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Learn about the interest-free lending protocol Liquity based on Ethereum

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Alternatives to MakerDAO?

Liquity: Interest-free Algorithmic Borrowing on Ethereum

原文作者： Oguz Genc

Looking east, the way to DeFi

Liquity launched on mainnet in April 2021 as a newcomer to DeFi lending offering a novel decentralized lending product. Liquity is similar to MakerDAO in that it offers interest-free loans to ETH, the only asset that can be used as collateral. Its loans are paid in LUSD, a stablecoin pegged to the dollar, and borrowers need to maintain a minimum mortgage ratio of 110% to avoid liquidation.

Although Liquity is very similar to MakerDAO, it differs in several respects, including 0% lending, immutable and decentralized agreement management, greater capital efficiency, redemption, and robust Peking.

1. Start strong

Liquity attracted a lot of user attention when it launched, with TVL (total lock-up value) going from $0 to $1 billion in 10 days. This need resulted from Uniswap's allocation of incentives for participants in LP cultivation of LUSD ETH pools and the issuance of LUSD. After this period, we observe a downward trend in total LUSD supply, with no significant upturn yet.

Meanwhile, the Liquity total mortgage ratio (TCR) fell suddenly during the market crash of May 19, but immediately reversed as the collateralised debt obligations positions were liquidated. During this event, TCR soared to almost 500%, then found new normal levels around 300%. The data is limited to individual market events.

2. The fundamentals of borrowing

Ethereum is accepted as sole collateral for the Liquity agreement. Liquity claims that this decision was made in pursuit of decentralization, simplifying the user experience and the economics of the protocol. Ethereum is ethereum's most decentralized asset, and using ETH as its sole collateral allows Liquity's LUSD to have more decentralized support. From the user's point of view, using ETH as the only collateral can also reduce the complexity of liquidity.

There is an instant liquidation mechanism for an insufficient collateralized debt obligation (CDP) position on Liquity. CDP is, in effect, a vault for borrowers to withdraw and maintain loans. Liquity calls these vaults Troves.

Trove consists of two parts. One is ETH collateral and the other is a stablecoin LUSD denominated debt agreement. The minimum debt is 2000 LUSD and there is no deadline for repayment of the debt as long as the minimum mortgage rate is maintained. Users can close Troves after paying off their debts.

3. Liquidation and stabilization pools

The existing CDP platform performs clearing in two ways. Either auction off positions with insufficient collateral or sell at fixed prices at a discount. Liquity thinks both business models are flawed. Auctions are not optimized for time efficiency, and discount sales do not achieve best price discovery because the primary pricing dynamics are not public market demand.

On Liquity, Troves with insufficient collateral are liquidated automatically. If any Trove falls below the 110% minimum collateral ratio (MCR), the agreement liquidates the position immediately. The process is algorithmically based and does not require a buyer or bidder to make these sales. Liquidated borrowers keep their remaining LUSD and all their ETH collateral is allocated back to the stabilization pool.

The stabilisation pool is the agreement's insurance fund, acting as the first line of defence to keep the system solvent by repaying the debts of the clearing vault. The stabilization pool is financed by other borrowers, known as "stabilization providers," who issue LUSDS with their ETH as collateral. They then put LUSD loans into a stabilization pool to profit from liquidation.

Since Troves are liquidated once they fall below MCR, LUSD tokens are destroyed from the stabilization pool in an amount equal to the liquidated debt. In return, the collateral of the liquidated Troves is added back to the stabilization pool (as collateral) to ensure that the total LUSD supply is still supported.

In this destruction process, the stabilization providers lost some LUSD, but they were compensated for liquidating the collateral because they were the only ones providing liquidity to the stabilization pool. The destruction of LUSD and reallocation of liquidated ETH are carried out in proportion to stable providers.

Since liquidation occurs immediately when CDP falls below the 110% level, stable providers may receive more LUSD in exchange for the collateral they post. It also means that the liquidation penalty is equal to 10% of the value locked in.

4. Risk management

Troves still runs the risk of running out of collateral in the event of a flash crash. During the market turmoil of May 2021, more than 300 Troves were liquidated due to a sudden drop in ETH prices. 7.9% of the stabilization pool is used for these liquidations, with the stabilization provider repurchasing ETH at an average price of $1916.91. Meanwhile, "recovery mode" was activated twice during the market downturn, meaning that the system's total mortgage ratio (TCR) fell below 150%.

Once "recovery mode" is activated, the requirement to seek a minimum mortgage rate of 110% is removed. A vault with a ratio of up to 150 percent can be liquidated from the lowest collateral to the highest. In this case, users with low collateral are naturally encouraged to increase their collateral positions and top up the stable pool.

No new borrowers are allowed unless the TCR is raised and new Troves exceed the 150% threshold. Losses, meanwhile, are capped at 110 per cent, allowing liquidators with higher mortgage ratios to recoup the difference.

In the event that the stabilisation pool is depleted, the contingency plan is to redistribute debt and collateral to other borrowers in the system in proportion to their respective debt and collateral positions. This seems unlikely as LUSD holders are more likely to keep their savings in stable pools.

Volatility of ETH and higher Gas costs are important variables to understand the key collateral scenarios of the agreement. By changing these parameters over different time intervals using average ETH price assumptions, users can conduct separate simulations of liquid market risk assessment.

To subsidize the cost of clearing gas, the clearing reserve keeps 200 LUSD deposits in each opened Trove. The deposit can be refunded in full after the debt is repaid, meaning that only liquidated Troves will lose it. The compensation for initiating liquidation is 200 LUSD in the liquidation reserve plus 0.5% of Trove collateral to cover the gas cost of liquidation.

In order to reduce the total gas cost, Trove liquidation will be conducted in batches. Reallocating the proceeds of clearing, however, is trickier. If every reallocation required a transaction on Ethereum, Layer 1 would become crowded with operations to reimburse the stability provider. Liquity uses mathematics to provide a highly scalable algorithm for tracking changes in a user's balance after clearing.

5. 0% interest and LQTY mortgage

The traditional way of stabilising prices introduced by Maker is much like the way central banks treat variable interest rates. Liquity introduced the concept of interest-free loans.

Since there is no supply side at the agreement level, Liquity can support a 0% interest rate. MakerDAO can do the same, but they need interest rate returns to control DAI prices, which is an important difference between the price stabilization mechanisms of the two agreements.

The absence of loan interest payments to the supplier side provides MakerDAO with stronger value creation. Liquity, on the other hand, has a fairer value proposition to users/borrowers, but it forgoes the value gain of its secondary platform token LQTY because charging interest rates increases demand for that token.

LQTY tokens are granted to stability providers who can pledge the tokens to generate value from the fee income of the agreement. Rewards will again be divided according to share of ownership. The owner can simply pledge LQTY tokens in the contract, and the tokens pledged are not locked out. A pledge LQTY cannot be used for either support systems or governance.

6. 价格稳定机制

LUSD does not charge interest on its loans, but rather charges a one-time issuance fee. These costs vary algorithmically between 0.5% and 5% and are set to zero in recovery mode. Each loan has a repayment fee relative to the issuing fee, which is paid by ETH to keep the peg in balance. The redemption fee is kept above the issue fee to prevent traders from using Liquity. In this way, arbitrageurs can pay fees for system revenues, while borrowers are incentivized with lower issuance fees.

The fee algorithm takes into account as a key variable the redemption rate, which is the speed at which ETH exits the agreement when the borrower pays off the debt to redeem the mortgage. As redemption demand increases, the benchmark interest rate on issue fees is reduced to encourage borrowers and support the anchoring of the DOLLAR and overcome downward price pressure.

The price stability mechanism built around the hooks is a key difference from MakerDAO's DAI hooks, LUSD actually has a hard top of $1.10 /LUSD, at which point users can easily arbitrage LUSD.

If LUSD is trading above $1.10 in the market, arbitrageurs can deposit in ETH and foundry maximum debt at 110% and then continue to sell LUSD on the external market. That way, they will make a profit after the final step of repaying the loan. Thus, the arbitrage mechanism is responsible for LUSD's price ceiling and floor, adding another new aspect to the protocol.

With regard to the $1 /LUSD peg, redemptions make sense for borrowers when LUSD is trading above $1 because they are better off closing debt positions. At the same time, 1 LUSD = 1 USD remains the same throughout the agreement, and there is no prognoser price information on LUSD prices in external markets such as Uniswap and Curve Finance. In other words, Liquity will only receive Chainlink's ETH:USD price feed. Thus, if LUSD trades on the external market for less than $1 per LUSD, the borrower can buy LUSD in the market, redeem ETH, and then sell ETH for a risk-free profit.

Finally, it is worth noting that since Liquity is immutable and requires no governance, it is not possible to interfere with the source of the predictor price. If the ETH price feed is interrupted or frozen, the system will operate without manual intervention.

7. Conclusion: Is Liquity a viable alternative to DeFi lending?

Without a doubt, Maker has proven itself to be one of the strongest stablesoin and lending markets in DeFi. However, there is no denying that Liquity's value proposal offers an interesting alternative. Although the level of protocol it offers varies, Liquity can target DeFi users with different risk appetites. Borrowers with lower mortgages can take advantage of higher leverage, while borrowers with higher mortgages can stabilize agreements and earn returns from liquidation. This creates a balanced user profile between speculators and long-term contributors. Combined with a simple user experience, Liquity will likely increase DeFi adoption by unlocking more ETH.