Liquity is a decentralized borrowing protocol on multiple blockchains, including Ethereum, aiming to facilitate interest-free loans backed by Ether collateral and disbursed in LUSD. It aims to be non-custodial, immutable, and governance-free, striving for a secure and transparent borrowing process.^[1][2]

Overview

Liquity, founded in December 2019 by Robert Lauko and Rick Pardoe, is a borrowing system where loans are distributed in LUSD, a USD-pegged stablecoin, requiring a minimum collateral ratio of 110%. Operating without its own frontend, users can opt for various third-party operators, fostering decentralization. In the realm of Ethereum applications, stable-value assets are essential, with the majority in fiat-collateralized stablecoins like Tether and USDC. Liquity aims to address this by providing an efficient and user-friendly way to borrow stablecoins.^{[2][3][4][31]}

Stability Pool

The Stability Pool serves as a key element in Liquity's solvency management, aiming to provide liquidity for repaying debts from liquidated Troves and maintaining the backing of the total LUSD supply.

In the event of Trove liquidation, the Stability Pool burns LUSD equal to the remaining debt, utilizing its balance to settle the debt and acquire the entire collateral from the liquidated Trove. Funding for the Stability Pool comes from users, known as Stability Providers, who transfer LUSD into it. Over time, Stability Providers experience a proportional reduction in their LUSD deposits but gain a proportional share of liquidated collateral.

Depositing LUSD into the Stability Pool is encouraged as Stability Providers anticipate receiving a higher dollar value of collateral relative to the debt they settle, given the likelihood of Troves being liquidated just below the 110% collateral ratio. The motivation for contributing to the Stability Pool lies in the potential for Stability Providers to realize liquidation gains and obtain early adopter rewards in the form of LQTY tokens.^[5][6]

Liquidations

Liquidations are triggered when Troves fall below the 110% collateral ratio, aiming to maintain continuous full backing of the stablecoin supply. During this process, the Trove's debt is nullified, and absorbed by the Stability Pool, and its collateral is distributed to Stability Providers. Owners of liquidated Troves retain the borrowed LUSD but face a 10% loss, emphasizing the importance of maintaining a ratio above 110%, ideally exceeding 150%.

Any individual can initiate Trove liquidation, aiming to receive gas compensation of 200 LUSD and 0.5% of the Trove's collateral. Compensation for Trove liquidation is intended to cover associated gas costs. While batch liquidations reduce the cost per Trove, the protocol aims to ensure viability even during periods of high gas prices.

The gas compensation includes 200 LUSD funded by a Liquidation Reserve and a variable 0.5% in ETH from the liquidated collateral, slightly reducing the liquidation gain for Stability Providers.^[7][8][9]

Troves

A Trove in Liquity functions as a user's loan management space, linked to an Ethereum address. Similar to Vaults or CDPs on other platforms, each Trove holds asset (ETH) collateral and debt denominated in LUSD. Users adjust these balances by adding collateral or repaying debt, affecting the Trove's collateral ratio. Troves can be closed at any time by fully repaying the debt.^[30]

Redemptions

Redemptions entail exchanging LUSD for ETH at a nominal value of $1 per LUSD. Users have the option to redeem LUSD for ETH without restrictions, although a potential redemption fee may apply to the redeemed amount. The redemption fee calculation follows the formula (baseRate + 0.5%) * ETHdrawn. The dynamic baseRate increases with each redemption and undergoes decay over time with a 12-hour half-life. The redeemed amount influences the base rate and may impact the redemption fee, particularly for larger quantities.

It's essential to note that redemptions and debt repayment are separate processes. Debt repayment involves adjusting Trove's debt and collateral, while redemptions specifically aim to convert LUSD to ETH.^{[10][11][12][13][14]}

Price Stability

Hard Peg Mechanisms

Liquity upholds stability by offering a redeemable stablecoin, LUSD, exchangeable for ETH at $1, with a gradual redemption fee increase to discourage excessive redemptions. Arbitrage opportunities may arise when LUSD falls below $1, allowing potential profit for speculators. Burned LUSD reduces supply, potentially positively affecting the price and expediting rate recovery.

The proposed redemption fee formula, b(t) := b(t-1) + 𝛼 * m/n (𝛼 set at 0.5), aims to align with profit-driven arbitrageurs and restore the peg based on the Quantitative Theory of Money. A natural price ceiling at $1.10, enforced by a 110% minimum collateral ratio, aims to prevent LUSD from exceeding this value, contributing to stability and prompting a swift rebound if breached.^[15]

Soft Peg Mechanisms

Liquity employs soft peg mechanisms with the aim of aligning its stablecoin, LUSD, with USD. The Trove collateral ratios are calculated considering LUSD equivalent to USD, intending to establish parity as the equilibrium state. The 1:1 dollar peg is viewed as a Schelling Point, intended to guide the system back to equilibrium after temporary deviations. LUSD's trading range is confined between $1 (minus fees) and $1.10, with the objective of minimizing speculative possibilities and reducing adversarial speculation risks. To manage the creation of LUSD, Liquity uses an algorithmically determined issuance fee on debt, intending to replace variable interest rates. This upfront cost is intended to act as a deterrent for new loans, contributing to the system's stability by managing supply and demand.

The protocol allows for decentralized leverage, with a maximum ratio of 11x, influenced by the minimum collateral ratio. Higher LUSD prices are expected to make leveraging more attractive, impacting user decisions based on expectations of future price changes. The Stability Pool, holding a portion of the LUSD supply, is intended to serve as a dual-purpose reserve supporting system stability and the stable value of LUSD. As LUSD approaches $1.10, potential loss risks are intended to reduce stability deposits, injecting liquidity and contributing to LUSD depreciation.^[15]

Oracles: Chainlink and Tellor

Liquity incorporates the decentralized oracle Chainlink as its primary provider, emphasizing reliability, while Tellor serves as the secondary oracle due to its decentralized structure. Both oracles adopt a proxy-logic pattern for seamless upgrades.

Liquity's oracle logic involves calling both oracles, giving preference to the primary. If both freeze or break, the system reverts to the last reliable price. Chainlink is considered frozen after four hours without updates, and Tellor updates when tipped by miners.

In the unlikely scenario of both oracles failing, Liquity relies on the last reliable price but actively seeks recovery. The smart contract code ensures a dual-oracle design with fallback and recovery logic, managing glitches or critical failures without requiring human intervention.^[16]

Frontend Operators

Frontend Operators play a role in facilitating user interaction with the Liquity protocol through a web interface, aiming to receive a portion of LQTY tokens generated by users. The Kickback Rate, within a range of 0% to 100% set by Operators, aims to determine the distribution of LQTY rewards among Stability Pool depositors, users, and the Frontend Operator. While a higher Kickback Rate may attract users, providing a user-friendly interface and additional functionalities aims to maintain user interest even with a lower rate.

Rewards are intended to be disbursed in LQTY tokens, creating a direct incentive for Frontend Operators. Running a frontend involves installing the Liquity frontend launch kit or integrating the protocol using the Frontend SDK.^[17][18][19]

Liquity v2

Liquity v2 aims to introduce principal protection, designed to mitigate losses during market downturns and enhance the appeal of hedging positions. Additionally, it aims to incorporate a secondary market within the system to minimize liabilities associated with principal protection.

Hedging positions in Liquity v2 are perpetual and not subject to liquidation, allowing users to exit and claim their share of the reserve's surplus. The exit value is influenced by the price movement of the reserve asset, affecting leverage dynamics.^[20]

Principal Protection

A key feature in Liquity V2 is Principal Protection, designed to make hedging products more appealing by shielding users from losses during market downturns. Users, upon opening a hedging position, are assured that they can sell their position for at least its fixed principal amount, providing asymmetric protection against significant losses during market declines. This innovation aims to enhance the reliability and attractiveness of leverage products by offering users both amplified upside potential and protection from downside risks.

To implement this, Liquity V2 collects premiums from users when they open new positions through an auction-like mechanism. This premium, paid by users, ensures a balance of new capital inflow and maintains sufficient overcollateralization.^[20]

Subsidizing Secondary Market Sales

In Liquity V2, the secondary market operates as a platform for users to trade hedging positions, with the goal of averting potential bank run scenarios. Users listing positions for sale, often at a premium, can engage in transactions if there's ample demand, thereby safeguarding the system's reserves.

To address scenarios with no buyers, the protocol intervenes, gradually enhancing the position's value using collected premiums to subsidize the sale. Importantly, this process keeps subsidies within Liquity's system, avoiding any value leakage.

By combining principal protection mechanisms and a well-designed secondary market, Liquity V2 aims to incentivize market participants, mitigating the risk of sudden exits and contributing to decentralization, stability, and scalability.^[20]

Tokenomics

Liquity USD Token (LUSD)

Liquity USD (LUSD) is an ERC-20 stablecoin powering the Liquity decentralized borrowing protocol. It facilitates loans with stablecoin backing, requiring users to hold a Trove with a minimum ETH deposit and a 110% collateral rate. Validated through a Proof-of-Stake (PoS) consensus mechanism post-Ethereum Merge, users can deposit LUSD into a stable pool to earn rewards in ETH and LQTY.

As a token pegged to the US dollar, LUSD's value allows direct exchange into fiat currency or other token pairs like USDT.^[21][22]

Liquity Token (LQTY)

LQTY, Liquity's secondary token, captures fee revenue and incentivizes Stability Providers, comprising users depositing LUSD, frontends facilitating deposits, and liquidity providers in the LUSD:ETH Uniswap pool. With a capped supply of 100,000,000 tokens, LQTY isn't a governance token. Earnings come from depositing LUSD, facilitating Stability Pool deposits, and providing liquidity. Holders can stake LQTY to earn fees from loan issuance and LUSD redemptions.^{[23][24][25][26]}

Allocation

The distribution of LQTY tokens is as follows:

• Liquity Community: 35.3% (32,000,000 LQTY allocated to the rewards pool, earned through Stability Pool deposits, and rewarded to frontends and Stability Providers by the protocol; 1,333,333 LQTY allocated to LPs of the LUSD:ETH Uniswap pool, earned by staking LUSD:ETH Uniswap LP tokens and distributed over 6 weeks by the protocol; 2,000,000 LQTY allocated to the Community Reserve, sourced from the Liquity AG endowment, intended for grants, hackathons, events, and community initiatives)
• Team and Advisors: 23.7% (23,664,633 LQTY allocated to current and future Liquity AG employees and advisors; Tokens under a 1-year lockup, with 1/4 vesting after 1 year and 1/36 vesting every subsequent month)
• Investors: 33.9% (33,902,679 LQTY allocated to Liquity's early investors, subject to a 1-year lockup)
• Liquity AG Endowment: 6.1% (6,063,988 LQTY allocated to Liquity AG for company use, with a 1-year lockup)
• Service Providers: 1% (1,035,367 LQTY allocated to service providers assisting Liquity before launch, subject to a 1-year lockup)^[27]

Distribution Schedule

The issuance of LQTY to the community, excluding LP incentives and the Community Reserve, adheres to an annual halving schedule defined by the function: 32,000,000 * (1–0.5^year). This schedule is designed to provide favorable incentives for early adopters while ensuring a sustained incentive structure over the long term.^[27][28]

Investors

• Polychain Capital
• Tomahawk.vc
• Lemniscap
• 1kx
• A Capital
• Alex Pack
• Robot Ventures
• DFINITY Ecosystem Fund
• Pantera Capital
• Nima Capital
• Alameda Research
• Greenfield.one
• IOSG
• Angel DAO^[29]