Liquity & LUSD Stablecoin: A truly Decentralized Solution

The US is cracking down on the crypto industry through enforcement and new regulations. US-based exchanges, DeFi projects and stablecoin issuers are in the SEC's and other agency's crosshairs. Some of the largest stablecoin projects such as Tether’s USDT are under investigation for falsifying documents while BUSD has recently been ordered to wind down by the SEC. While uncomfortable for the industry, these recent actions also pave the way for specific projects that are truly decentralized, provide a functional solution and with team that are preferably not based in the US.

Meet Liquity, an on-chain protocol for borrowing and issuing a unique stablecoin. The Switzerland-based project offers investors a way to use their ETH as collateral to create 0% interest loans and receive their decentralized and dollar-pegged stablecoin LUSD. This provides investors increased capital efficiency as they do not have to sell their ETH but can still use their capital. A prerequisite is that their ETH holdings maintain a value of 110% of the borrowed LUSD amount.

How Liquity Protocol works

As a user, you can get a loan by providing ETH as collateral. You deposit your ETH into a smart contract on the Liquity network and create a "Trove," which can be best described as your own personal account. This trove consists of an ETH and LUSD account and is all you interact with. There are no intermediaries involved, and the entire Liquity process is fully automated through smart contracts. Once you have deposited your ETH, you can get issue Liquity's stablecoin LUSD up until roughly 90% of your ETH. LUSD is perpetually tied to the value of exactly one US dollar. You can use these LUSDs however you want, for example in DeFi, and when you're ready to pay it back, you can return the LUSD and get your Ether back at an instant.

There's a one-time fee when you open and close a loan. You pay 0% interest and the protocol's loans do not have a payback schedule. You can keep your Trove open and repay your loan whenever you choose as long as you keep a collateral ratio of at least 110%. You have to make sure there is always enough Ether in your Trove to cover 110% of the amount of LUSD you borrowed. So if you borrow $1,000 LUSD, you need to always have at least $1,100 worth of ETH as collateral. If the value of the ETH in your Trove drops too much, your loan is liquidated.

Liquidations and the stability pool

Because of the protocol's efficient and instant liquidation mechanism, Liquity's low collateralization ratio is possible. The system is fully algorithmic, automated and runs on smart contracts. To stabilize the system and enables loans, there is a stability pool. The Stability Pool is an important part of the Liquity system that ensures that there is always enough money to pay off any ‘Troves’ that get liquidated. This helps to maintain the value of the LUSD stablecoin.

You can see this as an insurance fund of the protocol to ensure the entire system stays solvent. The pool is funded by borrowers who are "stability providers" and deposit both their ETH and LUSD into the pool. In return, they receive LQTY rewards and the liquidations fees of closed loans. The Liquity protocol allows a loan-to-value ratio of 90.91%, the highest amongst its competitors. Two of its largest competitors include Compound (COMP) and Aave (AAVE), which have a loan-to-value ratio of 75% and 65%, respectively.

For more information about these mechanisms, check out Liquity's documentation.

True decentralization and decentralized frontends

Liquity's protocol is a fully decentralized smart contract protocol that is non-adjustable, even by the core developers. This means that people can use it without having to rely on a central authority and without having to worry about any changes to the protocol ultimately affecting their capital. The Liquity system has no admin key meaning it runs fully autonomous on the blockchain.

The core Liquity team also does not, and will not own their own protocol front end, which means that to use the Liquity protocol, you have to use one of the trusted front ends. A list of trusted front-ends can be found on the Liquity site. All third-party frontend operators such as DeFi Saver, Liquity.App, or Instadapp are compensated in Liquity’s LQTY token.

LQTY Team

The Liquity team consists of numerous industry and finance veterans. Micheal Svoboda, the CEO of Liquity, has previously been the CEO and COO at several blockchain companies and holds a degree in computer science and economics. Robert Lauko, head of research and founder of Liquity, holds a Ph.D. in Law. and has been previously employed as a researcher at DFINITY. Rick Pardoe, the Co-Founder of Liquity holds degrees in Physics and Economics. Furthermore, Liquity has two advisors, including Ashleigh Schap who is also an advisor at the major decentralized exchange Uniswap. Ashleigh also previously worked at stablecoin issuer and Liquity competitor MakerDAO (DAI). Additionally, Liquity protocol has an impressive network of partners and is currently expanding to various Ethereum Layer 2's such as Aztec and Arbitrum.

LQTY tokenomics

LUSD stablecoin

LUSD is the protocol's stablecoin, which is pegged to the US Dollar on a 1:1 basis. The stability of LUSD is ensured by its innovative and dynamic mechanism, which relies on an algorithmic peg, the stability pool and arbitrage. You can read exactly how this mechanism works here. LUSD's supply is constantly fluctuating based on loan demand.

LQTY Token

Next to LUSD, there is the LQTY token. LQTY is used as reward mechanism and revenue-share asset. The system rewards contributors and can be earned by depositing LUSD in the stability pool, running a front end or providing liquidity for the LUSD/ETH pair on Decentralized Exchanges. Additionally, the protocol shares the revenue it generates from loan issuance, loan redemptions and liquidations with LQTY token holders. LQTY has a capped supply of 100 million and its reward issuance is halved every year.

Market capitalizations

Liquity’s tokens have a combined market cap of roughly $432 million. The market cap of LUSD sits at $232 million while Liquity’s LQTY sits at a market cap of $180 million at the time of writing.

Liquity TVL

The protocol has been live since April 2021. At its peak, there was roughly $4.5 billion Total Value Locked (TVL) in the protocol but this has decreased to about $600 million due to the bear market.

A truly decentralized solution and expansion

Liquity protocol enables capital efficiency by allowing users to both hold on their ETH while using LUSD stablecoin for other (DeFi) purposes. Throughout its third party frontends, the protocol is easy to use and its 0% interest rates make it an attractive loan as this far outdoes competitors whose interest rates range from 1-5%. Even with the Trove creation and redemption fees, this still is highly competitive.

In an environment where US regulators and potentially regulators from across the world start cracking down on the crytpo industry, it's a relief to know that Liquity is truly decentralized. While this also means that nothing can be changed about the protocol, Liquity has been up and running for nearly 2 years without any major fallout. The project is also in the process of expanding to Ethereum's layer 2's such as Aztec and Arbitrum and is partnering with other projects, which should increase LUSD adoption. We'll be following this truly decentralized protocol over the coming period!