Liquity: A hybrid mechanism pegged to the US dollar, a decentralized stablecoin protocol backed by ETH
Centralized hosting solutions are not very secure, and nothing is "too big to fail."Author: Surf
Compiled by: Deep Tide TechFlow
"Banking risks posed by fiat-backed stablecoins," does this mark the beginning of the decentralized stablecoin narrative? Crypto analyst Surf provides an in-depth analysis of stablecoins and Liquity Protocol's $LUSD here.
Brief Introduction to Stablecoins
Stablecoins are cryptocurrencies designed to maintain a stable value, typically pegged to fiat currencies like the US dollar or commodities like gold. This stability makes them very useful for trading and storing value. Stablecoins can be divided into four main categories:
Fiat-backed stablecoins (e.g., USDC, USDT, USDP)
Crypto-backed stablecoins (e.g., LUSD, SUSD)
Commodity-backed stablecoins (e.g., PAXG, XAUT)
Algorithmic stablecoins (e.g., FRAX)
This article will focus on fiat and crypto-backed stablecoins.
Fiat-backed stablecoins are generally considered centralized stablecoins because they are backed by traditional assets (like the US dollar) held by centralized issuers or custodians. USDC is an example.
Its reserves ($32.4 billion) are held by BNY Mellon and managed by BlackRock.
Cash reserves are held at BNY Mellon ($5.4 billion), SVB ($3.3 billion), Signature Bank (for minting/redemption), and Customers Bank ($1 billion).
Most crypto-backed stablecoins are decentralized because they are issued and maintained by decentralized protocols operating on the blockchain, free from centralized control. Liquity's LUSD is such an example, which I will detail.
Brief Introduction to the USDC Incident
SVB announced the sale of loss-making bonds, realizing a loss of about $2 billion, and subsequently announced efforts to raise funds, leading to a bank run.
Unfortunately, Circle has a $3.3 billion risk exposure to SVB.
Over the weekend, FUD (fear, uncertainty, and doubt) about a USDC collapse spread rapidly. However, this scenario is unlikely to occur.
On March 12, despite the FDIC insurance limit of $250,000, it was guaranteed that SVB depositors could access all their funds on Monday.
Although USDC regained its peg on Monday, its circulating supply had decreased by over $3 billion due to redemptions compared to the previous week.
The decoupling of USDC also affected several other stablecoins:
The decoupling of USDC highlighted the counterparty risk of centralized custodians and the risks of centralized collateral to decentralized stablecoins. DAI, FRAX, and MIM decoupled due to USDC. Now a new narrative is forming—decentralized stablecoins with decentralized collateral.
Introduction to Liquity
Liquity is a decentralized lending protocol established in 2020 that allows users to borrow $LUSD against ETH collateral without interest.
Liquity has received support from trusted investors and partners, such as Polychain Capital, Pantera Capital, 1kx, Tomahawk VC, Robot Ventures, and more.
Liquity is non-governance to ensure that the protocol remains fully decentralized. Liquity's front end is almost "outsourced" to third parties, creating a fully distributed ecosystem.
They currently have over 15 front ends.
Front-end operators are rewarded by receiving a share of the $LQTY tokens generated by their users.
The "rebate rate" is the percentage of $LQTY rewards that front-end operators choose to share with stable pool depositors using their front end.
Liquity Mechanism
I. Troves
Troves are similar to MakerDAO's vaults, allowing users to access and manage their loans.
Your Ethereum address will be linked to a Trove (one Trove per address), which contains two balances: an asset balance in ETH and a debt balance in LUSD.
If the price of ETH rises, your collateralization ratio decreases because the value of your collateral decreases relative to your debt value. Conversely, if the price of ETH falls, your collateralization ratio increases because the value of your collateral increases relative to your debt value.
If your collateralization ratio falls below the system's required minimum collateralization ratio, your Trove will be liquidated. During liquidation, the system will sell your ETH to pay off your LUSD debt and will charge you a liquidation penalty.
Some details to note:
The minimum collateralization ratio is 110% (150% in recovery mode)
A borrowing fee of 0.5% - 5% is charged based on demand
There is a $200 liquidation reserve (similar to a deposit)
II. Stability Pool
The stability pool is a source of liquidity that maintains the system's solvency during Trove liquidations. Users can become stability providers by depositing LUSD into the pool, thus funding the pool.
If a Trove is liquidated, LUSD will be burned from the stability pool's balance to repay the debt, and the collateral from the Trove will be transferred to the stability pool. Stability providers will lose their share of LUSD in the deposit but will gain a share of the collateral from the liquidation.
Stability providers can earn from:
Liquidation profits (theoretically, they can receive a 10% share of the over-collateralized assets)
$LQTY rewards (based on pool share and front-end rebate rate)
Risks that may affect "liquidation profits" include:
Oracle failures
Flash crashes
III. Liquidation and Recovery Mode
When a Trove's minimum collateralization ratio falls below 110%, it will be liquidated to ensure $LUSD is backed. The debt of the Trove is canceled and absorbed into the stability pool, and its collateral is distributed to stability providers.
As previously mentioned, during liquidation, Troves with collateralization ratios below the minimum (110%) will be liquidated to ensure the backing of $LUSD. After Troves are liquidated, their debts are canceled and absorbed into the stability pool, while their collateral is distributed to stability providers.
Additionally, the previously mentioned $200 liquidation reserve/deposit will be used as a reward (in addition to 0.5% of the Trove collateral) to compensate users who initiated the liquidation process for their gas fees.
When the system's total collateralization ratio (TCR) falls below 150%, it enters recovery mode (which may occur during a sharp drop in ETH prices).
Troves with collateralization ratios below 150% will be liquidated, and the system will prevent borrowers from taking further actions that would further lower the TCR.
Recovery Mode encourages borrowers to raise the TCR above 150% and encourages LUSD holders to refill the stability pool.
Liquidation losses are capped at 110%, and the remaining 40% can be claimed by borrowers.
Thus, the complete borrowing process:
Pegging Mechanism
Liquity's LUSD is pegged to the dollar through both hard and soft pegging mechanisms. The hard peg mechanism includes a price floor of $1 (minus redemption fees) and a price ceiling of $1.10. The collateralization ratio is 110%.
The soft peg mechanism treats LUSD = USD when determining the Trove collateralization ratio, thus anchoring the equality of LUSD<>USD within the system.
A basic interest rate formula determines the redemption fee, starting at 0% and increasing with each redemption, gradually decreasing to 0% if no redemptions occur.
Liquity expects arbitrageurs to prevent LUSD from reaching $1.10; if it does reach this ceiling, it will quickly revert.
$LQTY Token
$LQTY is a secondary token used to capture fee revenue to incentivize early adopters and front-end operators. It is not a governance token—Liquity has no governance.
Its maximum supply is 100 million tokens, distributed as follows:
$LQTY can be earned through:
Providing liquidity in the LUSD<>ETH Uniswap pool (1,330,000 $LQTY allocated as rewards)
Becoming a stablecoin provider or front-end operator (32,000,000 $LQTY allocated as rewards)
$LQTY can be staked to earn corresponding amounts of LUSD and ETH borrowing and redemption fees, with a 7-day average annual yield of 29.95%.
A diagram illustrating the flow of funds between the protocol and users:
Conclusion
Centralized custodial solutions are not very secure; nothing is "too big to fail." After the USDC incident, the supply of USDC has decreased by $5 billion, highlighting alternatives like LUSD.
