Overview of Liquity Protocol: A DeFi Protocol Focused on Stablecoins + Lending

Source: Leo, The Blockbeats

With the end of the USDC de-pegging crisis and the restoration of its liquidity, USDC has rebounded to $1 yesterday, seemingly regaining its status as a stablecoin giant. However, this event has not diminished the industry's concerns about stablecoins; rather, it has intensified worries regarding dollar-pegged stablecoins. If USDC is not considered a stable asset class, where should we store our $1?

This article will introduce a decentralized lending protocol that also focuses on stablecoin yield: Liquity Protocol (LUSD & LQTY), which has been a topic of discussion in the market recently.

Introduction to Liquity Protocol

Liquity Protocol is a decentralized lending protocol, also known as a Collateralized Debt Protocol (CDP), which allows users to apply for interest-free loans by collateralizing ETH (the only type of collateral accepted by Liquity) to obtain LUSD stablecoin loans. As a DeFi protocol, Liquity Protocol features immutability, non-custodial, and free governance, making it a fully decentralized DeFi protocol.

Unlike stablecoins such as USDC and USDT, which are pegged 1:1 to the dollar, LUSD is not pegged to fiat currency (physical cash stored in banks) but rather to ETH. The protocol has anti-censorship characteristics, meaning no regulatory body can prohibit the issuance of LUSD, and the protocol operates entirely through code, which is immutable.

The interest-free lending mechanism of Liquity Protocol involves a one-time borrowing and redemption fee. This fee is algorithmically adjusted based on recent redemption activity. For example, if more redemptions occur recently (indicating that the trading price of LUSD may be below $1), the borrowing rate (fee) will increase, thereby hindering borrowing.

To borrow on this project, borrowers need to open a trove through an Ethereum address, with each address allowed only one trove. By depositing a certain amount of ETH into the trove, users can withdraw a corresponding amount of LUSD, provided that the collateralization ratio does not exceed 110%, with a minimum borrowing amount of 2000 LUSD. Of course, users can repay their debts and close the trove at any time. Although ETH also carries the risk of price decline, the protocol will instantly liquidate LUSD positions to ETH to ensure a fully 1:1 collateralized borrowing ratio.

Use Cases of Liquity Protocol

Its use cases include:

• Borrowing LUSD by collateralizing ETH;
• Depositing LUSD into the stablecoin pool to ensure liquidity;
• Staking LQTY to earn fees paid for borrowing and redeeming LUSD;
• When LUSD is below $1, exchanging $1 LUSD for $1 worth of ETH.

The sources of Liquity's yield are:

• LUSD Bonds
• Staking LQTY
• LUSD Stable Pool

LUSD Bonds Yield

Bonds have enhanced auto-compounded yield, which can be held or traded. The yield is converted into bLUSD through three different sources, achieving yield growth. Bonds can technically act as NFTs and be traded on OpenSea.

The advantages of bLUSD are:

• It offers higher yields compared to depositing LUSD in the stable pool;
• The generated yield is automatically harvested and compounded;
• It is also an ERC-20 token that can be used as collateral for price appreciation.

Staking LQTY

By staking LQTY, users can earn a portion of the protocol fees (ETH, LUSD). Once staking begins, users can earn a proportional share of the borrowing and redemption fees. According to DefiLlama data, Liquity Protocol ranked 11th in fees over the past 24 hours.

The redemption mechanism of Liquity Protocol allows users to redeem $1 LUSD for $1 ETH without restrictions on price. LUSD is then burned, but the redemption process incurs a certain fee. As mentioned earlier, with an increase in redemption volume (indicating that LUSD may fall below $1), the borrowing fees will also increase, thus reducing the attractiveness of borrowing. This mechanism prevents new LUSD from entering the market and pushing the price below $1.

LUSD Stable Pool

Depositing LUSD into the stable pool earns LQTY yield and ETH yield from liquidations, with the current APR around 8.42%. As mentioned earlier, the liquidation yield comes from the trove. When users deposit ETH to borrow LUSD, if the price of ETH declines and users do not increase their positions or repay part of their debt, it will lead to a collateralization ratio below 110%, resulting in the liquidation of the trove.

Special Mechanisms of LUSD

So how does LUSD maintain a stable peg to ETH and sustain its circulating supply? LUSD has several special mechanisms.

The hard peg mechanism means that LUSD can be exchanged 1:1 for ETH, with the system charging a one-time redemption fee that increases with each redemption. If no redemptions occur over time, the fee gradually decreases to zero. LUSD is burned upon redemption.

For example, if the peg = $0.98, an arbitrageur buys LUSD at $0.98 and redeems it for $1, earning a profit of $0.02, which creates buying pressure that drives the price up; if the peg = $1.15, an arbitrageur borrows the maximum amount at a 110% collateralization ratio and sells LUSD for a profit of $0.05, creating selling pressure that drives the price down.

The soft peg mechanism means that LUSD also benefits from an indirect dollar parity mechanism, with LUSD's dollar parity being one of the Schelling points. Since Liquity Protocol treats LUSD as equivalent to the dollar, the parity between the two is an implied equilibrium state of the protocol.

Additionally, the same mechanism for borrowing and redemption fees prevents LUSD supply from spiraling out of control. When depositing ETH to borrow LUSD, the borrowing fees and redemption fees operate in the same way (the more people issue LUSD, the higher the fees will rise).

The Liquity Protocol's stable pool, as a liquidity reserve, is also a source of liquidity for repaying debts in liquidation positions. If the stable pool is depleted due to liquidations, debts and collateral will be evenly distributed, serving as a buffer for Liquity Protocol against risks.

Liquity Protocol also has a special recovery mode designed to address large-scale liquidations, which is activated when the system's Total Collateral Ratio (TCR) falls below 150%. Positions with collateralization ratios below 150% can be liquidated, and the recovery mode aims to encourage deposits of ETH and debt repayment.

How to Obtain LUSD

In addition to collateralizing ETH to obtain LUSD, users can also acquire LUSD on other CEX or DEX platforms.

DEX: Uniswap, Curve

CEX: Gemini

Liquity Protocol Partners and Token Economics

Liquity Protocol has a strong lineup of partners, including Pantera Capital, Polychain, Nexus Mutual, Synthetix, Coinbase, Velodrome, OlympusDAO, Gemini, and Huobi, while LUSD is also among the top ten stablecoins by market capitalization.

The maximum supply of LQTY is 100 million, with a circulating supply of 91 million. According to Coinmarketcap, its current market capitalization is approximately $285 million.