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Technology and Design
The Liquity Protocol is a decentralized finance (DeFi) platform that offers interest-free loans backed by Ethereum (ETH) collateral in the form of its native stablecoin, LUSD. LUSD is designed to maintain a peg to the US dollar, and the protocol employs a multi-faceted approach to achieve this objective. This article discusses the four primary mechanisms that Liquity uses to maintain the peg: Redemption, Stability Pool, Redistribution, and Recovery Mode.
Redemption:
Liquity employs a Collateralized Debt Position (CDP) model, where each LUSD is backed by at least $1.1 worth of ETH. If LUSD falls below $1, arbitrageurs can re-peg LUSD by purchasing it in the open market and redeeming $1 worth of ETH from the protocol. This process reduces the debt of Troves with the lowest collateral ratios (CR), incentivizing debtors to improve their CR by topping up collateral or repaying loans. To deter excessive redemptions, the protocol charges a fee (base rate + 0.5%), making it unattractive except for arbitrage purposes.
Troves
Troves are similar to vaults in MakerDAO. They are loans based on the deposited collateral and the debt issued. However, with a Trove, only one Ethereum address can be associated with a Trove (one Trove, one address).
source: @dani
Stability Pool:
The Stability Pool serves as a reservoir of LUSD for instant liquidation of Troves with low CR. Users are incentivized to deposit LUSD into the pool due to the potential profit from liquidations, which ranges from 8% to 10%. When a Trove is liquidated, the corresponding LUSD debt is burnt, and the Stability Pool receives the collateral from the liquidated Trove. This mechanism helps maintain the LUSD peg, especially during market turmoil, when demand for LUSD increases as borrowers seek to repay loans or participate in liquidation opportunities.
Redistribution:
When a Trove is liquidated, the debt is repaid by burning LUSD from the Stability Pool's balance, and the Trove's collateral is transferred to the Stability Pool.In the event that the Stability Pool is depleted, Liquity redistributes both the debt and collateral from liquidated Troves to all existing Troves based on each Trove's collateral proportion. This process decreases individual Troves' CR, making them more susceptible to liquidation. However, debtors benefit as they receive more than $1 worth of ETH for each additional LUSD repaid. This redistribution mechanism helps maintain the LUSD peg even when the Stability Pool is empty.
Recovery Mode:
Liquity enters Recovery Mode when the Total Collateral Ratio (TCR) falls below 150%. In this mode, all Troves with a CR below 150% are liquidated, with only 10% of their collateral penalized. Borrowing fees are set to 0% during Recovery Mode, encouraging users to mint and deposit more LUSD to replenish the Stability Pool.
In addition to these four mechanisms, Liquity has introduced a tool called Chicken Bonds to address the persistent premium of LUSD above $1. Chicken Bonds allow the protocol to increase its Protocol-Owned Liquidity (POL) as more users participate, enabling Liquity to create sell pressure on LUSD when it is above $1 and buy it back when it is below $1 using accrued assets from LUSD sales. This open market operation strategy helps maintain the peg while capturing arbitrage profits.
Chicken Bonds
Chicken Bonds represent a pioneering mechanism that enables projects to establish protocol-owned liquidity at zero cost while enhancing yield opportunities for end users.
Users can deposit their LUSD and in return receive an accruing balance of bLUSD. At any point, bondholders can choose to either reclaim their principal and forfeit the accrued amount (known as "chicken out"), or they can exchange it for the accrued bLUSD (known as "chicken in"). In the latter case, a portion of the system-secured LUSD backs the bLUSD supply, with the specific portion depending on the timing of the chicken in the event.
The protocol maintains a Treasury, comprising three logical components, or "buckets": the Pending Bucket, the Reserve Bucket, and the Permanent Bucket. The Pending Bucket, acting as a protocol-controlled vault, holds LUSD for depositors who are yet to make a chicken in/out decision. These funds are invested in B.Protocol and then promptly deposited into the Liquity Stability Pool.
The Reserve Bucket, another protocol-controlled vault, stores a section of the LUSD obtained from previous bondholders post a "chicken in" event. All yields generated by the funds in each bucket are funneled into this Reserve Bucket, thereby supporting bLUSD's supply. The Reserve Bucket backs the bLUSD supply, creating a progressively increasing hard price floor for bLUSD.
Lastly, the Permanent Bucket, a protocol-owned vault, keeps the remaining portion of the LUSD amassed from former bondholders.
bLUSD and Yield
The yield in the Liquity protocol is generated by investing the funds in two primary sources: B.Protocol and the Yearn LUSD3CRV vault.
- B.Protocol: Funds in the Pending bucket are consistently invested through B.Protocol. A portion of the Reserve and the Permanent bucket will also be invested in B.Protocol. The funds invested in B.Protocol are then deposited into the stability pool to facilitate liquidations. The ETH and LQTY generated through these liquidations are sold at a discounted rate for LUSD and redeposited in the stability pool. If liquidations are carried out with a collateral ratio of more than 100%, the LUSD quantity will increase.
- Yearn LUSD3CRV Vault: LUSD in the Yearn vault is deposited into LUSD3CRV-f, and the resulting LP tokens are supplied to Convex Finance to earn CRV, CVX, and potentially other tokens. The earned tokens are harvested and sold for more LUSD3CRV-f, which is then redeposited back into the strategy. This transfer of LUSD to the LUSD3CRV Curve pool acts as a peg-reinforcing mechanism, balancing the demand and supply of LUSD in the LUSD3CRV pool.
When a user bonds LUSD, they essentially receive a promise to redeem an accrued amount of bLUSD at the time of the chicken-in event, forfeiting the bonded LUSD. The accrual of bLUSD depends on several variables, such as the time, the bonded amount, chicken-in fees, the accrual parameter (alpha), and the redemption price of bLUSD.
A user's bonded LUSD amount, after accounting for the 3% chicken-in fees, is considered for the calculation of bLUSD accrual. The accrual rate may fluctuate based on the current redemption price, which is determined by the LUSD amount in the Reserve bucket divided by the bLUSD supply.
Furthermore, there is a mechanism that reduces alpha to speed up the bLUSD accrual rate. When the current weighted average bond age exceeds the target age of 15 days, the controller will decrease alpha. This function is primarily triggered when bondholders are reluctant to chicken in or out, indicating that they are not convinced that the accrued bLUSD is profitable enough to chicken in.
Liquidations
Liquity users, or debt holders, are required to maintain their "Trove" – a mechanism analogous to a Collateralized Debt Position (CDP) or vault – at a minimum collateral ratio (CR) of 110% under normal conditions, or 150% during active recovery mode. Trove management is crucial to prevent liquidations. The loans are safeguarded by a Stability Pool filled with LUSD, which oversees liquidation procedures.
The Stability Pool is a strategic source of liquidity used to settle debt from liquidated Troves. When a Trove is liquidated, an amount of LUSD equivalent to the remaining debt is burned from the Stability Pool's balance to cover the Trove's debt. In return, all the collateral from the Trove is transferred to the Stability Pool.
In unfortunate circumstances where the Stability Pool lacks funds to manage liquidations, the debt obligation from a liquidated Trove may be transferred to other LUSD debt holders. This transfer of debt obligation could negatively affect the health factor (collateral ratio) of remaining Troves, rendering them susceptible to liquidation should the ETH price plummet further.
The reallocation of collateral and debt is conducted proportionally to the recipient Trove's collateral amount. Troves with higher collateralization receive more debt and collateral from liquidated positions, a design which ensures that the system does not trigger a cascading liquidation effect.
Recovery Mode is triggered when the protocol's Total Collateral Ratio (TCR) drops below 150%. In such cases, Troves with collateralization ratios between the current TCR and 110% are liquidated. These liquidations are executed at 110% CR, allowing the borrower to recover excess collateral. Recovery Mode induces more liquidations with a capped discount. However, if the Stability Pool lacks sufficient funds, liquidations are impeded, which could potentially lead to market stress testing LUSD's peg.
Chicken Bonds were designed as an innovative solution to ensure the Stability Pool has sufficient liquidity to facilitate liquidations and safeguard the LUSD peg even under harsh market conditions.
Maintaining the Peg
The Liquity protocol incorporates a sophisticated mechanism to ensure LUSD peg stability, employing both hard and soft peg stability measures.
Source: Liquity
Achieving Hard Peg Stability
Every LUSD holder can redeem LUSD for ETH at face value, translating to 1 LUSD for $1 of ETH. In such cases, the system uses the redeemed LUSD to offset debt and extracts collateral from the riskiest Troves. This direct arbitrage mechanism establishes a price floor for LUSD at $1.
Furthermore, the 110% minimum collateral ratio sets an upper LUSD price at $1.10. Should the LUSD price exceed this level, arbitrageurs can deposit ETH worth $110 and sell 100 LUSD (valued at >$110) for a profit.
Implementing Soft Peg Stability
When the price of LUSD exceeds $1, borrowing becomes more appealing as users anticipate repaying at a lower rate or arbitraging on various decentralized exchanges (DEXs).
An increase in redemption volume implies higher Borrowing fees, making new loans less enticing and thereby curtailing LUSD supply.
As LUSD approaches the $1.10 mark, the profitability from Stability Pool liquidations starts to dwindle. This scenario would prompt users to withdraw their LUSD from the Stability Pool, thereby increasing the circulating supply of LUSD.
Dual Oracle Design
Liquity is a decentralized and immutable protocol that relies heavily on the ETH-USD price for several critical operations, including the calculation of Troves' individual collateral ratios (ICR) and the total system collateral ratio (TCR). Given the importance of an accurate and up-to-date ETH price, Liquity employs a dual-oracle design with sophisticated logic for handling temporary oracle failures or freezes without the need for human intervention.
The primary oracle in Liquity's system is Chainlink, which is known for its excellent track record, decentralization, and constant improvements. The secondary oracle is Tellor, a fully decentralized system where miners compete to push accurate data and win the associated "tip." Inaccurate data is disputed, with the threat of stake slashing incentivizing honest price reporting. Both Chainlink and Tellor use a proxy-logic pattern, enabling them to upgrade their logic without changing their endpoints, which is crucial for Liquity's immutable design.
When Liquity requires the ETH price, it calls both oracles and tracks their operational status. The primary oracle is preferred, but the secondary oracle is used if the primary fails or freezes. If both oracles are frozen or broken, the system uses the last good price it has seen. In case of a primary failure or freeze, the system keeps checking both oracles and switches back to the primary when both are live and in-sync again.
Chainlink is considered frozen if it hasn't updated its price for more than four hours. In this case, Liquity switches to Tellor. Tellor operates differently, with the price updated only after receiving a "tip" and miners submitting price data. If both oracles are frozen, the system uses the last good price and awaits Tellor's updated price, switching back to Chainlink when both oracles report current data.
An oracle is deemed broken if it provides no response, has an invalid timestamp, or returns a price of zero. Additionally, Liquity checks the price deviation between two Chainlink price updates. If the difference is greater than 50% and the Tellor price doesn't match, Liquity considers the primary price incorrect and switches to Tellor. If the Tellor price matches, Liquity infers that the major price change is legitimate and continues using Chainlink.
In the unlikely event of a double-oracle failure, Liquity freezes the price used by the system and continues to monitor the oracles for recovery. Switching back to the primary oracle is only possible when both oracles are live and have a price difference of less than 5%, as the likelihood of both oracles serving the same incorrect price data is low. If both oracles meet this criterion, Liquity infers that they are serving the real market price and switches back to the primary oracle.
The dual-oracle design, coupled with fallback and recovery logic, maximizes system resilience in the face of oracle glitches or critical failures. This approach ensures that Liquity remains functional for years to come without human control or intervention, providing an accurate and up-to-date ETH price even during times of oracle issues.
Cross-chain Opportunities
As the Ethereum mainnet's high gas costs limit smaller wallets from interacting with protocols such as Liquity, exploring cross-chain expansion becomes essential. Layer 2 solutions, like Optimism and Arbitrum, offer low-cost transactions, allowing smaller wallets to use LUSD without worrying about transaction costs. However, Liquity can only exist on the mainnet due to its immutable code. Although bridging LUSD and LQTY to other chains can cater to smaller wallets, it's essential to understand the limitations and opportunities.
Expanding LUSD utility and use cases on new chains involves three steps: 1) growing liquidity, 2) diversifying use cases, and 3) obtaining a ChainLink price feed for advanced integrations. Growing liquidity is the first step, followed by establishing partnerships with other DeFi projects to enable non-price-sensitive use cases. Once liquidity and volume are sustained, obtaining a ChainLink price feed allows more advanced integrations like using LUSD as collateral.
Expanding Liquity and LUSD across chains can introduce additional risks. To minimize these risks and grow the ecosystem sustainably, the teams working on integrations must consider the following:
- Select chains wisely to reduce the overall risk scope.
- Maintain a balanced or capped scale of LUSD's L2 presence.
- Hedge risks posed by LUSD's presence on L2, ideally.
Staking
To begin staking in Liquity, users simply need to deposit their LQTY tokens into the Liquity staking contract. Once deposited, users start earning a pro rata share of the borrowing and redemption fees in LUSD and ETH, proportional to their share of the total LQTY staked at the time the fee occurred.
The amount earned from staking LQTY depends on the user's share of the total LQTY staked. As fees are generated from borrowing and redemption activities, users with a larger share of the staked tokens will earn a higher proportion of the fees.
Unlike some other staking platforms, Liquity does not enforce a lock-up period for staking LQTY tokens. Users can withdraw their staked funds at any time, offering flexibility and easy access to their assets.
In Liquity, only LQTY tokens can be staked. However, users can deposit LUSD into the Stability Pool to secure the system and receive rewards.
Staked LQTY tokens in Liquity serve a different purpose than those in some other platforms, such as Maker. They are not used to backstop the Liquity system or for governance purposes, as Liquity is a governance-free protocol. Instead, staking LQTY tokens allows users to earn a share of the generated fee revenue, incentivizing participation and contributing to the growth of the platform.
