Liquity (LQTY) – Interest-Free Loans Against Ether
Liquity (LQTY) is a decentralized borrowing protocol on Ethereum that lets you take out interest-free loans against ether.
Stablecoins may be a bit of an underappreciated innovation, but they make up a huge portion of the cryptocurrency space. The issue is that the biggest ones are all centralized and collateralized by fiat money.
While this is fine for many of the use cases, it does create systemic risks, especially when it comes to DeFi. The success of MakerDAO and DAI shows that there’s high demand for decentralized stablecoins – but even DAI is partially backed by centralized assets.
Liquity demonstrates that there’s room for more experimentation with similar mechanisms as DAI. It’s an elegant way to construct such a system, and quite a clean design – there’s not much excess fat in the protocol.
In a way, Liquity is a perfect representation of what this new wave of the Internet is all about – self-executing, automated, immutable protocols that act as a kind of public good.
Let’s see how Liquity works.
What is Liquity?
What is a Trove?
How do liquidations happen?
Liquity governance
The LQTY token
What is Liquity (LQTY)?
Liquity is a decentralized borrowing protocol that lets you take out interest-free loans against ether. These loans are paid out in the platform’s primary token – LUSD. Each LUSD aims to achieve a peg with 1 USD through the ability to redeem LUSD for $1 of ETH at any time and associated arbitrage opportunities.
Each loan needs to maintain a low collateral ratio of 110%, which is quite unparalleled in the world of DeFi. Overcollateralization is a decent way to minimize the chance of there being a deficit in the system but isn’t particularly capital efficient. Even so, it’s worth mentioning that even with such a low minimum collateral ratio (MCR), it isn’t advised to keep a debt position close to this value thanks to the high risk of liquidation.
So what makes this low MCR possible? In addition to the collateral itself, there’s another mechanism aiming to secure that the loans are sufficiently backed at all times called the Stability Pool. It contains LUSD and tries to ensure that the peg is maintained through various mechanisms. Borrowers can deposit their LUSD to the pool and become Stability Providers to receive liquidation gains in ETH and LQTY rewards.
LQTY, the secondary token of the platform can also be staked to earn LUSD and ETH from borrowing and redemption fees.
What is a Trove in Liquity?
These debt positions are managed through a mechanism called a Trove. Borrowers need to deposit ether, the only type of collateral accepted, and can borrow LUSD against it with an MCR of 110%. There’s no expiration date for a position, but a minimum debt of 2,000 LUSD is required.
A one-time fee is paid upon borrowing and redemption. This fee cannot be lower than 0.5% and is variable based on how much borrowing and redemption is happening. The idea behind the algorithmically set fee is to ensure smooth operation and a healthy balance between borrowing and redemptions. For example, if more redemptions are happening, which likely means that LUSD is trading below 1 USD, the borrowing fee is increased to discourage borrowing.
When a Trove is opened, 200 LUSD is set aside to the Liquidation Reserve to account for gas fees in the event of the position getting liquidated. If the position isn’t liquidated, this reserve is refunded to the depositor upon closing the Trove. The amount in this reserve is calculated as debt, so it slightly decreases the collateral ratio as a result.
How do liquidations happen?
Liquidations can be done by anyone if a Trove’s collateral ratio falls below 110%. In the event of liquidation, the borrower loses their collateral, but they still maintain their borrowed LUSD. In exchange for the service done to the system, liquidators receive gas compensation from the Liquidation Reserve mentioned earlier.
When a Trove is liquidated, an amount of LUSD is burned from the Stability Pool to pay off the remaining debt incurred by the position, and the collateral is transferred from the Trove into the Stability Pool.
As mentioned earlier, borrowers can deposit LUSD into the Stability Pool and become Stability Providers. Even though liquidations decrease the LUSD balance in the pool, Stability Providers should still end up with an increased balance in dollar value thanks to the liquidated collateral being transferred to the Stability Pool. Since it’s likely that most positions are liquidated below a 110% collateral ratio, Stability Providers should receive a higher dollar value in ether than the debt they paid off in LUSD. In addition, Stability Providers also receive rewards in LQTY tokens.
Chainlink oracles are used to ensure the lowest possible chance of oracle manipulation attacks.
Liquity governance
As mentioned earlier, the design is fairly lightweight. Liquity is ‘governance-free’, meaning there’s no valueless governance token to act as a theatrical way to enforce changes.
While over the long-term, we may figure out ways to use governance tokens in a way that benefits these protocols, they can lead to a lot of friction, add a lot of unnecessary baggage, and create potential conflicts between core developers and other stakeholders.
That’s not to say it’s not worth experimenting with governance tokens at all, but creating a protocol that simply works is also a reasonable approach. Not to mention the fact that designing a governance system resilient to all sorts of attacks and potential points of centralization is extremely difficult. As such, Liquity chose to go for a governance-free approach to maintain a high degree of decentralization and censorship-resistance. These properties are especially desirable when it comes to stable-assets, as so many composable DeFi applications rely on them.
The operation of the Liquity protocol is automated, and the contracts are immutable, meaning there’s no way to tinker with parameters after a contract has been deployed. Liquity also doesn’t have any admin keys or ways to upgrade the smart contracts, which can help with long-term security.
The developers chose to focus on development – so much so that even frontends are outsourced. Frontend developers receive LQTY rewards for providing this service to the protocol. This can be a neat way to increase decentralization and ensure a higher degree of censorship-resistance. You can find a list of the various frontends for Liquity here.
The LQTY token
While the protocol doesn’t have a governance token, there is a way to benefit from the potential growth of the platform – the LQTY token. It aims to capture fees paid to the protocol and is used to incentivize early adoption and frontend creation.
Summary
Liquity is an innovative borrowing protocol that aims to create a censorship-resistant stablecoin pegged to the dollar.
While it would be more desirable to rely on some other benchmark instead of the dollar, LUSD may have longevity in the DeFi space as one of the prominent decentralized stablecoins.