Reflections on Liquity LUSD V2

A Quick Look on Liquity’s LUSD V1

Liquity LUSD V1 is a decentralized, immutable, and governance-free borrowing protocol that allows users to obtain interest-free loans using Ethereum (ETH) as the sole collateral. The loans are issued in LUSD, a stablecoin pegged to the US dollar, with a minimum collateral ratio requirement of 110%. The circulating supply of LUSD exceeds 100 million, and the total value locked (TVL) remains above 700 million, reflecting relative stability despite its modest total size.

Similar to MakerDAO’s CDP, the Trove is where Liquity users manage and maintain their loans. Each Trove is associated with a single Ethereum address, and each address can have only one Trove. A Trove maintains two balances: collateral (ETH) and debt (denominated in LUSD). Users can adjust these balances by adding more collateral or repaying debt. As these balances change, the Trove’s collateral ratio also changes, and users can close their Troves at any time by repaying their debt in full.

Key Innovation of LUSD: Stability Pool

The Stability Pool is the primary defense against system insolvency, consisting of LUSD provided by independent stability providers. When a Trove is liquidated, LUSD in the Stability Pool is burned to cover its debt, and in exchange, the collateral from the liquidated Trove is transferred to the Stability Pool and proportionally distributed to the stability providers. Over time, stability providers proportionally lose their deposited LUSD in the pool but gain the collateral from liquidations. Additionally, because the collateral is acquired at a discount during liquidation, stability providers effectively obtain ETH at a reduced price.

LUSD Stability Mechanism

Hard Peg Mechanism: LUSD holders can redeem the underlying collateral ETH from borrowers at any time.

The redemption feature allows any LUSD holder to exchange their stablecoins for $1 worth of ETH. When LUSD is below peg, users can buy it for e.g. $0.99 off the market and sell to the protocol for $1.00 worth of collateral.

This mechanism maintains a hard price floor around $1 through direct arbitrage, and is key for LUSD’s reputation as the most resilient stablecoin; many existing stablecoins have suffered from downward peg deviations due to high sell pressure.

During redemption, the system repays the lowest collateralized Trove using LUSD, transferring the corresponding amount of ETH from the affected position to the redeemer. This process incurs a one-time redemption fee, which starts at 0%, increases with each redemption, and gradually returns to 0% if no redemptions occur over time. This fee ensures that redemptions are not overly frequent, maintaining price stability.

Soft Peg Mechanism: The price of LUSD influences borrowing and repayment behaviors, thereby regulating the total supply of LUSD. The supply of LUSD is closely linked to its value relative to the US dollar.

Main Advantages of LUSD

1. Interest-Free Loans: Despite a one-time borrowing fee, there are no ongoing interest payments, making it highly favorable for long-term borrowers. Compared to other platforms that require regular interest payments, LUSD offers a more cost-effective option.
2. Stability Pool Mechanism: The Stability Pool makes the liquidation process more efficient, quick, and straightforward. For users who are long-term bullish on ETH, participating in the Stability Pool allows them to acquire ETH at a discount, increasing their motivation to participate.
3. Decentralization and Governance-Free: The decentralized and governance-free nature of the Liquity protocol ensures operational transparency and fairness, reducing the risk of human intervention and enhancing user trust in the system.

Disadvantages of LUSD

1. Redemption Risk When Below Peg: When the price of LUSD is below $1, CDPs with relatively low collateral ratios are redeemed. Although these CDPs still have high absolute collateral ratios, this mechanism can lead to the loss of collateral for users with collateralized loans.
2. Arbitrage Difficulty When Above Peg: When LUSD is priced above $1, there is no straightforward arbitrage mechanism to quickly return LUSD to its peg. This issue, similar to DAI’s situation before the introduction of PSM, lacks effective market adjustment methods. For most of 2023, LUSD remained above $1.
3. Collateral Restrictions: Due to Liquity’s early launch and immutable contracts, only ETH is accepted as collateral, excluding liquid staking tokens (LSTs) like stETH. This limitation reduces user choice and flexibility.
4. Insufficient Liquidity: The liquidity pool of LUSD with 3crv is too small, limiting its market trading convenience and liquidity. This can lead to high slippage and transaction costs for users during large trades.

LUSD V2 (BOLD)

Team team released LUSD V2 whitepager. In this whitepaper, LUSD V2, with a new name BOLD, is introduced, with realted mechanisms explained.

Main Improvements of LUSD V2

• Interest Rate Mechanism: Transitioning from interest-free loans to user-set interest rates. Users can set interest rates according to their needs, and the redemption order will be based on interest rates rather than collateral ratios. This change aims to address user concerns about redemptions and align better with market interest rate environments.

• Improved Pegging Mechanism: Liquity v2 employs a market driven monetary policy through user-set interest rates which can dynamically react to situations where BOLD is above or below $1.
• Liquidity Incentives: Built-in liquidity incentive measures aim to address the issue of small liquidity pools, by leveling a fixed portion of the interest revenue from all borrow markets to eligible LPs, and the split is determined through weekly gauge voting. By attracting more users to provide liquidity through incentives, the market depth and trading convenience of BOLD will be enhanced.
• Acceptance of Liquid Staking Tokens (LSTs): LUSD V2 will accept LSTs as collateral, expanding users’ collateral options and increasing the system’s flexibility and attractiveness.

Potential Issues with LUSD V2

Despite the significant improvements, LUSD V2 still has some potential issues:

• Complexity of User-Set Interest Rates: Setting user-determined interest rates may be more complex in practice than other lending platforms, requiring users to have a certain level of market judgment and operational experience. Additionally, to avoid redemption, users may need to set high-interest rates, increasing borrowing costs and diminishing the original advantage of interest-free loans.
• Interest Rate Volatility Risk: The user-set interest rate mechanism may lead to increased interest rate volatility, especially in rapidly changing market conditions. Uncertainty in interest rates may negatively impact users’ borrowing decisions and increase the overall risk of the system.

Suggestions to Address the Above Issues

To further optimize the design of LUSD V2, we propose the following suggestions:

1. Retain the Original Interest-Free Loan Mechanism: We suggest retaining the one-time borrowing fee and continuing to offer interest-free loans. This would maintain LUSD’s differentiated competitive advantage in the market, attracting long-term borrowers. However, this might conflict with the current V2 proposal of user-set interest rates.
2. Introduce Dynamic Interest Rate Mechanism: When LUSD is below $1, the protocol starts charging dynamic interest, with higher deviations leading to higher interest rates. This interest can be allocated to the Stability Pool, attracting more LUSD deposits, which is also beneficially to the peg.
3. Introduce PSM (Peg Stability Module): Allow 1 USDC:1 LUSD exchange. When LUSD is above $1, USDC holders can easily arbitrage; when LUSD is below $1, the pool can act as a buffer before redemption, providing an additional market stabilization mechanism.
4. The redemption fee can be increased to, say, 1%, to act as a last-resort correction mechanism when the peg deviation exceeds 1%. Under this configuration, redemptions would not occur frequently under normal circumstances with deviations less than 1%, the above mentioned dynamic interest rate and PSM would serve as the primary methods for stabilizing BOLD.

Prisma

Before the launch of LUSD V2, the Prisma protocol had already made certain improvements to LUSD V1. In Prisma, users can use LSTs (such as wstETH, rETH, sfrxETH) as collateral to mint mkUSD at a 4% interest rate plus a 0.5% minting fee, maintaining a minimum collateral ratio of 110%-120%. The current interest rate is determined by community voting. mkUSD is pegged 1:1 to the dollar and can be redeemed for $1 worth of collateral at any time. The Vault with the lowest collateral ratio becomes the redemption target, reducing the Vault holder’s debt upon redemption.

Prisma’s Improvements to LUSD

• Acceptance of LSTs as Collateral: Prisma Finance originates from Liquity’s code and retains the concept of the Stability Pool. mkUSD holders can deposit mkUSD into the Stability Pool. When collateral prices fall, causing Vaults to reach the minimum collateral ratio, the Stability Pool is used to liquidate the Vaults, and the acquired LSTs are proportionally distributed to Stability Pool LPs.
• Introduction of veTokenomics: Prisma adopts Curve’s veTokenomics. By locking governance tokens (Prisma), users can obtain protocol income dividend and vePRISMA , enhancing their rewards in the Stability Pool or other LPs.

Issues with Prisma

Despite Prisma’s improvements to LUSD V1, some issues remain:

1. Security Concerns: On March 28, 2024, Prisma experienced a hacking incident. The team’s response was not proactive, with compensation measures taking over a month to discuss and implement. This delayed response might affect users’ trust in the platform.
2. High Borrowing Rates: Prisma’s borrowing rates are set manually and cannot reflect market supply and demand changes, making the protocol less competitive under certain market conditions. For example, stETH users might prefer platforms with lower interest rates like Spark, Morpho, or Aave for borrowing. For example, at the end of May 2024, borrowing rate on Prisma using wstETH is 10% with a mint fee at 0.12%, while at spark, the borrowing rate is 9%. Even without considering the redemption risk at Prisma, the interest rate is not attractive to wstETh holders to borrow mkUSD.
3. Dispersed Incentives: Prisma’s incentives are too dispersed, resulting in small mkUSD liquidity pools. This situation limits mkUSD’s market trading convenience and liquidity, with high slippage affecting user experience.

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