Liquity is a decentralized application for borrowing crypto money without paying an interest rate on the ETH collateral. You may wonder, doesn’t this defeat the purpose of lending?
Not when it comes to decentralized finance (DeFi). Liquity’s borrowing platform integrates dual tokens — LQTY and LUSD — to provide liquidity for decentralized loans.
Liquity Protocol Summed Up
Liquity offers a 110% collateral-to-debt ratio against ETH collateral, with the loan itself issued as LUSD stablecoin. The 110% ratio is fairly low compared to other DeFi lending platforms because Liquity employs an “instantaneous liquidation mechanism,” to making capital flows more efficient.
Liquidity providers (LPs) make the Liquity lending robust by holding LUSD stablecoins and depositing them into Stability Pools. These are smart contract bulwarks against debt liquidations. LPs also earn additional incentive via Liquity’s LQTY token.
Liquity’s Incentive Mechanism Explained
Like other lending dApps, Liquity relies on the power of smart contracts to offer three important variations on traditional finance:
There is no need to verify credit history, or even identity, because all parties interact with the self-regulated logic — smart contracts.
Smart contracts pool liquidity for loans to be borrowable.
If Liquity offers zero-interest rate loans, where does the incentive come from? Typically in lending dApps, liquidity providers lock their deposits in smart contracts for other people to borrow. In exchange, they get an annualized percentage yield (APY), thereby mimicking the role of a bank.
This is where Liquity’s stablecoin LUSD comes into play. When borrowers want a loan on Liquity, they need to deposit a collateral, denominated in ETH, the native cryptocurrency for the Ethereum blockchain. This ETH collateral deposit is then swapped for a LUSD stablecoin.
The incentive comes from borrowers paying a one-time fee when this collateral is locked-in for the loan. Another incentive source comes from Liquity’s LQTY token. Here is how that process works in greater detail.
Liquity’s LUSD and LQTY Tokenomics: DeFi Arbitrage
Liquity is not like other decentralized applications. It is best understood as the underlying lending protocol because it relies on frontend operators to actually use it. In other words, Liquity is more of an infrastructure application that offers the governing logic of its dual tokenomics.
DeFi developers can then permissionlessly build a website to anchor their service into Liquity Protocol. Here is what they are getting.
At the base of Liquity are “Stability Pools.” These are smart contracts that pool liquidity provided by, you guessed it, liquidity providers (LPs). On the borrowing side of the equation, borrowers enter Liquity’s collateralized debt position (CDP), dubbed a “Trove”.
Specifically, borrowers need to deposit ETH collateral at a minimum of 110% ratio on the loan. For instance, if the loan is worth $10,000, they would need $11,000 worth of ETH. To make sure the whole system doesn’t collapse if the borrower’s Trove gets liquidated, LUSD token holders can keep these stablecoins in Stability Pools.
Each LUSD is redeemable for $1 worth of ETH at the market price.
When borrower’s Troves get liquidated, LUSD stablecoin holders receive a portion of the ETH that was locked-in as a collateral. As an extra incentive, when LUSDs are redeemed for their worth in ETH, the borrower has to pay a redemption fee.
Typically, the value of liquidated collateral exceeds the loan itself, so LUSD token holders receive a nice profit because Liquity Token (LQTY) is rewarded to all Stability Pool LUSD depositors.
When all is said and done, Liquity Protocol provides an arbitrage opportunity against borrowers’ collateral. This is why Liquity managed to avoid the typical DeFi model of APYs on loans. Moreover, the LUSD stablecoin itself provides another arbitrage opportunity.
LUSD Stablecoin Arbitrage
Not to be confused with algorithmic stablecoins like TerraUSD (UST), Liquity’s LUSD is a soft-pegged stablecoin. Its floor price and ceiling are not determined by another cryptocurrency, as was the case with UST and LUNA.
Instead, LUSD’s peg is maintained by a balance between borrowing fees and loans. For example, if LUSD goes under the dollar’s one-to-one ratio, Liquity users can redeem LUSD for $1 worth of ETH. That ETH would then be worth more because it was redeemed for a discount price. This is called an arbitrage, in which price differences are exploited to turn a profit.
As an intended effect, increased LUSD redemptions would then lower LUSD supply, which increases its demand. As a result, LUSD’s peg would go back to the dollar’s one-to-one ratio, making it a soft-peg stablecoin.
Liquity Token (LQTY)
As mentioned previously, LQTY tokens are rewarded to Stability Pool liquidity providers to safeguard the system against debt liquidations. But LQTY has other roles as well:
To incentivize frontend operators to build upon the Liquity Protocol, as they create web interfaces that tap into Liquity’s smart contracts.
LQTY token holders can stake them, without a lock-in period, to earn a portion of fees paid for issuing loans and redeeming LUSD stablecoins.
Unlike most DeFi tokens, LQTY is a utility token. Typically, such tokens assume both the governance and utility role. Nevertheless, because governance tokens impart voting rights on the protocol, and whales could hold most of them, the Liquity team opted not to include a governance function.
Ironically, by not having community governance via LQTY tokens, Liquity ended up being more decentralized than other DeFi platforms.
Liquity was developed by CEO Robert Lauko, a former DFINITY research associate, and Rick Pardoe, the project’s lead engineer. Following 18 months of development, Lauko and Pardoe launched Liquity on the Ethereum blockchain in April 2021.
Arbitrage is trading that exploits the tiny differences in price between identical assets in two or more markets. The arbitrage trader buys the asset in one market and sells it in the other market at the same time in order to pocket the difference between the two prices.
The Liquity Token (LQTY) supply is capped at 100M, of which over 80% is in circulation.
Who Made Liquity Protocol?
Originating from DFINITY as a research associate, in charge of developing the Internet Computer (IC), Robert Lauko launched the protocol in April 2021. In his new role as Liquity founder and head of research, he received $8.4M in funding capital across three funding rounds, mostly from Pantera Capital and Polychain.
In October 2022, Liquity added another novelty via Chicken Bonds. Taking advantage of Liquity’s stablecoin, Chicken introduced a yield-amplifying bonding mechanism with a boosted LUSD — bLUSD. This means that LUSD depositors can get even higher gains against collateralized debt.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.