DeFi Insight: Liquity Analysis
Liquity is a novel borrowing protocol that puts great emphasis on decentralization and immutability. It enables users to provide ETH as collateral and mint LUSD stablecoins in return. The main benefits of the protocol include a 0% interest rate for borrowers, a minimum collateral ratio (MCR) of 110%, as well as the opportunity to directly redeem LUSD at face value for underlying collateral at any time.
Author: Martin Palazov, Valentin Kalinov
Comparative analysis: Liquity and MakerDAO
At first sight, one could notice a resemblance with the value proposition of MakerDAO. However, when examined closely it becomes apparent that Liquity solves some of the flaws present in similar Decentralized Finance (DeFi) Protocols. It could be considered one of the most trustless borrowing protocols for many reasons. Firstly, the developers behind the project have prioritized decentralization by not having admin keys to the smart contracts and have provided access to the dApp via multiple interfaces hosted on different frontend operators. This guarantees the censorship resistance of the protocol. Moreover, any operations such as minting of stablecoins are fully automated and algorithmic. All the protocol parameters are set at the time of contract deployment, which ensures that the protocol is governance-free and immutable.
Liquity and Maker are similar to some extent due to their function as borrowing protocols. In fact, the minting process of LUSD requires the user to put ETH as collateral in a Trove. It can be related to the process of utilizing a Vault for the generation of DAI. Both protocols are different from money markets such as Aave. Not relying on liquidity pools allows the borrowing protocols to be more competitive. The lending of stablecoins becomes capital efficient as they do not have to incentivize lenders with higher returns, as in the case of Aave. Moreover, borrowers benefit from lower fees as they are accessing the tokens directly from the protocol.
Although Maker is efficient, the variable annual fees and collateral ratios can be adjusted by the governance body. That is the reason why the MCR (Minimum Collateralization Ratio) for ETH at the Oasis app fluctuates between 130% — 170% (depending on the collateral type ETH-A, ETH-B, ETH-C), and the variable annual fee can soar above 4%. The 0% interest rate for borrowers, as well as the one-time fees offered by Liquity open new horizons for investors who want to use leverage. Specifically, the protocol provides the cheapest opportunity for long-term borrowing against ETH. Speculators can increase their leveraged position up to 11 times by acquiring LUSD against Ethereum and then reselling the stablecoins on the open market to get more ETH. This further democratizes the investment scope for retail and private investors.
What makes Liquity special?
From the comparative analysis, it could be established that the obvious features that differentiate Liquity from other borrowing protocols are:
- The human governance factor is eliminated and replaced with an algorithmic solution.
- Full decentralization is achieved through Frontend Operators that guarantee censorship-resistance, but are also incentivized to run a front-end with the LQTY token as a reward.
- The decision to solely accept ETH as collateral because of its trustless nature compared to the Multi-Collateral system of the Maker Protocol.
However, Liquity’s most innovative DeFi features are the fee management system and the instant liquidation mechanism. Zooming in on the process of using a Trove for the minting of LUSD the borrower is presented with all the necessary information in a transparent manner. There is a one-off borrowing fee that stands at 0.5% (can range from 0% (Recovery Mode) to 5%) under normal operations and a Liquidation Reserve equal to 200 LUSD.
Once the debt is repaid, the Liquidation Reserve is given back to the borrower. This system provides the users with a more efficient way to leverage their positions in comparison to the protocols that offer variable fees, such as Compound and Maker. Particularly, the one-off fee guarantees additional predictability and transparency of their capital cost. This feature incentivizes borrowers to position their assets in Troves for years.
The feature that adds the most value to the protocol is the instant liquidation of undercollateralized Troves. It is enabled by a liquidation mechanism that requires LUSD to be staked in a Stability Pool. Intrinsically, the liquidity in this pool serves as the main layer of security in Shortfall Events. The mechanism seemingly resembles the Safety Module in Aave; however, what makes it even better is the fact that it is prompt and does not rely on auctions where the collateral can be sold at a discount in a slower manner.
LUSD providers could contribute to the Stability Pool with the intent to benefit from the LQTY rewards, but also, whenever a liquidation event is triggered (e.g., MCR falls below 110%), they would receive ETH as well. This could also be a great strategy to hedge capital efficiently and receive a decent return during rapid drops in ETH’s price. Looking at this feature from a user’s perspective makes it easier for anyone to become a liquidator. It is a great incentive to receive 0.5% of the Trove plus the Liquidation Reserve. Furthermore, the instant liquidation mechanism has another key advantage in comparison to the auction mechanisms in Aave and Maker. Whenever a shortfall event occurs on the latter protocols, it could take up to 6 hours for the whole process to reach finality. This could turn out to be a problem because ETH’s price may drastically decrease in such a period. However, with the backstop mechanism, this risk is eliminated because it only takes minutes for the whole throughput. That is the reason why Aave, Maker, Compound, and other protocols are now utilizing B.Procotol which is offering a service resembling the one of Liquity. Additionally, by incentivizing users to be liquidators and providers of stablecoins, the rewards are kept within the protocol, which allows for higher returns for the users.
Potential risks and opportunities
Liquity is a fairly new borrowing protocol that follows a philosophy to rely only on ETH as collateral. By doing so, a trustless and censorship-resistant environment is ensured but at the expense of limiting the protocol’s exposure to other tokens and potential markets.
On the other hand, lending protocols such as Maker have the first-mover advantage and a relatively bigger user base which could be considered a hurdle. However, the adoption is present as holders of LUSD/LQTY have been steadily growing since Liquity’s inception in 2021. Furthermore, the interest from CeFi and DeFi is there as well. On the 20th of April, 2022 — Bitcoin Suisse announced that they are launching a Decentralized Finance Offering. Particularly, their clients can directly lock ETH as collateral in the protocol and mint their own LUSD. This is a clear sign that Liquity could be considered a really good alternative to Maker. Lastly, about 13% (95 mil.) of the PCV (Protocol Controlled Value) of Fei and approximately 11% (49 mil.) of the OlympusDAO reserve are kept in LUSD.
CeFi and DeFi projects can potentially benefit from the staking opportunities available on Liquity. Specifically, depositing LUSD to the Stability Pool — receiving 5.5% APR in LQTY + ETH (7-day average — 21/04/2022), or staking LQTY to benefit from the initiation and redemption fee — 4.2% APR (21/04/2022). However, it is good to be noted that these APR numbers are highly volatile.
On the technical side, there are two potential risks that could be exploited. Firstly, the smart contracts that are deployed on Liquity cannot be upgraded. This choice is definitely in favor of further increasing the immutability and censorship-resistance of the protocol but could also be problematic. Moreover, Liquity relies on Chainlink and Tellor for the provision of the ETH:USD price feeds. In case of a delay or wrongful price data/timestamp, the protocol switches from the former to the latter oracle. Potential problems with the price feed could lead to Trove’s liquidation. However, the consequences of such faulty behavior could be catastrophic for the whole DeFi domain.
Finally, the pegging mechanism that is responsible for the stability of LUSD is of great importance. The floor is ensured by the redemption mechanism that allows the exchange of LUSD for ETH at face value. A base rate that is algorithmically calculated and a 0.5% redemption fee (it is variable, but not capped at 5%) is charged for the procedure. This mechanism provides arbitrageurs with the opportunity to generate profits when LUSD trades for less than $1. In return, this facilitates the establishment of a price floor. Looking at the proposition for pegging down the price of LUSD by relying on the 110% MCR leads to arbitrage opportunities above a price of $1.10 (and thus a price ceiling). However, this is not suitable on its own for keeping LUSD pegged to $1 in case of upward price pressure. That is why Liquity is incorporating other mechanisms to keep the price closer to $1. On the other hand, Maker came up with the idea to reduce the CR of USDC to incentivize traders to peg down DAI with arbitrage.
It is my strong belief that Liquity is a truly decentralized borrowing protocol that can solve some of the problems present in other projects such as Maker and Aave. Specifically, the 0% interest rate, the instant liquidation mechanism, as well as the staking of LQTY and LUSD are great value propositions not only for individuals but for institutions. I am specifically excited about the potential synergies with CeFi and DeFi protocols. In my opinion, Liquity has the potential to become the ultimate borrowing protocol for DeFi and has already started to revolutionize the field. It is a great addition to the quickly expanding collection of money legos in DeFi.
The classification of LUSD according to the ITC:
Economic Purpose (EEP): LUSD is listed as a fiat-pegged payment token (EEP21PP01USD) similar to the other stablecoins in the industry.
Industry Type (EIN): The issuer of LUSD is active in the field of Payment Services and Infrastructure (EIN06PS).
Technological Setup (TTS): LUSD is an Ethereum ERC-20 Standard Token (TTS42ET01). The Class “Ethereum ERC-20 Standard Token” captures every token that is implemented by means of the ERC-20 Standard on top of the Ethereum blockchain.
Legal Clam (LLC): The LUSD token does not entitle its holder to any legal claim or rights against the issuing organization, therefore it is listed as a No-Claim Token (LLC31).
Issuer Type (LIT): The dimension “Issuer Type” provides information on the nature of the issuer of the token. Liquity AG initially developed the protocol, but LUSD has no legally represented issuer; hence Issuer Type is an Entity without Legal Personality (LIT62).
Regulatory Framework (EU) (REU): The dimension “Regulatory Status EU” provides information on the potential classification of a token according to the European Commission’s proposal for a Regulation on Markets in Crypto Assets (MiCA, Regulation Proposal COM/2020/593 final). The LUSD token qualifies as a Non-Authorized Significant E-Money Token (REU51EM12) according to the definition provided in Article 3 (5) of Regulation Proposal COM/2020/593 final.
The International Token Standardization Association (ITSA) e.V.
The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.
- The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
- The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to the market capitalization of classified tokens.
- ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.
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Martin Palazov is a DeFi and Data Science specialist. His professional experience includes positions at the intersection of analytics and business at Procter and Gamble, DeFi and Custody at Sygnum Bank, as well as Data Mining Research at the Institute of Computer Science in St. Gallen. He completed his Bachelor in Economics, Management and Computer Science at Bocconi University. Currently pursuing his Master in Computer Science at the University of St. Gallen, you can contact him via firstname.lastname@example.org and connect with him on Linkedin, if you would like to further discuss anything about DeFi or have any open questions.
Valentin Kalinov is an Executive Director at International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database, including a classification framework and unique token identifiers and locators. He has over five years of experience working at BlockchainHub Berlin in content creation and token analysis, as a project manager at the Research Institute for Cryptoeconomics at the Vienna University of Economics and token analyst at Token Kitchen. You can contact Valentin via email@example.com and connect on Linkedin if you would like to further discuss ITSA e.V. or have any other open questions.
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- Official Liquity Documentation, docs.liquity.org/
- The Stability Pool as a Liquidity Reserve, liquity.org/blog/