LQTY deep user narrative: LUSD is a top DeFi stablecoin, but it faces the pain of expansion

Author: darkforest

Recently, the market has started to show some FUD towards USDC, BUSD, and even DAI. We can see the change in market sentiment from the trading volume of Curve, with the 3pool's 24-hour trading volume reaching $613 million, even surpassing the pool's TVL, which is quite exaggerated. As players in the cryptocurrency space, what kind of stablecoin do we need to gain the freedom from fear? Let me talk about the Liquity project in detail. As a heavy user who has been using Liquity since its launch, I have deep feelings for this project, and I have also suffered greatly. Of course, all the pain cannot be blamed on Liquity; it’s just my own issue. But in this process, I have deepened my understanding of this project, and I hope to share my experiences and insights with users who are currently using or planning to use it in the future, to think more deeply about the pros and cons of entering this project.

If you want to have the most censorship-resistant and decentralized dollar stablecoin, $LUSD is definitely the best choice. Regardless of the FUD surrounding $USDT, $USDC, or $DAI, $LUSD is always the king that watches from the sidelines, observing coldly.

Why do I say $LUSD is the top stablecoin in DeFi?

• First, the collateral is only ETH and is over-collateralized;

• Second, the Liquity protocol is non-upgradable, meaning no one can change its smart contracts. If there are no vulnerabilities in the protocol from the start, there will never be an opportunity to introduce new vulnerabilities, making it very secure;

• Third, downward de-pegging is almost impossible because the protocol provides a mechanism to redeem ETH at $1, ensuring its value is well-protected;

• Fourth, censorship resistance. @LiquityProtocol does not run the front end; there are many third-party front ends that cannot be banned.

Whenever the market experiences severe fluctuations, $LUSD holders are undoubtedly the happiest. For more than half of the past year, it has been de-pegging upwards, even reaching $1.05 at its peak, which made me doubt it would ever return. With the recent FUD against $USDC and $BUSD, Liquity's project token $LQTY suddenly surged violently. The project is undoubtedly a good one, but it is not a very profitable project, at least for $LQTY token holders. Don’t ask me how I know; users who have been mining $LQTY for over a year are feeling the pain.

This is a typical example of a good project not equating to a good token.

Why use Liquity? Isn’t MakerDAO good? Before May 2021, my entire DeFi career revolved around MakerDAO. As one of the earliest players who participated in the Ethereum founder's crowdfunding in 2014, my faith in Ethereum is ingrained in my genes. Accumulating Ethereum without ever selling a single one has been my consistent approach over the years.

However, if you need some funds for turnover in life or investment, DeFi lending platforms are naturally a more ideal way. Compared to MakerDAO, Liquity has the following advantages for borrowing stablecoins against ETH:

1. Lower liquidation threshold and higher capital efficiency.

Liquity's collateral ratio is only 110%, while MakerDAO had 150% at that time. This means that if you collateralize $1500 worth of ETH in MakerDAO, you can borrow a maximum of $1000 worth of DAI, but if ETH drops slightly, you will be liquidated. In Liquity, if you borrow $1000 worth of LUSD, you can withstand the value of the collateralized ETH dropping to $1100.

2. No-interest loans versus interest-bearing loans

Borrowing stablecoins through Liquity only requires a one-time borrowing fee of 0.5%, while MakerDAO has varying annual fees. Currently, there are two tiers: one is low-rate borrowing, requiring a collateral ratio greater than 170%, with an annual fee of 0.5%. The other is medium-rate borrowing, requiring a collateral ratio greater than 145%, with an annual fee of 1.5%.

For a cryptocurrency user who aims to never sell ETH while maintaining some cash flow, Liquity is undoubtedly a more rational choice compared to MakerDAO.

Why is the usage rate so "awkward"? After all this praise, it’s time to talk about the awkward situation Liquity is facing. If LUSD is so good, why isn’t anyone using it?

I think it’s because there are very few users who truly need a censorship-resistant decentralized stablecoin. Most people come to the crypto space primarily to make money, unlike so-called geeks who are naive and idealistic. Most people still prefer the convenience and efficiency of centralized stablecoins, which is fine, but you shouldn’t panic every time there’s FUD.

In my view, if you want to use a cold wallet to store a certain amount of cryptocurrency assets, even passing them on to future generations, then for the stablecoin portion, you must use LUSD. After all, there are not many century-old stores, let alone centralized stablecoins backed by companies.

Most of the LUSD borrowed through Liquity is in Liquity's own stability pool (which has remained between 60%-70%), and not used for other scenarios.

The expansion woes of Liquity and the downfall of chicken bonds The lack of application scenarios for $LUSD made the emergence of @chicken bonds an excellent opportunity to address this issue.

The mechanism of chicken bonds is quite complex and ingenious. Simply put, it divides the LUSD existing in chicken bonds nominally into three pools (pending, reserve, parliament), but only one of these pools can enjoy the full benefits of all three pools (reserve). $BLUSD is used to represent the user's share in this exclusive benefit pool. At the beginning of the project, the nominal APR of BLUSD was very high, reaching a nominal APR of 70 BLUSD.

This way, the chicken bonds system can continue to operate. In the chart below, we can see that at the beginning of the project, the market price of $BLUSD was once significantly higher than the fair price. The design of this mechanism is truly excellent, but the calculations of the mechanism designers did not materialize in practice. From a macro perspective, chicken bonds have hardly brought any positive externalities to Liquity. The protocol's TVL did not see significant changes after the launch of chicken bonds. In my view, it can only be said that the $LUSD originally in the stability pool has entered chicken bonds, still resulting in internal capital competition, leading to the initial high APR being merely an illusion. The rapidly moving wheels of chicken bonds gradually came to a halt due to various frictions and losses in reality. From my personal experience, due to curiosity about this novel mechanism, I created three bonds at different times to participate in this experiment, but ultimately canceled two of them. One has been held for over 100 days without breaking even. Fortunately, the mechanism of chicken bonds does not cause you to lose money; it just results in a significant opportunity cost.

Currently, the price of $BLUSD has approached its floor price, and the lower limit of the fair price is getting further away, with chicken bonds already entering a certain degree of death spiral. As the price of $BLUSD falls, no one's bonds are profitable, leading to no one rebonding. A large number of users cancel bonds to exchange back for $LUSD and stop participating. New users also lack the motivation to enter because creating bonds no longer yields returns.

This has resulted in a cliff-like collapse of the pending pool, with the pending/reserve ratio continuously declining, and the BLUSD yield multiplier also decreasing, causing the BLUSD APR to plummet, with market premiums turning negative, leading to a drop in the price of $BLUSD, thus forming the death spiral of chicken bonds. From the logical reasoning above, if chicken bonds cannot trigger external inputs to bring in a large number of new users to Liquity, increase TVL, and expand the scale of $LUSD, then failure seems inevitable. Just as the second law of thermodynamics states, an isolated system spontaneously evolves toward thermodynamic equilibrium—maximum entropy state—similar to expecting users to continuously rebond to keep operating is an impossible second kind of perpetual motion machine.

Temporary countermeasures: Can we say that chicken bonds have already failed? It may be too early to draw conclusions. If chicken bonds plan to transfer the LUSD in the permanent pool to the reserve pool, it would immediately significantly raise the floor price of BLUSD, directly aligning with the net asset value shown in the chart below. This represents a potential 6% increase in returns, with the risk being a real drop to the current floor price, presenting a 0.9% downside risk exposure. After doing this, chicken bonds might still operate for a while longer, but whether chicken bonds will take this action is currently uncertain. Personally, I believe the original intention of the parliament pool was to maintain the balance of LUSD in the LUSD/3CRV pool on Curve. Since it is already balanced, there is no need to maintain a parliament pool; raising the price of BLUSD is the core for the protocol to continue operating.

In summary, I am quite pessimistic about chicken bonds. Without external resource inputs, merely operating in a closed system, the yields of both LUSD and BLUSD come from the token rewards $LQTY provided by the Liquity project team. No matter how many tricks such a system plays, it is likely a zero-sum game.

Although chicken bonds have become the expansion woes of Liquity, the challenges faced by $LUSD go far beyond this.

As time goes on, Ethereum itself is undergoing profound technological changes, and the upcoming Shanghai fork is officially heralding the formation of LSD (Liquid Staking Derivatives) as a near risk-free interest rate comparable to U.S. Treasury bonds in the cryptocurrency space.

This means that simply holding ETH as before comes with a significant opportunity cost. If the 100 ETH you hold can earn you nearly risk-free returns of 4 ETH per year, then now, if you place it on various lending platforms, in the long run, you might only dare to borrow stablecoins up to 1/3 of your position. Not counting fees, you would need to achieve a stable annualized return of 12% just to break even. This level of safe and consistently stable returns is actually hard to find in DeFi. If we factor in fees, rebalancing costs, and gas fees, I estimate that it would need to exceed 15% APY to match directly participating in Ethereum staking.

As a result, many users will pay off their positions in Liquity, withdraw ETH, and stake it. This puts Liquity in a situation of continuously shrinking TVL. What’s worse is that the project token $LQTY used for mining in the stability pool is already running low. This mining pool essentially represents the risk-free interest rate for $LUSD. Once it drops to zero, whether these $LUSD will have new uses becomes questionable.

As a loyal user of Liquity, I have also had to pay off some loans and withdraw part of my ETH for staking due to the aforementioned considerations. I would very much welcome Liquity to accept some LSD as collateral, but… this will inevitably undermine the status of $LUSD as the most censorship-resistant and decentralized stablecoin.

However, if this is not done, $LUSD will only become a stablecoin used by a small number of geeks or even hackers, while MakerDAO will take up the banner of LSD collateral and embark on the path of expansion once again.

And this is a very dangerous road for the entire DeFi and Ethereum community.