Overview

*This Project Breakdown Specifically Covers Liquity V1 Only, Not Liquity V2*

There are already many models for creating a stablecoin in DeFi, however, there was a market demand for a fully decentralized stablecoin that was backed by ETH and where there was no governance. Having learned from past mistakes like the collapse of UST, Liquity came up with LUSD, a governance-free and censorship-resistant stablecoin backed by ETH at a 110% collateral ratio.

Similar to how Maker works for DAI, Liquity’s engine allows users to draw a loan in a sovereign currency pegged to USD in exchange for depositing collateral. These loans are secured by virtue of being over-collateralized. The process involves opening a trove where users deposit ETH at a 110% collateral ratio, which allows them to borrow LUSD at the expense of a dynamically calculated borrowing fee within a 0.5-5% range. Debt repayments and liquidations ensure solvency and, to fund the work performed by liquidators, the protocol has a liquidation reserve to cover transaction costs.

Most lending protocols that use CDPs (Collateralized Debt Positions), like MakerDAO, use variable interest rates to incentivize or disincentivize borrowing. Borrowers don’t feel the cost upfront with this model. In fact, the interest paid by borrowers is not the net outcome of their own debt, but of the debt incurred by other borrowers. Because of this and the need for governance, Liquity opted out of this model and chose to build a decentralized and direct feedback system built on one-off fees. 

The protocol revenue is distributed to its participants with an innovative dual token model, involving the LUSD stablecoin, and the LQTY secondary token. The protocol earnings come from issuance and redemption fees so that anyone can redeem 1 LUSD for 1 USD worth of ETH as part of the pegging mechanism. 

There are two incentive mechanisms that help the protocol to remain solvent and stabilize the peg around LUSD. The first incentive rewards LUSD holders who deposit their funds to the stability pool. These are known as stability providers and receive revenue from liquidations (paid out in ETH from the liquidated collateral) and LQTY rewards. The other incentive mechanism is for frontend operators who provide users with a web interface to interact with the protocol smart contracts. For this service, frontend operators are rewarded with a share of LQTY tokens. Liquidity providers who supply liquidity on the Uniswap ETH-LUSD pair are also rewarded with LQTY rewards.

Liquity is a decentralized, immutable, and governance-free borrowing protocol that allows users to draw interest-free loans in LUSD against Ether as collateral. LUSD is a USD-pegged stablecoin that maintains a 110% collateral ratio. A stability pool further strengthens the peg by collecting the deposits of LUSD borrowers that act as guarantors of last resort.

The collateral ratio is the ratio between the Dollar value of the collateral deposited by users and its debt in LUSD. It is an indicator that represents the size of the collateral required by the protocol compared to the value of the loans it serves.

Collateral is any asset provided by a borrower to take out a loan from the protocol.

Why the Protocol was Created

The protocol was created to design a fully algorithmic and automated way a non-censorable asset like ETH to be used as collateral for minting a stable value asset.  Besides providing stability, the system is designed to offer interest-free loans, so that borrowers can deposit lower amounts of collateral when compared to other protocols. 

Why Liquity Created “Chicken Bonds”

The Liquity team came up with the idea of Chicken Bonds to let protocols capture liquidity in a more efficient manner. The idea behind this bonding model is to provide better guarantees and less downside for users than existing bonding approaches. 

Before Chicken Bonds, every user in the Liquity stability pool earned the same amount of yield (from buying ETH at a discount, and from LQTY rewards). With Chicken Bonds, this will no longer be the case, since users will be able to bond their LUSD to receive the right to claim bLUSD. bLUSD tokens will capture and auto-compound an extra yield from the protocol operations. Users will be able to leverage their LUSD yield if they want to by acquiring a boosted LUSD token, bLUSD. These are the main differences between bLUSD and LUSD:

  • bLUSD offers a higher yield compared to LUSD deposits in the stability pool.
  • The yield produced by bLUSD is automatically auto-compounded.
  • bLUSD is an ERC20 token and, therefore, can be used as collateral. 

Roadmap

The Roadmap has been revamped with the introduction of Chicken Bonds, a novel bonding mechanism presented as a separate product with its own website. Its value proposition is that the bonding principal remains protected, there is no lockup, and users get access to boosted bLUSD tokens at a discount. This is achieved by using dynamic NFTs designed by Luchador. The properties of the NFT will change to reflect the state of the bond.

Chicken bonds allow protocols to bootstrap liquidity at minimal cost while providing better principal protection guarantees to its users since this bonding mechanism can be applied to any yield-bearing token. When applied to LUSD, its holders get an amplified yield-earning opportunity that also helps to stabilize the price of LUSD and improve its liquidity.

The bond has no maturity and, at any time, users may choose to:

  • “Chicken in” to claim their bLUSD accrued from their bond in LUSD. After chickening in, the user retains the NFT created at the time of creating the bond, but the NFT will change its state to no longer represent an active bond claim over any asset.
  • “Chicken out” to cancel the bond and get their principal back by foregoing the accrued bLUSD balance. This ensures principal protection (the money you originally deposited, doesn’t include any yield from the bond).

The actions users can take depend on the assets they are holding:

  • LUSD holders:
    • Create a LUSD bond and accrue bLUSD.
    • Trade LUSD for bLUSD on the bLUSD/LUSD-3CRV pool.
  • Dynamic NFT bondholders:
    • Chicken in to claim the accrued bLUSD.
    • Chicken out to cancel your bond and reclaim your principal by foregoing the accrued bLUSD balance.
  • bLUSD holders:
    • Trade bLUSD for LUSD on the bLUSD/LUSD-3CRV Curve pool.
    • Become a LP in the bLUSD/LUSD-3CRV Curve pool.
    • Redeem bLUSD for LUSD.

Team

  • Michael Svoboda, CEO. 
    • Previously CEO and COO at several blockchain companies
    • Degree in Computer Science and Economics
  • Robert Lauko, Head of Research.
    • Founder of Liquity
    • PhD in Law
    • Previously Researcher at DFINITY
  • Rick Pardoe, Lead Engineer
    • Co-founder of Liquity
    • Degrees in physics and economics
    • Solidity developer
  • Bingen Eguzkitza, Head of development
    • Degrees in mathematics and philosophy
    • Backend developer
    • One of the main contributors to Aragon Dao
  • Edward Mulraney, software engineer
    • Previously in banking and fintech
  • Daniel Attila Simon, software engineer
    • Senior developer with 10+ years of experience
    • Previously at Cognex
    • Frontend developer
  • Bojan Pecek, Operations
    • VC startup background
  • Token Brice, DeFi strategist
    • DeFi enthusiast
    • Previously at Paraswap
  • Samrat Lekhak, Head of Growth
    • Growth and Biz specialist with experience in software companies
  • Yuliyan Velichkov, Growth Hacker
    • Growth hacker with 7+ years of experience in digital marketing
  • Ashleigh Schap, Advisor
    • Advisor at Uniswap
    • Previously at MakerDAO
  • Cedric Waldburger, Venture investor and advisor
    • Early-stake tech investor
    • Previously built companies in the agency, consumer, and blockchain sectors.

Meet the Liquity team: https://www.liquity.org/team 

DeFi Subsector

Liquity is classified as a CDP (Collateral Debt Position) and borrowing protocol that allows the issuing of a stablecoin against a single-collateral asset, ETH. Existing CDPs such as MakerDAO apply variable interest rates (stability fees) as a soft peg mechanism. Instead of this, Liquity replaces interest rates with an algorithmically determined one-off issuance fee. This issuance fee is an upfront cost for borrowers. This fee is increased upon every redemption (which signals that LUSD is likely to be worth less than 1 USD) and decays in phases without redemptions. 

In MakerDAO, the stability fee is a variable rate fee continuously added to a user’s vault (equivalent to a trove). The reason for introducing this fee is to address the inherent risk in issuing new debt against the vault’s collateral. A portion of this fee goes to the DAO treasury for operations. This covers costs such as the Dai Savings Rate, Risk teams, and other costs associated with the maintenance of the protocol.

Liquity was designed with the goal to give users full control and complete freedom in managing their risks, whereas in other protocols like Maker, all borrowers have to pay the monetary policy (stability fees) imposed by their governance, which has an interest to maximize fee revenue.

Liquity is also different from other protocols because it only accepts one asset as collateral; ETH. Similar protocols in the industry are MakerDAO, Abracadabra, Angle, QiDAO, Reflexer…

With Chicken Bonds, Liquity is innovating and tackling a different playing field that aims to let other protocols bootstrap liquidity at a minimal cost through a bonding mechanism. Bonders will benefit from principal protection by having the option to “Chicken Out” or cancel their bond and claim their principal back.

Industry Overview and Potential Adoption

The success of Liquity depends on its stability mechanisms, like including a single collateral asset (ETH) and non-governance dynamics. If the protocol can successfully convince users of the utility of having two types of money, it can reach a greater degree of adoption compared to other competitors. These two types of money are spending money (LUSD) and collateral money (ETH).

Competitors Overview:

  • Abracadabra issues the MIM stablecoin against yield-bearing assets, which allows for leveraged borrowing positions and user-adjusted levels of risk tolerance according to the collateral they use.
  • Angle is an over-collateralized stablecoin protocol that allows for minting stable assets against any token at face value. This allows the protocol to accomplish other use cases such as open perpetuals, earn a yield on deposits, get leverage from collateral assets…
  • QiDAO allows for borrowing a stablecoin against collateral assets. Similar to Liquity, it allows for 0% interest rates. QiDAO is governed by the community and accepts a variety of collateral assets
  • Reflexer is a governance-minimized protocol that issues RAI against ETH collateral. Its liquidation protection mechanism is achieved by using Uniswap LP tokens, which enable use cases such as self-repaying loans and other arbitrage opportunities. When interest rates are negative, the protocol pays minters by devaluing RAI or by self-repaying everyone’s loans. RAI does not maintain a peg to 1 USD. Instead, it aims to achieve a low-volatility floating currency with a redemption price equivalent to one unit of debt in the system. For that reason, it is meant for internal accounting and not for market price. In most cases, there will be a difference between the market price and the redemption price, which allows for arbitrage.

The strength of Liquity is its interest-free borrowing, censorship-resistant stablecoin, and governance-free redemptions. On top of that, the protocol also rewards users with its incentives for stability providers and stakers and even frontend operators.

  • borrowers can take out an interest-free LUSD loan backed by ETH without any recurring cost except for a one-time upfront borrowing fee.
  • Third-party front-end providers can earn a share of the stability pool rewards for their service.
  • Immutable smart contracts are censorship-resistant and don’t have administrator privileges that could alter the protocol operations in any way.
  • 110% collateral ratio which allows a 90% loan-to-value ratio. This makes borrowing extremely efficient and allows for up to 11x leverage
  • LUSD is a fully redeemable stablecoin at face value for the underlying ETH collateral
  • Governance free and reliance on an algorithmic and automated monetary policy that does not require human intervention
  • Incentives for stability providers from liquidation gains, and LQTY rewards
  • Incentives for stakers from the value captured from borrowing and redemption fees

Unlike other stablecoins, Liquity does not have any dependency on the real world and is one of the most censorship-resistant stable currencies on the market. The competitive landscape is currently dominated by Maker, and Liquity’s competitive advantage is already starting to show with the recent USDC censorship whitelists (most of DAI supply is backed by USDC).

Chains 

Due to its reliance on ETH collateral, Liquity is currently deployed on the Ethereum mainnet and as of December 2022, Liquity ranks 15th amongst Ethereum Protocols via TVL comparison.

However, several releases have provided additional LUSD utility on other networks like Optimism. LUSD was introduced to Optimism by the Synthetix team, which launched a LUSD-USDC pool on the DEX Velodrome, as well as support on the cBridge.

The significant usage of the Synthetix protocol on Optimism required a further strengthening of the protocol issued sUSD peg. Hence, wrappers were introduced for other stablecoins like LUSD or DAI. This wrapper contract enables users to burn sUSD to redeem LUSD 1:1 (0.05% fee) or lock LUSD to mint sUSD.

Velodrome allows for more LUSD liquidity on the Optimism network, while the cBridge allows for fast transfers from the Ethereum mainnet to Optimism in minutes. Withdrawals, however, are subject to a 7-day delay to allow verifiers to detect possible fraud on the transactions submitted by Optimism.

Liquity is open to expanding outside of Ethereum but is mostly focused on collaborating with Layer 2s and bridges. Since Liquity issues a stablecoin, it is critical for the protocol to not spread risk on too many chains and bridges. For instance, they are exploring with Aztec on how they borrow funds on the mainnet and cheaply access funds on a layer 2 network.

For Users

Target Users

Liquity’s users are investors who want to borrow a stablecoin against their ETH holdings in a capital-efficient manner. Instead of selling their ETH, they can use Liquity to have access to liquid funds and borrow against their ETH by using it as collateral. 

For example, borrowers speculating on the future price of ETH can use the protocol to leverage their Ether positions up to 11 times, thus also increasing their exposure to volatile price fluctuations. This leverage is achieved by using ETH to borrow LUSD, then selling LUSD to purchase ETH on the open market, and so on. The more times this process is repeated, the higher the leverage ratio. Assuming a $1 price for 1 LUSD, 11x is the maximum leverage ratio, since leveraged is calculated by 

(Minimum Collateral Ratio) / (Minimum Collateral Ratio – 100%) = 11

To interact with the Liquity protocol, users must own enough ETH to open a Trove and pay for the associated gas fees. Users can generate revenue in 2 ways:

  • By depositing LUSD to the stability pool and earning protocol revenue from liquidations and LQTY rewards
  • By staking LQTY and earning LUSD and ETH from the revenue the protocol makes from its borrowing and redemption fees.

There are two scenarios where users may lose part of their funds:

  • Borrowers (Trove owners) might lose part of their funds if their ETH collateral decreases in value and is liquidated by the protocol. When this happens, the user can still access the borrowed LUSD, but its Trove will be closed and its collateral will be seized to compensate Stability Pool depositors.
  • The LUSD of the Stability Pool is used to repay debt from liquidated borrowers. Liquidations are triggered when the borrower’s collateral ratio drops below 110%. Most of the time, more ETH will be returned. However, it is possible that depositors may lose value if ETH price decreases.

In the beginning, most users were retail participants who saw an opportunity to earn interest rates in the stability pool. Institutional adoption is more of a long-term process. As of now, Liquity is in contact with DAOs, since it already saw an uptake when Fei and Olympus added LUSD to their balance sheets. LUSD is a currency that can be used for paying contributors, and also as an accessible fiat off-ramp when listed on centralized exchanges.

Stablecoins like Tether or USDC are backed by fiat collateral, which comes at the expense of centralization and censorship resistance. These assets play an important role in the Ethereum economy, since they are not volatile and keep a stable value, usually pegged to USD. Despite the existence of decentralized stablecoins like DAI, FRAX, or sUSD, decentralized stablecoins are only a small portion of the stablecoins market share.

Liquity aims to fix this problem by creating a new, more capital-efficient and borrower-friendly stablecoin backed by ETH.

  • 0% interest rates – borrowers don’t need to worry about constantly incurring debt.
  • 110% minimum collateral ratio – more capital efficiency of ETH collateral deposits
  • Governance free – all operations are performed in a fully automated and algorithmic manner.
  • Face value direct redemptions – LUSD can be redeemed at face value for the underlying collateral at any time
  • Fully decentralized – Liquity contracts have no admin keys and are accessible via multiple frontend interfaces hosted by multiple operators.
  • Liquity contracts cannot be upgraded – Liquity smart contracts are immutable and the rules of the system cannot be altered.

The properties of the protocol and its dual asset model derive the main use cases of Liquity:

  • Borrow LUSD against ETH by opening a Trove
  • Secure liquidity by earning rewards for depositing LUSD to the Stability Pool
  • Stake LQTY to earn fee revenue paid for borrowing or redeeming LUSD
  • Redeem 1 LUSD for 1 USD worth of ETH when the LUSD peg falls below 1 USD. 


Liquity Breakdown LUSD

Troves

Troves are where users take out and maintain their loans. Each trove is linked to an Ethereum address and each address can only have one trove. Troves are responsible for keeping track of two balances that can be adjusted by adding/removing collateral or repaying debt. 

  • ETH collateral 
  • LUSD debt


Liquity Breakdown Troves

Troves are closed when debt is fully repaid. When borrowers take out a loan, they are charged a one-off fee and a 200 LUSD Liquidation Reserve. The latter will be returned to the user after fully repaying the debt. The Liquidation Reserve is fully refundable and serves the purpose of paying for the gas costs incurred by the liquidator when closing the borrower’s trove.

Since loan repayments are done in LUSD, users must be aware of the market price of LUSD. For instance, if LUSD is trading at $1.02, they are being charged a 2% fee that they can avoid by waiting and repaying their loan once LUSD goes back to peg.

Loans issued by the protocol do not enforce a repayment date so that trove openers can repay their debt at any time as long as they maintain their collateral ratio above 110%.

As the price of the borrower’s collateral, ETH, changes, its collateral ratio will fluctuate. This can be adjusted by adding more ETH collateral of paying off some of the debt to avoid being liquidated. For example, if the ETH price is $3,000 and a borrower deposits 10 ETH as collateral to borrow 10,000 LUSD, then the collateral ratio of the trove is calculated as:

(10ETH * $3,000) / (10,000 LUSD) * 100% = 300%

When a trove is liquidated, the user loses access to its collateral and its debt will be paid off through liquidations. The user can keep the LUSD borrowed, but will no longer be able to retrieve the original collateral back. Hence, a liquidation results in a 9.09% (10 / 110)  net loss of the collateral’s dollar value.

When borrowers redeem their collateral back after paying off their loans, the protocol provides the redeemer with the ETH allocated to the trove with the lowest collateral ratio (even if it is above 110%). 

  • Redemptions can be thought of as somebody else repaying your debt.
  • By redeeming collateral from the trove with the lowest collateral ratio, the protocol reduces the overall risk of the remaining troves by increasing their collateral ratio.

Redemptions can be of 2 types:

  • Partial redemptions are redemptions that do not reduce the borrower’s debt to 0.
  • Full redemptions are redemptions that fully repay the borrower’s debt. Full redemptions effectively close a trove and allow the borrower to claim its collateral surplus and the refundable deposit to the Liquidation Reserve.

By making liquidations instantaneous, Liquity needs less collateral to provide the same security guarantees as other protocols that rely on lengthy auction mechanisms to sell off collateral in liquidations. For example, in MakerDAO, whenever a position falls below the minimum collateralization ratio, the collateral is locked and liquidators participate in an auction. The fact that collateral gets liquidated after a pretty long time, makes the outcome and value of liquidation unpredictable.

In DeFi, when the collateral ratio of a position goes below the minimum allowed threshold, a borrowing position is opened up for liquidations. When this happens, a group of participants usually bots, participate in an auction to be able to buy the borrower’s collateral at a discount. This discount is offered by protocols as an incentive for liquidators to repay the borrowers’ debt and remain solvent.

When a user’s trove is redeemed, the user does not experience a net loss. Despite losing some ETH exposure, the trove’s collateral ratio will improve as a result of the redemption. The best way to avoid being redeemed against is by maintaining a high collateral ratio compared to the rest of the trove’s in the system, since the riskiest troves (the lowest collateralized) are the first in line when a redemption takes place.


Liquity Breakdown Trove

Stability Pools

In Liquity, stability pools are the first line of defense against insolvency. By being the source of liquidity for repaying debt from liquidated positions, stability pools act as the mechanism that ensures that the total LUSD supply remains fully backed at all times.

When a trove is liquidated, an amount of LUSD corresponding to the trove’s debt is burned from the stability pool’s balance to repay its debt. In exchange, the trove’s collateral is transferred to the stability pool.

The stability pool is funded by users who deposit LUSD into the pool to claim a pro-rata share of the collateral liquidated by the protocol. However, since troves are likely to be liquidated at just below 110% collateral ratios, it’s expected that stability providers will receive a higher dollar value of collateral relative to the debt that was paid off from their deposits.

Deposits to the stability pool can be withdrawn at any time. If the stability pool is empty when there is a need for liquidation, the system uses a secondary mechanism called redistribution. In this mechanism, the system redistributes the debt and collateral from liquidated troves to all other existing troves, based on the table below.


Liquity Breakdown Debt and Collateral

Stability providers also benefit from early adopter rewards. To qualify, they must open a trove, borrow LUSD, and deposit the borrowed LUSD into the stability pool. In 2023, they will start earning LQTY rewards proportional to the size of their deposit and according to the rewards schedule and the front end’s kickback rate.

Liquidations

Liquidations are the mechanism that allows the protocol to ensure that the total LUSD remains fully backed. This is achieved by closing the troves whose collateral ratio falls below the minimum allowed 110%. When this happens, the trove’s collateral is liquidated and absorbed by the stability pool. Once in the stability pool, it is distributed equally among stability providers.

Anybody can liquidate a trove as soon as the collateral ratio falls below 110%. The initiator will receive a gas compensation (200 LUSD from the borrower’s liquidation reserve + 0.5% of the trove’s collateral in ETH) as a reward for this service.

Recovery Mode

When the Total Collateral Ratio (TCR) of the system drops below 150%, Recovery Mode is activated. When this happens, troves with a collateral ratio below 150% are liquidated and the systems block borrowing transactions to increase the TCR. New LUSD may only be issued by adjusting existing troves in a way that the TCR is improved, or by opening a new trove with a collateral ratio >= 150%.

The Total Collateral Ratio is the ratio of the dollar value of the entire system collateral at the current ETH-USD price, to the entire debt of the system.

In other words, the Collateral Ratio is the sum of the collateral of all troves expressed in USD, divided by the debt of all troves in LUSD.

Recovery Mode encourages collateral top-ups and debt repayments.

Recovery Mode has no impact on the redemption fee but sets the borrowing fee to 0% to encourage borrowing.

Users can avoid liquidations by setting their collateral ratio above 150%. The maximum loss from liquidations in Recovery Mode is capped at 110% of a trove’s collateral. Any remainder collateral above 110% can be reclaimed by the liquidated borrower.

Liquidations in Recovery Mode:

  • If the individual collateral ratio is below 100%, liquidations redistribute all debt and collateral to active troves.
  • If the individual collateral ratio is greater than 100% but lower than the minimum collateral ratio and the stability pool LUSD balance is greater than the aggregate trove debt, the trove’s ETH collateral is shared between depositors.
  • If the individual collateral ratio is above 100% but lower than the minimum collateral ratio and the trove debt is greater than the amount of LUSD in the stability pool, liquidations ensure that the remaining debt and collateral are redistributed to active troves.
  • If the individual collateral ratio is greater than the minimum collateral ratio but lower than 150% and the stability pool LUSD balance is greater than the total trove’s debt, a fraction of ETH collateral is shared between depositors and nothing is distributed to active troves.

Pricing

LUSD can be redeemed at face value for $1 worth of ETH. The minimum collateral ratio of 110% serves the purpose of creating a price floor and price ceiling through arbitrage opportunities.

The protocol treats LUSD as being equal to USD, creating an implied state of equilibrium so that when redemptions increase (LUSD is below $1), so does the baseRate.  This basically makes borrowing less attractive and can prevent new LUSD from hitting the market and driving the price further below $1.

Liquity uses Chainlink’s ETH-USD price feed, falling back to the Tellor ETH-USD oracle when the following happens:

  • The Chainlink price feed has not been updated for more than 4 hours.
  • The Chainlink response reverts and returns an invalid price or timestamp.
  • The price change between two consecutive Chainlink price updates is > 50%.

Redemptions are a separate mechanism from debt repayments. Repayments are means for closing a trove by paying back debt and getting back the original collateral. Instead, redemptions are made against any trove. Under normal operations, the redemption fee is calculated as a (baseRate + 0.5%) * ETH withdrawn, where the baseRate is dynamically adjusted. The baseRate increases with each redemption and decreases according to the time passed since the last fee event. This fee event is either the last redemption or the last LUSD issuance.

Price Stability and Peg


Liquity Breakdown Price Stability and Peg

Liquity keeps LUSD price pegged to USD via various implicit and explicit mechanisms.

Hard Peg Mechanisms: 

Since LUSD is redeemable against the borrower’s collateral, every LUSD holder can exchange their LUSD for Ether at face value (e.g. 100  LUSD for $100 worth of ETH). When redeemed, the system uses the LUSD to repay the riskiest trove with the currently lowest collateral ratio and transfer the respective amount of ETH from the affected position to the redeemer. In other words, Ether is redeemed from the trove with the lowest collateral ratio. Since there is a redemption fee that increases with every redemption and decays over time when no redemptions take place, speculators can make instant gains from arbitrage opportunities whenever the ETH they redeem is worth more than the value of the redeemed stablecoins

  • When the price of LUSD is below 1 USD, arbitrageurs can immediately sell to redeem 1 USD worth of Ether.
  • A price floor is set such that if the price of LUSD is below parity by a given percentage, the redemption fee will be equal to that percentage of the total LUSD supply to restore the peg.
  • A price ceiling is set by means of the minimum 110% collateral ratio. This creates a price ceiling of $1.10. When the price exceeds that level, borrowers can make an instant profit by borrowing LUSD against ETH collateral and immediately selling it on the market for another stablecoin.

Soft Peg Mechanisms: 

The protocol treats the value of LUSD as equivalent to 1USD when determining the collateral ratio of its troves.  Even though the borrower’s debt is expressed in LUSD, the value of ETH held in the system as collateral is expressed in USD. This intended parity between LUSD and USD is built  into the system by the redemption mechanism:

  • As long as most users foster the belief that a LUSD price of 1 USD makes it more attractive for borrowing (as you can repay at a rate of $1 or lower), and a price below $1 incentivizes debt repayments, the total LUSD supply will grow when more LUSD is borrowed than repaid over time. This excess supply will make the tokens cheaper in USD terms when compared to other stablecoins. 
  • On the other hand, if the repaid amounts are higher than the new LUSD debt being issued, the money supply will shrink and LUSD will appreciate.

Frontend Operators

Unlike most other protocols, Liquity does not provide its own Frontend for users to use their dApp from.  Instead, frontend operators are service providers to the protocol users. This service consists in providing end users with an accessible user interface that simplifies interactions with smart contracts. For that service, they are rewarded with LQTY rewards. These rewards are awarded to stability pool depositors and then proportionally shared between the users themselves and the frontend operator who provided the interface they interacted with.

Frontend reward shares are calculated based on the total deposits tagged by the frontend, and these rewards come from the same pool as user rewards. Frontends earn a share of 32,000,000 LQTY tokens distributed to users based on the frontend’s kickback rate and the total rewards earned by users. When a stability provider makes a deposit to the stability pool, the frontend will be tagged by the system and remain in the user’s deposit. If the user wanted to add a new tag to a different frontend, the user will have to completely withdraw the initial deposit to the stability pool and redeposit through the new frontend.

Registering a frontend interface is a permissionless process that does not need any approval by the core Liquity protocol team. In order to ensure decentralization, each frontend operator may set a kickback rate between 0 and 100%. This kickback rate is the fraction of LQTY that will be paid out as a kickback to stability providers that used the frontend. For example, a frontend operator that sets a kickback rate of 60% would earn 40% of LQTY rewards, while its stability providers users will earn 60% of rewards.


Liquity Breakdown Front End

Once an address is registered as a frontend with the stability pool and has set a kickback rate, this rate cannot be adjusted. However, if a frontend operator wants to change their kickback rate, they can register a new frontend address with a new kickback rate. Users who wanted to access the updated kickback rate would have to withdraw their deposit to the stability pool and deposit again with the new frontend tag.

Frontend listing process: https://github.com/liquity/frontend-registry

How to Create a Bond

Bonds are created by depositing LUSD into the Chicken Bond system. Once deposited, the bond accrues a virtual bLUSD balance over time based on an asymptotic curve. This balance is tracked internally by the system and is not paid out until the user claims it. Note that Chicken bonds have no maturity date.

Liquity Breakdown bLUSD Accrual Curve
bLUSD Accrual Curve
  1. User creates a bond by depositing LUSD into Chicken bonds
  2. Once the bond is created, users will accrue a virtual balance of bLUSD tokens
  3. Every bond is represented as an NFT, which makes it tradeable and transferable
  4. Users who own the bond NFT can choose to “Chicken in” or “Chicken out”
    • Chicken in: Users claim their bond by exchanging their LUSD for the accrued bLUSD balance. 
    • Chicken out: Users cancel their bond to regain ownership over their original LUSD principal. This cancels the bond and forgoes any yield accrued by the bLUSD virtual balance.4


Liquity Breakdown Chicken In Chicken Out

 


Liquity Breakdown Boosted LUSD Strategy

Bonds as NFTs

Every time a bond is created, a unique ERC721 NFT is minted and issued to the user’s Ethereum address. Ownership of this NFT gives ownership over the bond. Similarly, transferring the NFT transfers control of the bond.  Users can own more than one bond too. The visual representation of the NTF in Chicken Bonds is dynamic and will change based on the state of the bond:

  • Egg – pending bond with full access to the underlying assets
    • Color of the border.
    • Background color of the card.
    • Color of the egg.
    • Size of the egg.


Liquity Breakdown Eggs

  • Chad Chicken – after a “Chicken in” with no control over any assets
    • Inherits the attributes of the egg.
    • Gains bonus attributes for on-chain activities.
  • Runway Chicken – after a “Chicken out” with no control over any assets
    • Egg size.
    • Color of the border.
    • Card color.

The NFT artwork and rarity traits are randomized and determined by: 

  • Bond size.
  • Size of the Liquity trove.
  • LQTY staked.
  • veCRV devoted to the LUSD/3CRV and LUSD/FRAX gauges.

All the artwork is in SVG format and generated fully on-chain. Some marketplaces are slow to refresh their metadata, which can result in NFT showing as bonding, while in reality, it has already “Chickened in or out”.

Limitations

  • There is a minimum period of 15 days that must pass between the bond creation and the first “Chicken in”. Once the first “Chicken In” has occurred, bonders may “Chicken in” at any point after bond creation. This restriction ensures that someone cannot “Chicken in” early and redeem a very small amount of bLUSD for all of the initial yield captured by the protocol. Besides, all LUSD accumulated before the first “Chicken in” takes place is real yield. Once the first “Chicken in ” occurs, the accumulated yield is sent as a reward to the bLUSD/LUSD-3CRV pool LPs. This prevents the first bLUSD holder from capturing outsized returns.
  • Transferring ownership of the bond, which is the equivalent of selling the NFT, is not allowed for the first 24 hours after a “Chicken In” or “Chicken Out”. This ensures that bond sales cannot be front-run by a “Chicken In” or “Chicken Out” that removes its economic value. This also helps NFT marketplaces such as OpenSea to have enough time to refresh and show the new artwork for the new NFT that has no bonded LUSD associated with it.

bLUSD

bLUSD is an ERC20 that gets minted when a user “Chickens in”. This act of minting bLUSD represents that a user has given up their bonded LUSD to the protocol in exchange for a claim in bLUSD. Because of this, the received amount of bLUSD depends on the virtual balance when the “Chicken in” takes place. bLUSD can also be traded on the bLUSD/LUSD-3CRV pool.

Note that bLUSD is a volatile token and its token holders might incur gains/losses depending on the perceived risk by the market and the premium other people are willing to pay for the future expected yield accrued in bLUSD. With that being said, bLUSD captures an enhanced yield compared to the yield obtained by LUSD deposits to Liquity’s stability pool. 

bLUSD is backed by funds in the Reserve Bucket and can always be redeemed for a proportional share of the Reserve (x% of the bLUSD supply redeems x% of the Reserve). Upon redeeming, users receive a mix of LUSD and yTokens from the Yearn Curve LUSD vault. The mix of tokens being received will depend on how the Chicken Bonds system funds are deployed at that moment – that is, how the funds are split between the protocol and the Yearn Curve vault.

Anyone can redeem bLUSD by calling the “redeem” function on Etherscan. However, in the economic sense, it only makes sense to redeem when the market price of bLUSD is below the redemption price. This is most likely an arbitrage opportunity that will usually be captured by arbitrage bots. For this reason, frontend operators do not include this functionality on the user interface, which is why it has to be done by manually interacting with the contract on Etherscan.

Where bLUSD Yield Comes From

bLUSD is supported by a yield amplification mechanism that is achieved by having 3 different buckets that act as sources of yield. This bucket system is what makes it possible for bLUSD to achieve a higher yield than depositing LUSD in the stability pool.

  • Bonding or pending bucket: Pending user bonds (which have not yet “Chickend in or out”) that earn yield from the stability pool.
  • Reserve bucket: LUSD acquired from “Chicken ins” backing the bLUSD supply and earning yield from the stability pool.
  • Permanent bucket: Protocol-owned liquidity holding excess LUSD diverted from bonds that were “Chickened in” early and that are earning yield from the stability pool. The LUSD that is owned by the protocol can never be redeemed.


Liquity Breakdown Permanent Bucket

In the beginning, early bLUSD holders will profit from the yield of later bonders. This is the initial kickoff for a flywheel effect where the first bonders to “Chicken in” will earn the yield from those users who are still bonding.

  1. Bonding amplifies yield
  2. Boosted LUSD (bLUSD) gains in value
  3. Bonding becomes more attractive
  4. Repeat


Liquity Breakdown Bonding

This feedback loop depends on the yield from the bonding process. The yield amplification, however, is not only dependent on new bonders. The reason for that is because over time the Protocol Owned Liquidity of the Permanent Bucket will grow and provide additional yield even if no new bonds are created.  This is the design where Chicken Bonds prevent a bank run situation because anybody can redeem bLUSD for their LUSD principal in the Reserve bucket (principal protection). 

The following actions create yield:

  • Bonding
  • Chicken in (claim bond)
  • Chicken out (cancel bond)

To achieve a yield amplification effect, the LUSD held by the system is allocated to 2 different yield sources:

  • B.Protocol
  • Yearn Curve LUSD Vault

The amplified effect comes from “Chickens out”, since those users are claiming their initial LUSD and foregoing the yield their bond generated in its lifetime. This yield ends up in the Reserve and, therefore, gets captured in the redemption value of bLUSD. As a matter of fact, by “Chickening out”, a bonder gives up their right to claim bLUSD and this yield goes to bLUSD holders.

Bonders accrue a virtual balance during the lifetime of a bond based on a plateauing curve that ensures that a bonder’s bLUSD accrual rate decreases over time. 

  • The point of breakeven is reached when the market value of the accrued bLUSD equals the initial amount of LUSD that was bonded.
  • The optimal “Chicken in” time is reached when a bonder is willing to sell their bLUSD for LUSD to rebond again and maximize bLUSD value accrual in the long run.  
    • Because of fluctuations in the market price of bLUSD, it is not possible to predict when this optimal “Chicken in” time will take place. Nevertheless, this time will come after the break-even time.
  • As Early “Chicken ins” (before the optimal “Chicken in” time) claim their bonds, some LUSD goes to the Reserve and some goes to the Permanent bucket. The earlier the bond is claimed, the greater the amount of the bonded lUSD gets sent to the Permanent bucket.
    • When a bonder “Chickens in” early, they get less bLUSD and instead, give more LUSD to the Permanent bucket
    • The extra LUSD from early “Chicken ins” to the Permanent bucket flows to the Reserve, which amplifies the bLUSD yield
  • As Late “Chicken ins” (after the optimal “Chicken in” time) claim their bonds, they will earn bLUSD more slowly than those who “Chickened in” before. It will take these users longer to accrue a given value of bLUSD.
    • The net effect is that late “Chicken ins” are transferring their value to those who managed to “Chicken in” at the optimal time.

Keep in mind that the yield generated from the 3 buckets is auto-compounded and flows to the Reserve bucket. Therefore, the LUSD in the Reserve bucket grows faster than the natural rate at which LUSD compounds.

As yields flow to the Reserve bucket, the redemption price increases. 

If at a given time you can redeem 1bLUSD for 1 LUSD, then at a later time the LUSD will have compounded and 1bLUSD will be redeemable for more than 1 LUSD.

For Investors


Liquity Breakdown Investors

How Yield From Chicken Bonds Help Liquity



Liquity Breakdown Chicken Bonds

The Permanent Bucket stores the Protocol Owned Liquidity for LUSD. The protocol will use this LUSD to provide liquidity on Curve. In this way, LUSD funds can go back and forth between the Liquity stability pool and the LUSD pool on Curve. This reinforces the decentralization ethos of the protocol since this automated mechanism removes any human intervention.

Investing Strategies

The game theory of “Chicken in” early, “Chicken in” late, and “Chicken out”

There are good and rational decisions to make one decision or another in certain situations. 

  • When a user needs to get back bonded funds for repaying a loan, it makes sense to “Chicken out”.
  • Due to price fluctuations in the market price of bLUSD, there are good reasons to “Chicken in” before or after the optimal time.
    • It makes sense to “Chicken in” early when a bonder can make a profit on the bLUSD market premium. This would guarantee a profit and forego a possible future gain.
    • Late “Chicken ins” are inevitable, since solving for an exact optimum “Chicken in” time is not a trivial task and users are never perfectly responsive. Also, if you are a bonder and the Ethereum network is congested, it makes sense to be slow to react and leave some value on the table while saving ETH gas on high transaction fees.

Ultimately, bond returns depend on the bLUSD market price, and how well bonders time their bLUSD sale or redemption. Indeed, the bLUSD market price will capture the expectations of future growth as a speculative sentiment. This expectation will translate to a market price premium. The absolute return for a bonder will ultimately depend on the sale price and, since we have analyzed different rational scenarios for making one decision over another, it can be argued that the system is not a zero-sum game. A zero-sum would take place if all bonders only redeemed bLUSD. However, due to the bLUSD market premium, it is possible for all bonders in the aggregate to achieve better returns than compounding the underlying LUSD themselves.

Chicken Bond Strategies


Liquity Breakdown Chicken Bond Strategies

Bonding strategy: 

  1. Create a trove and deposit ETH to borrow LUSD
  2. Create a bond with the freshly minted LUSD to optimize returns. At this point, if the user needed to repay its debt due to ETH depreciation, he could cancel the bond at any time.
  3. After some period of time, the bLUSD balance will surpass the break-even point, meaning that bLUSD has accumulated enough yield to be worth more than the underlying LUSD.
  4. The user “Chickens in” and receives bLUSD in return for his initial LUSD deposit when the bond was created.
  5. The user swaps bLUSD back to LUSD for a profit and rebonds the LUSD principal amount

Trader strategy:

  1. If the price is close to the redemption price, the user buys bLUSD (at a low premium). When the demand for bLUSD increases and the price goes up, the user will sell bLUSD (at a high premium).

The LP strategy:

  1. User opens a trove to mint LUSD with ETH collateral
  2. The user starts bonding
  3. The user will “Chicken in” before reaching the break-even point to be one of the first users to provide liquidity in Curve in the LUSD/bLUSD pool to capture fees from “Chicken ins” and the pool trading fees.
  4. Once the user has deposited liquidity in the pool, when demand for LUSD spikes, the user will sell their bLUSD to rebond.

The Pro Trader strategy consists in opening many bonds of different sizes and using a mixture of strategies to hedge risk:

  1. The user opens 3 bonds worth different amounts
    1. For the first bond, the user “Chickens in” early so that he can be one of the first to provide liquidity and earn pool fees on Curve. By doing this, the user will be able to collect fees from the LP strategy.
    2. For the second bond, the user waits until bLUSD trades at a premium to resell it back to LUSD for profit. By doing this, the user will be able to speculate on the market price of bLUSD.
    3. For the third bond, the user waits to reach the break-even point to sell bLUSD for LUSD and start the whole process again. By doing this, the user will be able to rebond and compound yield for optimal long-term returns.

The Buy Low and Hold strategy:

  1. The user plans to open a trove and keep it open for multiple years.
  2. The user buys bLUSD on a DEX (decentralized exchange) to get access to the amplified bLUSD yield without going through the bonding process
  3. Contrary to other volatile assets, holding bLUSD has two distinct advantages:
    • There is a guaranteed price floor through redemptions (which can only increase and never decrease).
    • bLUSD earns an amplified yield, which means that under normal circumstances the market price should more or less grow at the same rate as the increasing redemption price.


Liquity Breakdown Buy Low Sell High

The NFT Collector strategy:

  1. User opens a trove to get LUSD
  2. User starts bonding and gets back the Egg NFT
  3. The user lends the Egg NFT to get more liquidity on its NFT collateral. Due to the fixed price floor, the user does not have to worry about its position being liquidated
  4. The user keeps ownership over the NFT while benefiting from the rising price floor of bLUSD and farming stables on top

The Arbitrage Bot strategy:

  1. The liquidator bot will monitor the market price of bLUSD and, every time the market price goes below the redemption price, the bot will buy bLUSD and redeem it for LUSD.

LUSD-based strategies

LUSD integration into other lending services such as Aave, Euler, and Gearbox, either as a borrowable asset or collateral allows the creation of strategies for investors, with three main use cases in mind.

  • Borrowing LUSD with different conditions (compared to Liquity):
  • Use LUSD as collateral:
    • Liquidity providers leveraging for better yields

Borrowing LUSD with different conditions (compared to Liquity)

Borrowing LUSD on money markets can be done with a wide range of collateral, and different borrowing terms, which can be beneficial due to the following reasons.

  • Liquity only allows ETH as collateral, while other money markets support various collaterals.
  • Liquity also charges no interest rates on borrowings but a 0.5% initiation fee. While this may be cheaper for long-term borrowers, it can be unfavorable for short-term positions.

Hence, having LUSD be borrowable on other money markets unlocks much more strategies and freedom for investors. An example of a strategy utilizing LUSD borrows would be a short-term LUSD peg shorting.

  • In the event of LUSD’s price appreciating above $1, the user can deposit USDC into a money market, borrow LUSD, and sell it into USDC.
  • Once LUSD has returned to peg, the user can simply buy LUSD at a cheaper price to service his debt.
  • However, the user must be aware of the period it may take for the price to return to peg, which may take months.
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Use LUSD as collateral

There are three main services that provide borrowing on LUSD, allowing usage as collateral for forex (fx) arbitrage strategies, being Angle, Mimo, and Silo Finance. For example, if the user is bearish on the EUR and wishes to short it.

  • The user deposits LUSD on Angle to borrow agEUR (Angle EUR stablecoin).
  • agEUR is sold into LUSD or another dollar-pegged stablecoin.
  • When EU has fallen to the target levels, the user can buy back agEUR at a cheaper price in order to service his debt.

Another example of using LUSD as collateral in an FX strategy involves off-ramping EUR using ETH as collateral via Liquity since Liquity charges no interest.

  • The user can deposit ETH on Liquity to borrow LUSD.
  • LUSD is deposited on Angle and agEUR is borrowed.
  • agEUR is swapped to jEUR and off ramped.
  • The user can then proceed to buy the required physical goods.
  • As Liquity only charges a one-time initiation fee of 0.5% and no interest, the user only has to manage:
    • The borrowed agEUR interest fee on Angle.
    • Loan health on the initial ETH.

Longing the LUSD peg can also be done as a strategy if the user thinks that the LUSD price will increase

  • The user can deposit LUSD on Silo Finance and borrow XAI (Silo stablecoin).
  • XAI is then swapped back to LUSD, essentially leveraging LUSD.
  • When LUSD reaches the desired price target, the user can sell LUSD in profit and service the XAI debt.

Liquidity providers leveraging for better yields

Users looking to borrow using a LUSD LP collateral to leverage the yield of the position and output a better yield. This can be done via Gearbox Protocol (composable leverage protocol that enables users access to leverage on essentially any protocol.)

  • Supply Curve LUSD/3CRV to obtain crvLUSD-3CRV LP tokens.
  • Deposit the LP tokens on Convex to obtain cvxLUSD-3CRV.
  • Deposit cvxLUSD-3CRV in GearBox Credit Account.
  • Choose the leverage and execute to enjoy boosted yields

Economics

Fees Breakdown

There is a one-off fee whenever LUSD is borrowed or redeemed. 

Borrowers pay a borrowing fee as a percentage of the total loan amount (in LUSD).

  • The borrowing fee is added to the Trove’s debt and is given by a baseRate fee confined to a range between 0.5% and 5%. This fee rate is multiplied by the amount of liquidity taken out in the original loan.
    • For example, borrowing 5,000 LUSD at a 0.5 baseRate fee means that the borrower is being charged a 25 LUSD borrowing fee.
  • Redeemers pay a redemption fee on the amount paid to users by the system (in ETH) when exchanging LUSD back for the ETH collateral. Redemption fees are calculated as (baseRate + 0.5%) * ETH withdrawn, where the baseRate is dynamically adjusted:
    • baseRate decays based on time passed since the last fee event (either the last redemption or the last LUSD issuance)
    • baseRate increases by an amount proportional to the fraction of the total LUSD that was redeemed.

Redemptions are separate from borrower’s loan repayments, which are free of charge.

In both cases, the fees depend on the volume of redemptions:

  • Fees increase upon every redemption based on the redeemed amount.
  • Fees decrease over time as long as no redemptions take place. This fee decay ensures that fees for borrowers and redeemers gradually slow down as volume decreases.

The reason for this mechanism is to have algorithmic control over the actions taken by users, such that large redemptions are accumulated with higher fees and borrowing activity takes place after large redemptions.

For example, if more redemptions are happening (which means that LUSD is likely trading below 1 USD), the borrowing fee would continue to increase to discourage borrowing.

  • Fees cannot become lower than 0.5%, except in Recovery Mode. This protects redemptions from being front-run by arbitrageurs.

Liquity Breakdown Fees

  • The maximum amount charged in fees is also capped at 5% in order to incentivize borrowers during phases of large redemptions.
  • Borrowing fees are 0% in Recovery Mode.

Tokens

The Liquity Protocol uses a dual-token model

  • LUSD is the USD-pegged stablecoin used to pay out loans. LUSD can be redeemed at any time against the underlying collateral at face value.
  • LQTY is the protocol-issued token that captures the revenue generated by the protocol. This revenue is used to incentivize front-end operators and protocol participants. LQTY has a total supply of 100,000,000 tokens.

LQTY Rewards

LQTY is the secondary token issued by the protocol. This token captures the fee revenue generated by the system and incentivizes early adopters and front-end operators to remain engaged in the protocol.

LQTY rewards only accrue to stability providers, frontends who facilitate those deposits to the stability pool, and liquidity providers to the LUSD-ETH Uniswap pool.

To start staking, LQTY tokens are deposited into the staking contract. Once done, the user will start earning a pro-rata share of the borrowing and redemption fees in LUSD and ETH respectively.

There is no lockup period for withdrawing staked LQTY tokens.


Liquity Breakdown Lockup

Token Distribution

  • LQTY has a maximum supply of 100,000,000 supply. 
  • LQTY is not a governance token, as Liquity is a governance-free protocol
  • LQTY can be earned in 3 ways:
    • Depositing LUSD to the stability pool
    • Facilitating stability pool deposits as a frontend operator
    • Providing liquidity to the ETH-LUSD Uniswap pool
  • LQTY can be staked to earn fees generated from loans issuance and LUSD redemptions
  • LQTY’s community issuance follows a yearly halving schedule: 32,000,000 * (1 – 0.5 ^ year). The purpose of this issuance curve is to incentivize early adopters while also maintaining long-term incentives.


Liquity Breakdown LQTY Allocations


Liquity Breakdown LQTY Allocations

Token Distribution:

  • 33.5% to the Liquity Community:
    • 32,000,000 LQTY to the rewards pool. These rewards are earned through the stability pool deposits and will be rewarded to stability providers and frontend operators
    • 1,333,333 LQTY to LPs of the ETH-LUSD Uniswap pool. These tokens are earned by staking the ETH-LUSD Uniswap LP tokens and will be distributed over 6 weeks
    • 2,000,000 LQTY to the Community Reserve to fund grants, hackathons, events, and other community-focused efforts.
  • 23.7% to team and advisors
    • 23,664,633 to the current and future team members and advisors
    • All LQTY tokens in this category are under a 1-year lockup and are ¼ vested after 1 year of engagement and 1/36 every month afterward
  • 33.9% or 33,902,679 tokens to early investors under a 1-year lockup
  • 6.1% or  6.063,988 tokens to Liquity AG for use by the company subject to a 1-year lockup
  • 1% or 1,035,367 tokens to service providers under a 1-year lockup

bLUSD

bLUSD or bonded LUSD is an ERC20 stablecoin that gets minted when a user “Chickens in”. This act of minting bLUSD represents that a user has given up their bonded LUSD stablecoin to the protocol in exchange for a claim in bLUSD. Because of this, the received amount of bLUSD depends on the virtual balance when the “Chicken in” takes place. bLUSD can also be traded on the bLUSD/LUSD-3CRV pool.

Note that bLUSD is a volatile token and its token holders might incur gains/losses depending on the perceived risk by the market and the premium other people are willing to pay for the future expected yield accrued in bLUSD. With that being said, bLUSD captures an enhanced yield compared to the yield obtained by LUSD deposits to Liquidity’s stability pool. 

bLUSD is backed by funds in the Reserve Bucket and can always be redeemed for a proportional share of the Reserve (x% of the bLUSD supply redeems x% of the Reserve). Upon redeeming, users receive a mix of LUSD and yTokens from the Yearn Curve LUSD vault. The mix of tokens being received will depend on how the Chicken Bonds system funds are deployed at that moment – that is, how the funds are split between the protocol and the Yearn Curve vault.

Anyone can redeem bLUSD by calling the “redeem” function on Etherscan. However, in the economic sense, it only makes sense to redeem when the market price of bLUSD is below the redemption price. This is most likely an arbitrage opportunity that will usually be captured by arbitrage bots. For this reason, frontend operators do not include this functionality on the user interface, which is why it has to be done by manually interacting with the contract on Etherscan.

Governance

Unlike other protocols, Liquity is governance-free. Instead of a token voting system, it relies on built-in algorithms that fully automate and dynamically update its adjustable parameters without the need for token voting and governance calls. This is achieved by measuring redemption volume and applying a time decay mechanism that constantly adjusts the base rate, serving as a basis for both borrowing and redemption fees.

The protocol has no admin key, and nobody can alter the rules of the system in any way since the smart contracts are immutable.

LiquiFrens Initiative

The program was ended on May 5 2023 by the Liquity team, as the team was unable to find the optimal setup yet for such a community-led endeavor.

LiquiFrens was a grants program, introduced on January 27 2023, that provided funding for user-made proposals and $LQTY holders voted on which proposals got funded, thus giving holders a more hands-on role on where to steer activities within the Liquity ecosystem.

The Liquity AG would donate the yield of the 5m of staked $LQTY to the Liquifrens initiative as the initial funding.

While the program only lasted about 4 months, multiple proposals were passed under it, including:

  • LQIP-1 – Ambassador for Liquifrens and help bootstrap the program [1500 LUSD]
  • LQIP-2 – Build a Dune dashboard for $LUSD & $LQTY yield opportunities [3k LUSD]
  • LQIP – 4 – Enable $LUSD pairs on Mean Finance for decentralized dollar cost averaging [5000 USD]
  • LQIP-8 — Seed LUSD in Tarot lending pools on Arbitrum [5,000 LUSD]

Risks

Security

As a fully automated and algorithmic decentralized protocol, all tokens are transferred from users to the protocol without the intervention of any person or legal entity. Because of that, users who interact with the protocol are subject to the rules set forth in Liquity’s smart contracts.

Audits

Economic Attacks Vectors

Decentralized lending protocols face 4 main risk factors:

  • Security risk: correct execution of smart contract logic, store of supplied assets, management of borrowed assets, and efficient liquidations.
  • Governance risk: administrator privileges and key management, poor voting participation, and concentration of voting power. None of these apply to Liquity since it is a governance-free protocol.
  • Oracle risk: Precise pricing and liquidation mechanisms of the lending contract. Oracle price feeds are used for assigning a value to outstanding loans and estimating which ones are in default. 
    • Manipulation of Oracle price feeds can force the protocol to liquidate loans that are not in default, thus causing a loss of customer funds
    • Liquity’s ETH-USD price feed has undergone multiple security analyses and its risk is negligible
  • Market risk: Exogenous risks such as safety of liquidations, market volatility, cascading liquidations…
    • Borrowers need the protocol to remain solvent, otherwise, they will not be able to get their ETH collateral back
    • LUSD stakers can lose some or all of their principal if liquidations are not performed fast enough as the ETH price is falling
    • Liquidators may not be sufficiently compensated when the Ethereum network is congested and gas fees are high.

Liquity Breakdown Collateralization Ratio
Liquity Breakdown Collateralization Ratio

Some recommended parameters for users who want to decrease market risk

Chicken bonds:

  • Smart contract risk of Chicken Bonds as well as the smart contract risk of its dependent protocols, B.Protocol and Yearn.
  • Economic risk derived from the volatile market value of bLUSD.
  • Temporary delay to withdrawals due to liquidations. This can occur if heavy liquidations take place in Liquity. This would cause a delay and “Chickening out” may be temporarily suspended for a small portion of users. This will persist for some time until the ETH from liquidations has been recycled back to LUSD.
  • Economic losses from liquidations under extreme market conditions. For example, if a large volume of ETH is liquidated and the ETH price drops significantly during the time interval between the liquidation and ETH harvest, the Reserve bucket would incur a loss that, by extensions, would also affect bLUSD holders. This is unlikely due to the presence of a 9% buffer to absorb any possible ETH price drop.

Chicken bonds might turn non-profitable as the product matures:

  • After a LUSD deposit into the Chicken bond contract, the rate of accrual of bLUSD will start growing quickly. However, after time goes by, this rate of increase will start to slow down. This is intended and expected by design. At this point, the user must assess whether it is worth it to hold and claim the bond after it turns profitable, or whether it is preferable to cancel the bond and market buy bLUSD. The user will now be faced with a situation in which bLUSD can be obtained in 2 ways: mint bLUSD by depositing LUSD, or buy bLUSD on the open market on Uniswap or Curve. These actions will have an impact on the floor price of bLUSD. For instance, the bLUSD floor grew 7% after 60 days. The decision that the user will make will depend on the age of the bond, the size of the bond, and the price of bLUSD.
  • Because of this, bonders will need to take into account the following variables (which are used to determine the bLUSD rate of accrual): the amount of LUSD bonded, the “Chicken in” fee, the redemption price of bLUSD, the accrual parameter, and time.
    • It turns out that the rate accrual might stagnate and not reach profitability for a long time. This happens because the bLUSD that is accrued can go down when there is an increase in the floor price (the growth in the floor price will outweigh the increase from the rate of accrual).  When this occurs it makes no sense to bond any longer. The user would chicken in and claim the bond to benefit from the increasing floor price (or supply to Curve to earn additional revenue from fees).
    • When the bond is aged between 15 and 35 days, there are some cases where it makes sense to chicken out and market buy bLUSD instead. However, this will depend on the size of the bond. For instance, if the slippage is too large, the user could be better off waiting, and then claiming partially to deposit liquidity on Curve. For reference, see this Dune Dashboard.
  • The protocol is designed in such a way that there should be an external liquidity pool where bonders can sell bLUSD to realize profits. This will happen when the price of bLLUSD is higher than the redemption price of the bond. Nonetheless, higher bonding volumes might generate an increased bLUSD sell-off after “Chickening in”. This selling pressure is absorbed by incentivizing LPs in the bLUSD pool. This incentive comes from the 3% “Chicken in” fee. On top of that, the Liquity team also proposed adding a CRV gauge to the bLUSD-LUSD3CRV V2 pool
    • If the price of bLUSD rises, this would result in higher bonding activity and more demand to hold bLUSD, such that the average bond age would be lower. The market price of bLUSD would increase in the following scenarios:
    • LPs providing single-side LUSD liquidity.
    • Users “Chickening out” after bonding for long periods of time.
    • Users “Chickening in” early.
    • Users redeeming bLUSD to take a loss.
    • If the price of bLUSD falls, this would lead to lower bonding volume and the average bond age would be even lower. Based on a Cryptoriskteam report, If a reduction in the market price due to a decrease in the accrual rate parameter was greater than the price increase in bLUSD, there would be a drop in the price of bLUSD such that if the market price goes beyond 1.031 times the redemption price, there would not be a single profitable trade. To solve this issue, the following solutions were proposed:
    • Let the accrual rate be a fixed variable rather than a dynamic parameter.
    • Split the yield coming from the Permanent Bucket into:
    • A portion goes to the Reserve Bucket.
    • A portion goes to the LPs of the bLUSD-LUSD3CRV pool.
    • A portion going to a fourth “Boosted Bucket” would drive the demand for bLUSD while reducing its selling pressure. Similar to how locking CRV works, users could stake bLUSD in the “Boosted Bucket” to earn LUSD, such that only the distribution of LUSD would change instead of the amount accumulated.
  • As a novel concept, the idea of Chicken Bonds has been actively tested and simulated in many situations. However, while modeling and running simulations can be a good way to estimate future outcomes, the market performance can not be predicted and traders will need to adjust their strategies. The Liquity team is also observing the behavior of Chicken Bonds in the market and potentially working on new products to improve the utility and efficiency of this mechanism. Some of these ideas are:

Chicken bonds risks:

  • Risks of impermanent losses for bLUSD-LUSD3CRV Liquidity Providers (LPs), in 2 forms. This happens when the price of one or both assets shifts, resulting in a change in the ratio of the initial liquidity provided.
    • bLUSD price risk: Low liquidity on bLUSD-LUSD3CRV results in higher price volatility, leading to a higher bLUSD price drop when selling it. As bLUSD is an interest-bearing version of LUSD, its floor price (FP) is always increasing. Hence, the gap between market prices and FP will widen if 
      • Bonding volume > chicken in volume
      • More users bond
      • Users chicken out after bonding for a considerable time
      • Users chicken in early

However, if the above factors are controlled, the market price will eventually drop and trade near FP in the long run, resulting in slowed trading activity and opportunity costs for the LPs.

  • LUSD price risk: LUSD may get depegged if people are not confident in holding ETH in a flash crash.

Risks associated with yield generation:

  • B.Protocol – Stability pool: LUSD chicken bonds protocol makes use of B.Protocol to store funds in the stability pool whilst generating yield. 
    • ETH price crashing heavily and liquidations in the event of extreme market conditions could cause a loss in the stability pool investments. 
    • Oracle price feeds being unable to catch up with flash crash prices.
  • Yearn LUSD vault: Only funds residing in the bucket pool can be deposited in the Yearn vault.
    • While Yearn can be considered a relatively safe protocol that has been battle-tested, smart contract risks are always existent. 
    • As of November 2022, only 500k LUSD is exposed to the permanent bucket.

Opportunity cost:

  • The Risk DAO’s technical paper concludes that the system might reach a state where bonding will not be profitable, assuming
    • Negligible chicken in fees
    • Halting bonding-rebonding
    • Stagnant bLUSD-LUSD trades lead to negligible vAPY.

Risk assertions:

Dependencies on Other Protocols, Liquidity Risk, Asset Risk…

While liquidations will occur at a collateral ratio above 100% most of the time, it is possible that a trove gets liquidated below this level in a flash crash or due to an oracle failure. When this happens, stability pool depositors may suffer a loss, since the gain from the collateral will be lower than the reduction of their original deposit.

Additional Information 

Partners

Investors: TomaHawk.vc, Polychain Capital, Pantera Capital, 1kx, a_capital, Robot Ventures, AngelDAO, Alameda Research, GreenField One, Nima Capital, Zola, Lemniscap, IOSG Ventures

Security: Gauntlet, Trail of Bits, Hats.Finance, Nexus Mutual, and Coinspect

Exchanges: Coinbase, Gemini, Huobi

DeFi:

  • Olympus DAO – Issuer of $OHM, the decentralized reserve currency of DeFi.
  • Synthetix – Financial primitive enabling the creation of synthetic assets, offering unique derivatives and exposure to real-world assets on the blockchain.
  • Velodrome – The central trading and liquidity marketplace on Optimism network.
  • Camelot Exchange – The Arbitrum native DEX. Custom-built liquidity infrastructure to support builders & generate real yield.
  • Aztec Network – Aztec is a first-of-its-kind hybrid zkRollup supporting both public and private smart contract execution.
  • Maverick AMM – Maverick Protocol is a new decentralized finance infrastructure featuring LUSD in liquidity pools.

FAQ

What is Liquity?

Liquity is a decentralized and interest-free borrowing protocol that allows users to draw 0% interest loans against Ether as collateral. Loans are paid out in LUSD, a stablecoin pegged to US Dollars at a 110% collateral ratio.

How can I use Liquity?

Liquity is accessible via any of the front-end systems that allow access to the protocol smart contracts. The core team building the protocol does not intend to operate a front-end interface and the protocol will be accessed via front-end applications built by community contributors.

List of frontends: https://liquity.org/frontend#list

How does Liquity offer interest-free borrowing?

By charging one-time borrowing and redeeming fees, the protocol manages to stay solvent and adjust its fees algorithmically based on the last redemption time.

What are the main benefits of Liquity?

  • 0% interest rate loans
  • 110% collateral ratio
  • Governance-free protocol (all decisions are algorithmic and fully automated)
  • LUSD can be redeemed at face value for the underlying collateral by anyone at any time
  • Censorship resistant and permissionless

How can I earn on Liquity?

Users can earn in 2 ways:

  1. Deposit LUSD to the Stability Pool and earn protocol revenue from liquidations and LQTY rewards.
  2. Stake LQTY and earn protocol revenue from issuance fees (in LUSD) and redemption fees (in ETH).

How can I access the Liquity protocol?

Liquity is accessible via frontend interfaces created by the community and run by multiple operators. The core team building the protocol does not intend to create its own user interface.

List of frontends: https://www.liquity.org/frontend.

What happens if my trove is liquidated?

You will lose your collateral and your debt will be paid off through liquidations. This means that you will no longer be able to get your collateral back by repaying your debt.

How is LUSD pegged to USD?

LUSD is not perfectly pegged to USD and can deviate slightly in both directions under certain market conditions. 

Why did the collateral and debt of my trove increase without my intervention?

If troves are liquidated and the stability pool is empty (or gets emptied due to liquidations), every borrower will receive a portion of the liquidated collateral and debt as part of a redistribution process.

What are Chicken bonds?

Chicken bonds are a bonding mechanism that allows protocols to bootstrap liquidity by protecting principal deposits and applying a bonding mechanism to yield-bearing assets.

How can I use LUSD Chicken Bonds?

  • Bond LUSD in exchange for bLUSD to get a boosted yield compared to the LUSD deposited in the stability pool.
  • Buy and hold bLUSD and benefit from the positive price tendency due to its rising price floor and enhanced yield.
  • Collect Dynamic Chicken Bond NFTs.
  • Provide liquidity for LUSD to the bLUSD/LUSD-3CRV pool and earn LP rewards and trading fees.

Is there a minimum bond size?

Yes, there is a minimum 100 LUSD bond size and the bond amount can’t be changed during bonding.

What is Rebonding?

Rebonding is the process by which a bonder “Chickens in”, sells their obtained bLUSD for LUSD at a profit, and then creates a new, larger bond.

How is my principal protected in a Chicken Bond?

While a user is bonding, the principal remains protected since the user can cancel the bond at any time and claim back the principal (initial LUSD deposit). Be aware that once you have “Chickened in” to claim your bond you are getting bLUSD back and your principal is not protected the same way anymore. 

How is the fair price of bLUSD calculated?

Estimating a fair price would be calculated based on the amount of yield being generated. In theory, the higher the yield, the higher the value of the token. In practice, each person’s idea of a fair value will vary based on time preference and the weight assigned to each of the qualities of the Chicken Bond system.

What is the difference between Olympus and Chicken Bonds?

Olympus DAO was the first example of how on-chain bonding works. However, the (3,3) coordination model relied on highly inflationary OHM rewards. This allowed the protocol to acquire assets rapidly, but then late joiners were left holding assets that would depreciate more and more over time. Contrary to OHM, bLUSD tokens will have a rising floor price due to the amplified yield and hard redemption mechanism. Besides, Chicken Bonds are also principal protective, and users can choose to withdraw their full LUSD principal.

How do Chicken Bonds improve LUSD peg stability?

Chicken Bonds accumulate Protocol Owned Liquidity in LUSD and the bonded LUSD is deposited to the stability pool.

  • When a user “Chickens in”, their bonded LUSD becomes Protocol Owned Liquidity and gets split between the Reserve and Permanent buckets. 
    • LUSD in the Permanent bucket can be shifted out to the stability pool and to the Curve pool via the Yearn Curve vault. 
    • Funds in Curve can also flow back to the stability pool.
    • Since Curve is the main venue for LUSD trading, the system ensures that shifting is performed only when it is possible to improve the peg (the shifting must bring the spot price of LUSD closer to $1).

Community links 

Official Links

Crypto Community Links

How to Use Liquity

  • Blogs:

Beginner:

Integration tutorials: 

Technical:

Twitter threads: 

Technical papers:

Economic modelling and simulations: