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IOSG: Why Liquity is a strong competitor to MakerDAO

IOSG Ventures

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How does Liquity provide more capital efficient lending with lower risk?

Original title: "IOSG Weekly Brief | Can Liquity successfully challenge Maker's dominance? #66"

Original source: IOSG Ventures

Introduction

In recent times, the supply of stablecoins has experienced explosive growth, and centralized fiat stablecoins have occupied half of the market. (For example, USDT, USDC). The decentralized stablecoin MakerDAO is regarded as the most reliable product, with a TVL (total locked position) worth $5.7 billion, and as of March 1, it has generated $2.4 billion worth of DAI. In addition to MakerDAO, other alternatives have also emerged in decentralized stablecoins (such as algorithm-based elastic stablecoins). The main reason is that MakerDAO uses stablecoins backed by fiat currencies as collateral to mint DAI, which is not completely censorship-resistant, and this has been criticized by users. However, elastic stablecoins are not very stable. Their mechanisms cannot withstand drastic price fluctuations. Instead, they are more volatile and more speculative than over-collateralized stablecoins such as MakerDAO and stablecoins backed by fiat currencies.

Room for improvement of MakerDAO mechanism

Low capital efficiency, such as over-collateralization

Inactive governance

Vulnerable to potential human errors

Only soft anchoring

Capital Utilization Lending Protocol

Liquity is a flexible stablecoin collateralized by crypto assets (which can solve the problems mentioned above), aiming to issue a fully decentralized, censorship-resistant stablecoin LUSD. In short, the main value of Liquity is reflected in:

LUSD, a stablecoin collateralized by crypto assets

Low threshold for collateral ratio - 110%

Algorithmic monetary policy

Non-governance, reducing the risk of human error

Price floor: LUSD can be exchanged for ETH at the current value at any time

Decentralized front end

Interest-free debt

The following table shows the comparison between Maker and Liquity mechanisms, and also explains why we believe Liquity has enough potential to challenge Maker's position.

Comparison between Maker and Liquity mechanisms

One of the reasons why Liquity is better than Maker is that it has a lower collateralization ratio. In macro terms, Liquity can release more ETH liquidity than Maker. In micro terms, users can get higher leverage and less liquidation risk. But how to achieve this lower collateralization ratio?

First, the reason why Maker requires ETH to provide 130/150% collateral is because of its liquidation mechanism. Assuming that the auction process is quite long, it leaves more time for price fluctuations to eat up the value of the collateral. In this sense, the additional collateral is a buffer to hedge the risk of price volatility. Liquity provides almost instant liquidation, so it does not need to take the same high risk as Maker, that is, it has the ability to reduce the collateral ratio. The innovative liquidation mechanism incorporates three layers of defense:

1, Stability Pool-Liquity avoids the lengthy liquidation procedures that are unique to MakerDAO and other borrowing protocols. The system supports automatic liquidation with a stability pool, which is designed to absorb and eliminate defaulted debts, and can liquidate up to 40 positions at a time once the collateral falls below 110%.

So what happens if the stability pool doesn't have enough liquidity to support the system?

2, Redistribution Mechanism - If the stability pool doesn't have enough liquidity, the second phase begins, which is the redistribution mechanism. The redistribution mechanism can redistribute the remaining debt from the liquidated positions to all existing positions. In this case, high-collateral positions will take on more debt and receive more collateral from the liquidated assets than low-collateral positions. In order to provide this additional layer of security for the system, these higher-collateral positions will receive rewards as liquidators, thereby essentially getting the underlying collateral after liquidation.

3, Recovery Mode - The third layer of protection focuses on systemic risk. Liquity introduces a recovery mode. This mode will be triggered if the overall collateralization ratio of the protocol drops below 150%. In this way, the system will try to offset the position of the holding with the lowest collateralization ratio (even if it is above 110%) with the stability pool.

LUSD is hard-pegged to USD

DAI has no redemption mechanism, so it is not hard-pegged to the US dollar, but it relies on governance to implement a sound monetary policy to push the value of DAI to $1. On the other hand, LUSD is implicitly designed to peg to the US dollar in the protocol.

LUSD tokens can be returned to the protocol for ETH at any time, depending on the price, ETH:USD ratio, and the redemption fee.

This redemption is important because when the price of LUSD is lower than the price of the USD, arbitrageurs will buy LUSD, redeem it for ETH, sell ETH for USD, and lock in arbitrage profits

Also, this process improves the health of the system because whenever a redemption occurs, the current supply of LUSD is reduced by undercollateralized borrowers, i.e. the system uses the redeemed LUSD to pay off the riskiest assets

On the other hand, the minimum collateral ratio is 110%, which makes the natural price cap at $1.10

When the LUSD:USD ratio exceeds 1.10, borrowers can make a profit by borrowing the maximum amount of collateral and selling LUSD at a price above $1.10

The game theory behind this concept provides a soft anchoring mechanism for LUSD price movements. To learn more, read the technical documentation: https://docs.liquity.org/documentation/resources. Decentralized front-ends Every aspect of Liquity’s design is based on the principle of decentralization. As a result, the Liquity team does not operate the front-end themselves. In other words, front-end operators are incentivized by rebates. That is, the distribution of LQTY between the front-end and the user is based on a rebate rate that can be freely set by the front-end operator (between 0% and 100%). As a result, Liquity has created a market for front-end developers. Front-end developers who provide the best interfaces and special features can win the most rewards, and the strong incentives for developers also create a secondary market solution for Liquity.

Summary

Decentralization, hard-pegged USD, algorithm-driven and non-governance protocol, interest-free debt, and high capital efficiency are a unique combination in the DeFi space that make Liquity one of the most anticipated projects in 2021. As a result, it is one of the first protocols to provide a highly viable alternative to the MakerDAO mechanism.

We believe that Liquity has a good product-market fit for both risk-averse and risk-averse users. Risky borrowers can take advantage of lower collateralization ratios to play higher leverage, while high-collateral borrowers will be rewarded through the redistribution mechanism.In addition, Liquity is important for the entire DeFi ecosystem because capital efficiency enables greater ETH liquidity to be unlocked and used in DeFi protocols. The Liquity protocol is expected to launch in mid-March, and interested participants can earn LQTY token rewards by providing liquidity to the protocol or building a front end. The Liquity smart contract will be audited by Trail of Bits to ensure user security. In addition to security considerations, we believe that Liquity's simple design can indeed be a game changer as it provides more capital-efficient lending with lower risk.