Can You Trust a Stablecoin's "Peg"? A Look into LUSD

By Michael @ CryptoEQ | CryptoEQ | 1 Sep 2023

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Liquity and LUSD

Liquity is a decentralized borrowing protocol that allows users to take out interest-free loans against Ether (ETH) deposits. The protocol is designed to be fully autonomous, with no admin keys or governance. Loans are paid out in the protocol's native stablecoin, LUSD, which is pegged to the US dollar.

LUSD is a stablecoin introduced by the Liquity Protocol, a decentralized borrowing platform that allows users to issue interest-free loans against Ether (ETH) collateral. The stablecoin is designed to maintain a value of approximately $1, with an algorithmic monetary policy mechanism ensuring its stability.

Other notable Liquity features include:

  • Non-custodial - users retain full control of their assets at all times.
  • Permissionless - anyone can participate, regardless of their technical expertise.
  • Decentralized - not controlled by any single entity.

LUSD is a USD-pegged stablecoin used to pay out loans on the Liquity protocol. It can be redeemed against the underlying collateral at face value. LQTY is the secondary token issued by Liquity, with a capped supply of 100,000,000 tokens. It captures fee revenue generated by the system and incentivizes early adopters and frontends.

To borrow LUSD, users need a wallet (e.g., MetaMask) and sufficient Ether to open a Trove and pay gas fees. To become a Stability Pool depositor or LQTY staker, users need LUSD and/or LQTY tokens, which can be obtained by opening a Trove, participating in the Stability Pool, or purchasing them on a decentralized exchange.

Liquity charges a one-off borrowing fee on loans as a percentage of the drawn amount (in LUSD) and a redemption fee on the amount paid to users (in ETH) when exchanging LUSD for ETH. These fees depend on redemption volumes, increasing upon every redemption and decaying over time as long as no redemptions occur. The borrowing fee is capped at 5%, while the minimum fee is 0.5%, which prevents misuse by arbitrageurs front-running the price feed.

Key Features of LUSD:

  1. Interest-free loans: One of the primary use cases of LUSD is to enable users to take out interest-free loans. Borrowers can deposit ETH as collateral and mint LUSD, which they can then use within the DeFi ecosystem or convert to other stablecoins or cryptocurrencies.
  2. Stability mechanisms: To maintain LUSD's peg to the US dollar, the Liquity Protocol employs a set of mechanisms that adjust the system's parameters. These adjustments incentivize users to either mint or redeem LUSD depending on the stablecoin's current price. For instance, if LUSD is trading above $1, users are encouraged to mint new tokens, increasing the supply and pushing the price down. Conversely, if LUSD is trading below $1, users can redeem their tokens for collateral, reducing the supply and pushing the price up.
  3. Decentralized governance: LUSD operates under a decentralized governance model, with token holders having the power to influence protocol decisions. This approach promotes transparency and community involvement, ensuring that the protocol evolves in line with the preferences of its users.
  4. Integration with DeFi platforms: LUSD is designed to be compatible with various DeFi platforms, allowing users to access a wide range of financial services such as lending, borrowing, trading, and staking.

Stablecoins in General

Stablecoins have emerged as the financial bridge between traditional currencies and the highly volatile world of cryptocurrencies. Their allure lies in the promise of stability, yet, like all financial instruments, they are not without risks, especially when the peg breaks. Understanding both the significance and the intricacies of stablecoin pegs is paramount for every financial professional navigating the crypto space.

Stablecoins derive their name and functionality from the notion of stability, closely pegging their value to conventional assets, most commonly fiat currencies such as the U.S. dollar. This pegging serves as a bastion against the notorious price fluctuations of renowned cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH).

Institutional investors and corporations find refuge in stablecoins. The predictability allows them to manage operations without the apprehensions tied to more volatile crypto assets. Furthermore, the global nature of stablecoins makes them instrumental in cross-border transactions, especially in regions grappling with fluctuating currencies or limited financial services. Not only do they promise efficiency, but stablecoins also potentially undercut traditional methods such as wire transfers in cost.

Moreover, in regions where banking infrastructure is sparse, stablecoins advocate for financial inclusivity. With them, the necessity of bank accounts or credit cards diminishes, allowing transactions in digital realms previously unreachable.

What is a "Soft Peg" like with LUSD?

The soft peg maintained by LUSD does not create significant risks for borrowers; rather, it offers stability and predictability. For instance, when borrowers repay their loans, they do so at a price of $1.02 for each LUSD token. This implies a 2% fee, which remains consistent, providing clarity to users about the cost of repayment.

Furthermore, the minting and borrowing fees can be temporarily adjusted based on the number of LUSD tokens minted or redeemed. This adjustment incentivizes actions that help restore the peg. Borrowers can take advantage of this dynamic to potentially generate profits.

The soft peg also allows for the potential of additional leverage compared to stablecoins with a hard peg. This is because of the arbitrage opportunity that arises from the difference between the price of LUSD debt ($1) and the trading price of LUSD in the market.

The Stability Pool

The Stability Pool plays a critical role in maintaining the stability and solvency of the Liquity protocol. Users holding LUSD are incentivized to deposit their funds into the Stability Pool, where they receive revenue denominated in $ETH from liquidated collateral and $LQTY rewards.

In the event of a borrower's collateral value falling below the required threshold, triggering a liquidation event, the Stability Pool provides the necessary liquidity to repay the debt, safeguarding the system from becoming undercollateralized.

However, the stability and effectiveness of the Stability Pool are subject to market conditions. In times of severe and prolonged market downturns, with a significant number of liquidations and collateral losses, the Stability Pool's capacity to cover debt obligations may be strained.

If the Stability Pool becomes depleted, the debt and collateral from liquidated positions are distributed to the Troves still in place, and this redistribution is proportionate to the amount of collateral in each Trove. This socialization of both collateral and debt ensures the preservation of the value and functionality of LUSD.

Recovery Mode

The Liquity protocol continuously monitors the Total Collateral Ratio (TCR), which represents the ratio of the USD value of the entire collateral to the USD value of all the debt in the system. When the TCR falls below 150%, Recovery Mode is activated to encourage collateral top-ups and debt repayments.

During Recovery Mode, Troves with a collateral ratio below 150% are liquidated, and further borrowing is disallowed to increase the TCR. However, to protect users, when a Trove is liquidated during Recovery Mode, the loss is capped at 110% of the Trove's collateral.

Since its launch, Liquity has only entered Recovery Mode once, which was on May 19, 2021, and lasted for approximately 2 minutes, demonstrating the protocol's resilience and stability.

The combination of these three features—the soft peg's predictability, the Stability Pool's safeguarding function, and the Recovery Mode's balance mechanism—ensures the stability and predictability of the Liquity protocol. As users continue to interact with LUSD on the Liquity platform, they can do so with confidence, knowing that these robust mechanisms are in place to safeguard their assets and maintain the integrity of the protocol.










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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


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