decrease in TVL, when looked in $ETH terms, has been less dramatic but still substantial, with a maximum of c. 1.1m $ETH locked as collateral vs. the current c. 320k—i.e. down 75% from the peak. The borrowing rate (floored to the minimum 0.5%) hasn’t been effective in stimulating demand.
So, who is actually using $LUSD, and why? Looking at on-chain data, we know that c. 65% of the outstanding monetary base sits in the protocol’s Stability Pool. In a strange recursive loop, $LUSD is minted to provide stability to its own minting. It seems, in other words, that the Liquity set of contracts ended up working better as a fully-funded limit order book for $ETH rather than a leverage facility, and that’s interesting. But is it working well enough? Stability Pool APRs continue to trend down towards the magical 5% number—they were much much higher earlier in the year. Intuitively, with diminishing value creation, idiosyncratic returns settle very close to $ETH’s native staking yield. There are several reasons to justify the slight premium/ discount and high volatility of the return rate.
How do the economics work for a rational staker? I have 1 $ETH, that I could stake natively or through a liquid staking protocol like Lido, at an APR of 5.2% currently. That’s the benchmark. I instead decide to deposit it on Liquity, and get 0.91 $LUSD that I immediately deposit in the Stability Pool. Equilibrium staking yield should be 5.2% / 0.91 = c. 5.7%—which is effectively what we are observing in the market today, give or take. This means that the market is assigning no additional value to the protocol itself, and it makes sense since during bear markets few would use Liquity as an aggressive engine for leverage. Which is, ultimately, what Liquity positioned itself to be, with a fee model that attracts those thinking to “mint and forget” with a collateralisation ratio (110%) well below even the most aggressive Maker vault, ETH-B, at 130%.
The chicken idea → The Liquity team, obviously, also realised that their baby became more of a yield generation machine rather than a leveraging facility, and reacted by launching, on the 4th of October, Chicken Bonds. I won’t go deep into the mechanics for chickening in and chickening out because readers can get those from the article, but ultimately what the protocol is trying to do is offering higher staking yields (to diversify the return profile of their Stability Pools from the base Ethereum rate) to those that commit liquidity for $LUSD—given that we have seen the stable has indeed massive liquidity problems. They are, in other words, trying to translate the time value of money into higher returns. Something that DeFi hasn’t really succeeded in doing in a sustainable way. Running on a decentralised frontend, the Chicken Bond system does not mess up with Liquity’s core engine, hence it won’t do anything bad to it if the idea won’t fly. And I think it won’t; playing liquidity games while there is pretty much zero fresh liquidity coming into the wider system is very difficult.
Good enough? → Liquity, concluding, it’s a fine-working aggressive leverage permissionless machine. It is, however, also an inefficient leverage machine since its sovereign leverage tool ($LUSD) is not liquid enough to sustain trades at large scale. If you had aggressive borrowing rates offered by a bank whose version of the dollar wasn’t accepted by so many venues around, those attractive rates wouldn’t be so meaningful any longer. Is this good enough for a project to justify its existence? Ironically, for a governance-minimised protocol, where token holders have no influence on the evolution of the protocol itself, I would argue that it is indeed good enough. The team behind Liquity created an imperfect leverage facility and left it roaming into the wild—in exchange for profits. Who would use it, and why, is of secondary importance. Liquity’s smart contracts will be code for ever engrained in the consensus-approved global status of the Ethereum machine. Liquity has created something that will forever live in the back of the mind of DeFi structurers, that might resuscitate it at times to serve unexpected needs. Liquity, in other words, has created (good) infrastructure, without the ambition of animating such infrastructure and empowering it to do things that should not be in the realm of bits of codes.
I like it. Because with Liquity, what you see is what you get. No ambition to reduce carbon emission, break the global financial system, or neither to improve it. No claim of a new dawn of a society without governments. Liquity is infrastructure and only infrastructure. Good enough for itself.