Pantera Partners Interpret the Highlights and Mechanism of Liquity

Source: Veradiverdict Blog

Author: Paul Veradittakit, Founding Partner of Pantera Capital

Compiled by: Li Ke

In March of this year, Pantera led a new decentralized lending protocol, Liquity, in a 6 million dollar Series A funding round.

Over the past year, many DeFi lending protocols have been launched and applied in the market, including giants like Maker and Compound, but several features make Liquity stand out:

• Fixed percentage interest rate, unlike the floating rates of other protocols

• 110% minimum collateralization ratio, the lowest currently in the market

• Fully decentralized governance, relying on algorithms and immutable monetary policy.

It is easy to imagine that these numbers are very attractive to the open financial community. Since its launch on the Ethereum mainnet earlier this month, Liquity has seen high user participation, accumulating approximately 2.7 billion dollars in total value locked (TVL) in just a few weeks.

Data Source: Dune Analytics (Complete chart created by @dani)

Let’s unravel how Liquity provides such low collateralization ratios and achieves 0% interest rates without sacrificing the systemic resilience of the protocol.

What happens when loan collateral is insufficient?

On March 12, 2020, following market volatility triggered by COVID-19, cryptocurrency prices faced unprecedented crashes, with Bitcoin dropping nearly half. Decentralized lending platforms, especially the well-known Maker, witnessed massive liquidations of collateral pools as the sharp price declines pushed some borrowers below the minimum collateralization ratio. This unexpected event is now referred to as "Black Thursday," which stress-tested many emerging DeFi protocols, leading to irretrievable losses for users in some cases.

When price shocks lead to insufficient loan collateral, many lending protocols liquidate collateral through automatic auctions. Similar to the "fire sale" of assets during traditional bank bankruptcies, collateral (most typically ETH in the case of Maker) is sold at auction to some buyers, thereby settling the outstanding loans. However, these auctions can sometimes take hours, as was the case on "Black Thursday," making crisis response difficult.

Liquity's solution to the liquidation problem is unique. Liquity does not auction collateral when the collateralization ratio (or "Trove") falls below a set value; instead, it creates a pool of users who have agreed to purchase collateral (ETH) at a discount before a price shock occurs. This way, collateral can be immediately released into the "stability pool" when the collateralization ratio is insufficient, rather than hours later.

In practice, this means users can deposit their LUSD (the protocol's native stablecoin, which will be discussed later) into the stability pool to proportionally receive the liquidated ETH. In addition to obtaining Ethereum from the "collateral surplus," the protocol also offers an annualized return of about 40-60% to incentivize liquidity provision.

Data Source: Liquity (Medium)

While participating in the stability pool is not without risks—you are implicitly agreeing to buy ETH during price declines, which carries the risk of further asset depreciation—it is an excellent way to purchase collateral at a discount below market price. The Liquity protocol has gained popularity since its launch because it provides value to many users.

In short, the stability pool is the secret behind Liquity's impressive 110% collateralization ratio without sacrificing system stability. As stated in the project's white paper:

"Since the acquirers agree in advance, there is no need to find buyers on the spot to acquire collateral when the collateral position is insufficient. This advantage significantly reduces the collateral ratio while maintaining high stability."

Since the liquidation mechanism of the stability pool is merely a transfer of ETH and does not involve auctions to purchase collateral with other assets, it does not increase the demand for the stablecoin LUSD (and affect its price).

How is 0% interest possible?

In addition to the lower collateralization ratio, Liquity is also highly attractive due to its interest-free borrowing. A 0% interest rate not only makes borrowing much cheaper than on other platforms, but the fixed rate is more favorable and predictable for borrowers compared to the floating rates that have almost become standard in DeFi.

Data Source: DeFi Rate

Since stability pool depositors are compensated through discounted ETH liquidation rather than interest payments, the protocol achieves true zero-interest borrowing, marking a milestone in open finance.

However, it is worth noting that while there is no interest, there are still a small number of fees: debtors need to pay at least a 0.5% "borrow fee" in advance, along with a refundable deposit of 200 LUSD (200 dollars) to cover gas fees in the event of liquidation.

How does the protocol's stablecoin fit into this?

Many lending platforms have their own stablecoins, which are "minted" when loans are borrowed on the platform and "consumed" when loans are repaid. Typically, like Maker's DAI, these are non-redeemable algorithmic stablecoins. In other words, they approximate fiat-pegged tokens, usually worth 1 dollar, without any claims on the currency itself.

Liquity's native stablecoin LUSD is unique: each unit of LUSD can be redeemed for 1 dollar's worth of ETH at any time. This ensures that LUSD maintains a fixed exchange rate of 1 dollar, as any price fluctuations can be balanced through arbitrage. A more complex dynamic adjustment mechanism is at work here, and despite the recent turmoil in the cryptocurrency market, the fact that LUSD has remained notably stable encourages confidence.

Data Source: Liquity (Medium)

Where does the corresponding ETH come from when redeeming LUSD?

Simply put, when someone wishes to redeem their LUSD, the "highest risk" Troves or outstanding loan agreements will provide the corresponding amount of ETH. As Liquity describes, this process occurs in several steps:

• Someone comes to redeem their LUSD
• All Troves (i.e., positions in Liquity) are sorted from the lowest collateralization ratio to the highest (from highest risk to lowest risk)
• The redeemed LUSD is used to pay off the debt of the highest risk Trove in exchange for its collateral
• The remaining collateral of the Trove owner is left for them to claim (the redeemed borrower does not incur a net loss)

Data Source: Liquity (White Paper)

If the trading price of the token falls below the dollar peg, redemptions will stabilize LUSD by creating easily exploitable arbitrage opportunities. Additionally, redemptions increase the overall collateral ratio of the Liquity borrower pool, contributing to the stability of the entire system. However, to limit excessive use of redemptions, a 0.5% default (variable) fee will be incurred.

While this can incentivize borrowers to maintain collateralization ratios well above 110%, thereby aiding the overall stability of the system, it is important to clarify that this is not a penalty. In fact, while redemptions may unappealingly reduce the ETH risk exposure of Trove owners, they do not incur a net loss; they simply take on a lower debt obligation. Moreover, redemptions are only advantageous to redeemers in the unusual case where the trading price of LUSD falls below 1 dollar.

Data Source: Liquity.app

How to use Liquity?

As mentioned earlier, users can utilize the protocol in several ways:

• Collateralize ETH to borrow LUSD interest-free. The minimum borrowing amount is 2000 LUSD.

• Provide LUSD to the stability pool to purchase ETH liquidations at a discount, in addition to earning an expected nearly 50% APY reward.

• Trade ETH to arbitrage LUSD when the market price is below 1 dollar.

• Over-stake LQTY to earn a portion of the fee revenue.

Another interesting aspect of Liquity is their advocacy for decentralization: unlike some other lending platforms, the protocol has no "governance," and no party can change the underlying smart contract code. While auditors have thoroughly reviewed the code, if a bug is found or a "Liquity V2" is created, it will be launched separately.

Due to the emphasis on decentralization, Liquity does not run a front end. Instead, they allow third parties to create their own front ends, allowing them to define their own "rebate rates." Currently, the most mainstream front end is liquity.app, which occupies nearly 80% of the stability pool's share, but users have dozens of other options beyond that.

In summary, despite the many decentralized lending platforms, Liquity is by far the most capital-efficient protocol to date. By replacing collateral auctions with a stability pool and creating a fully redeemable stablecoin, Liquity makes zero-interest and low-collateral borrowing possible, which is a true achievement in decentralized finance.