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TLDR below. This is not financial advice.
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Liquity is a decentralised borrowing protocol similar to the Maker DAO. In the Liquity protocol, users lock collateral to open collateralised debt positions (CDPs, in Liquity called troves). The system then lends the user $LUSD from the system – a stablecoin pegged to $1.
The two main and essential components of the project are $LUSD — stablecoin and $LQTY — revenue token:
$LUSD is a stablecoin that is collateralised only by $ETH and is kept stable at peg 1 $LUSD = 1 $USD.
Liquity ($LQTY) is the project’s utility token, only used for staking and earning protocol revenue generated during borrowing and redeeming $LUSD.
We look at them in four different ways:
It uses two mechanisms, a dual-token and a reserve. It’s soft pegged to USD and the collateral amount is over-collateralised. It uses just $ETH as collateral type.
There are two tokens in the system, $LUSD, which is a stablecoin soft pegged to USD and the other one is $LQTY which is not a governance token but purely a value accrual token. When we talk about value accrual there is a liquidation fee that is generated from the system. The $LQTY holders will be receiving this liquidation fee which is the profits from the system. You hold $LUSD when you want to be using it, creating it, and paying people in it and you hold $LQTY when you want to receive accrual from the system.
Reserves are over-collateralised. Ideally, it is 150% over-collateralised, but the entire system is 200% over-collateralised. The lower bound or the lowest amount that can be over-collateralised is 110% and below that you’ll be liquidated. It uses $ETH as collateral.
How Do We Create $LUSD?
Firstly, you deposit $ETH into your troves (vaults). You put $ETH in there, and from there, you can take out $LUSD.
It needs to be 150% over-collateralised so If I put $150 worth of $ETH into my vault then I can take 100 $LUSD out so when the $ETH price falls then my security deposit in the vault is worthless but I still have my $LUSD and so I can do three things:
Deposit more $ETH inside my vault so that I can continue holding my $LUSD.
Repay the $LUSD.
Do nothing. You will be liquidated when you do nothing.
$LQTY captures the revenue.
We don’t have any voting rights attached to the $LQTY tokens since the system is completely immutable which is also relatively unique in this space. These tokens give stakers the possibility to earn fees from the system by staking their $LQTY. Whoever stakes $LQTY becomes eligible for a pro-rata share of the borrowing fee and the redemption fee.
The system has a redemption fee. This fee is determined based on a very similar formula as used for the borrowing fee. Stakers are charged in $LUSD for the borrowing fee and in ether when it comes to redemptions and those two fees are captured by the system and paid out to whoever stakes $LQTY. So staking is like a share that gives you a dividend.
The liquidation in Liquity is pretty much the stabilisation mechanism. The stabilisation mechanism basically has this thing called the auto liquidation method.
Auto Liquidation Method
There is this big liquidation pool in the system. You can take your $LUSD and put it in the system and when $ETH prices drop, liquidation will happen. If the person does not repay they are auto liquidated. When you (vault owner) are auto liquidated it means that you lose your ETH collateral and the vault is closed. The corresponding amount of LUSD will be burnt, and that comes from the big community pool.
Let’s say there’s 100 $LUSD in and we need to burn 100 $LUSD. You take this 100 $LUSD from the pool, burn it, and then you put $ETH in. This liquidation pool will have less and less $LUSD and more and more $ETH in the long run. The $ETH is in proportion to how much $LUSD you put in at that time of the pool, so these different calculations are made on the smart contract.
Anyone Can Liquidate
Anyone can call for liquidation and the collateral ratio is ranked. The lower your collateral ratio the higher probability that you’ll be liquidated. Anyone can check the system and determine that it is time for liquidation. The person who determines that it is time to liquidate will get some fees so they will get 200 $LUSD plus 0.5% of the value of the troves.
Liquidation Mechanism Explained In Depth
In most platforms, you basically start an auction or some process when the loan’s collateral drops below the minimum threshold. At that point you start looking for a buyer or somebody who bails out the borrower who is underwater. However, in Liquity the funds are already collected that can be used in case of liquidation to immediately repay the debt of a liquidated borrower. This is done by introducing two mechanisms.
Mechanism 1: Stability pool
You can think of the stability pool as an insurance pool. Everybody who owns $LUSD can deposit $ETH into the pool and become like a guarantor of everybody’s loans. Now, when the system needs to liquidate a position it can simply take out the amount corresponding to the debt from the stability pool and burn those tokens and cancel the debt. Then the system is balanced again. In return, as an incentive for stability providers or depositors, the system takes the collateral from the liquidated borrower and distributes this collateral proportionally among all the stability providers. That should be around 110% of the value of the debt that is liquidated. Ideally, the stability providers lose 100% of the $LUSD that they put in the pool and gain slightly less than 110% of the value in the form of ether from every liquidation.
Mechanism 2: Redemption interest rate
In other systems there is an interest rate to control the number of loans that are given out. Over time this controls the peg because by expanding monetary supply through loans you can make sure that the price goes down, and vice versa. People are incentivised to pay back loans due to high interest rates, so the money supply will shrink.
In our case, Liquity does not have an interest rate so they need another mechanism or even a set of mechanisms. The main one is redemption. This is similar to what centralised stablecoins offer. With $USDC, for example, every $USD holder can theoretically exchange $USDC at face value. In our case, it is also possible to exchange $LUSD at face value but what you get back is not fiat as you get paid in $ETH. When you own like 100 $LUSD and redeem them for $ETH, you get $100 worth of $ETH. It is possible that those ether tokens are worth more than the $LUSD that you lost through the redemption, because the redemptions are also a way of burning $LUSD. This leads to a shrinking of the monetary supply.
One thing that is very different in Liquity from all the other stablecoins is that there is no governance. The mechanism is hard coded so you cannot change anything that is in the system at least in the primary market. What they can do is to partner with other protocols to allow different kinds of changes. This can be working with affiliated partner protocol in a different blockchain like Matic or BSC or Solana, or partnering with other protocols to increase the usability of $LUSD. The the things that can be changed that are in the secondary market.
Importance of Decentralisation
No one can change anything in the system and this is part of their decentralisation strategy. It has three aspects to it:
They are only using ether because it is the most decentralised token in the Ethereum ecosystem.
They are not running their own frontend but have a set of decentralised frontends. We also get an incentive for running a frontend.
The third aspect to it is that they are not keeping any admin rights over the platform and are not even using a governance mechanism because governance mechanisms are also subject to issues where whales control the voting rights. Many people just do not care and are not actively voting and it’s very easy to manipulate the outcome by just having a small relative majority.
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As a debt protocol, Liquity’s goal is naturally to expand the demand for $LUSD. When the demand for $LUSD increases, the protocol revenue earned from mint and redeem activities will also be larger.
$LUSD is an over-collateralised stablecoin with a minimum collateralised ratio of 110%, but the actual collateralisation of the system is around 250%. Liquity is one of a number of recent prominent lending projects. After more than 2 months of development, the project has achieved many notable achievements. $LUSD is currently the 8th largest market capitalisation stablecoin according to Coingecko’s statistics. However, $LUSD’s DeFi integrations and use cases are very limited.