Explain in detail Liquity’s new decentralized lending gameplay, can it catch up from behind?


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Analyze the main features of Liquity one by one: zero interest rate, low mortgage rate, direct redemption, low liquidation loss and additional income from pledge.

Original title: ” Can Liquity’s mechanism really catch up from behind?”
Written by: Footprint
Translation: Blockchain Research Society

As the two cornerstones of DeFi projects, DEX and Lending occupy an important position in the blockchain market. In addition to Aave and Compound, which occupy a leading position in the market, Liquity redefines Lending’s gameplay.

As the two cornerstones of DeFi, DEX and Lending occupy an important position in the blockchain market. In addition to Aave and Compound, which occupies a leading position in the market, Liquity, which received US$6 million in Series A financing in March 2021, redefines the new gameplay of the Lending project with its innovative mechanism. After the extreme market test in May, it proved its The effectiveness of the mechanism. At present, the amount of ETH locked up is about 400,000 pieces, which is about 1.6 billion U.S. dollars.

ETH lock-up amount (since May 2021), data source: Footprint Analytics

In addition to providing a loan business that can obtain stable currency LUSD by collateralizing ETH, Liquity also provides two other pools to help users obtain additional income: depositing in the stable pool LUSD to divide the ETH of the liquidated users, and at the same time obtain Liquity tokens LQTY rewards; pledge LQTY to get the user’s loan and redemption fees.

From Liquity’s official Docs, its main features include:

Are these characteristics really as they say?

This article will combine the existing data of Footprint Analytics and start the analysis one by one from the above five perspectives.

Interest rate is 0%

Liquity only supports ETH as collateral for borrowing, and the agreement provides interest-free loans. Liquity claims that it has higher capital efficiency than other lending systems. The interest rate is indeed 0%, but as a borrower, I am more concerned about the comprehensive rate due to borrowing.

Therefore, it cannot be ignored: when borrowing money, there will be a borrowing fee. The rate is generally 0.5%-5%. According to the calculation of the algorithm, the rate is basically maintained at 0.5% for the first half of the year. The only increase is around the extreme market in May. The highest is about 1.16%.

If the borrower is not liquidated, although he does not need to pay the borrowing interest rate, he will actually have to bear one-time borrowing costs. The user’s comprehensive fee rate is still 0.5%-5% of the borrowed amount, and the borrower will not continue due to the lengthening of time. Increasing borrowing costs, on the contrary, can be used to amortize the costs for a long time. If it is only a short-term behavior that is converted into an annualization, it will be a higher rate. Therefore, Liquity encourages borrowers to make long-term loans.

110% minimum mortgage rate

When Liquity borrows money, you need to open a treasury (Trove) and deposit a certain amount of collateral (ETH) into it. According to the mortgaged ETH, a custom amount of LUSD can be withdrawn, but the mortgage rate must be higher than 110%. When the mortgage rate is less than 110%, it will be liquidated. Although the 110% mortgage rate makes more effective use of the deposited ETH, what other information is easily overlooked?

First of all, the Borrowing Fee and Liquidation Reserve mentioned above will also be included in the mortgage rate.

Therefore, you can refer to the example in the figure below. The total loan amount is 2210 LUSD, and the official mortgage rate is 110% (0.6710 * 3622.92/2210 * 100%), but the actual amount that can be used for borrowing is 2000 LUSD. The available mortgage rate should be 121% (0.6710 * 3622.92/2000 * 100%).

Since the liquidation reserve is a fixed amount, and if no liquidation occurs, it will be returned to the borrower when repayment. Therefore, the liquidation reserve is not considered an expense when it is not liquidated. The borrower can also reduce the amount of borrowing by increasing the borrowing amount. The actual mortgage rate that is pushed up by the reserve.

Explain in detail Liquity's new decentralized lending gameplay, can it catch up from behind? Data source: https://eth.liquity.fi/

Secondly, Liquity will have a Recovery Mode. When the total mortgage rate (TCR) of the system is lower than 150%, the recovery mode will be activated to liquidate all users whose mortgage rate is below 150%, so when borrowing, Officials have also suggested that the mortgage rate should be kept above 150% to avoid liquidation under the recovery mode.

Third, users can also convert LUSD to ETH at any time. This behavior is called redemption. The system will start redemption from the treasury with the lowest mortgage rate at this time, and the borrower’s treasury will reduce the collateral and liabilities at the same time. Redemption will not cause a net loss to the user, but will lose part of the ETH position. Therefore, in order to avoid redemption, it is necessary to maintain a higher mortgage rate than others.

Therefore, although the minimum mortgage rate when borrowing money is 110%, in order to ensure that the account is not liquidated or redeemed, it is safer to maintain the mortgage rate at least above 150%. Through the data analysis of Footprint Analytics, Liquity’s TCR can quickly return to more than 300% after liquidation and recovery mode even in extreme market conditions. Currently TCR is also maintained at around 300%. It can be seen that although the minimum mortgage rate is 110%, users will still choose to accept a higher mortgage rate to ensure the security of the collateral. At this time, users are required to have a mortgage rate of 300% and a higher capital utilization rate. Make a trade-off between.

Explain in detail Liquity's new decentralized lending gameplay, can it catch up from behind? Total mortgage rate (since April 2021), data source: Footprint Analytics

Although the TCR is high, the 110% minimum mortgage rate will reduce the loss caused by liquidation compared to other agreements with higher mortgage rates. This part will also be analyzed in detail below.

Can be redeemed directly

Users can use LUSD to redeem the relevant collateral at face value at any time, as mentioned above, but since the redemption requires a 0.5%-5% fee, the same fee will be based on the time of the most recent redemption and the amount of the redemption. Adjusted, only when the amount of LUSD is less than 1 U.S. dollar, the user will arbitrage from it by redeeming LUSD, and the user can use LUSD less than 1 U.S. dollar to exchange 1 U.S. dollar worth of ETH and profit from it. Therefore, whether there is more room for arbitrage or the payment of more fees, users also need to measure by themselves based on the price of LUSD at the time. According to the data of Footprint Analytics, due to the “hard anchoring” and “hard anchoring” mentioned by Liquity founder Robert Lauko. With the “soft anchoring” mechanism, the daily price fluctuation of LUSD is basically stable between 0.99-1.02 US dollars.

Explain in detail Liquity's new decentralized lending gameplay, can it catch up from behind? LUSD price (from July 2021), data source: Footprint Analytics

From the perspective of the redeemed, although they did not suffer a net loss when they were redeemed, most of the users who mortgaged ETH borrowing were believers in ETH, and most believed that ETH was rising for a long time. When the ETH in their vault was reduced In fact, it reduces the possibility of asset appreciation due to the rise of ETH in the future.

Therefore, the behavior of redemption, for those who want to arbitrage from it, only makes sense when the LUSD is less than 1 US dollar and the arbitrage gain is greater than the redemption fee; for the redeemed person, the redemption behavior is also not very popular. However, Liquity provides an arbitrage method through this mechanism, which can also stabilize the price of LUSD at about 1 US dollar, and maintain the total mortgage rate at a high level by increasing the vault with the lowest mortgage rate.

Liquidation loss is less than 10%

When the mortgage rate is less than 110%, Liquity will repay the debt by liquidating the collateral, and the borrower will lose the collateral ETH. Liquidation will result in a net loss of 9.09% of the borrower’s collateral in USD value (=100% * 10/110) .

In addition, there is a liquidation reserve of 200 LUSD at the time of borrowing. When liquidation occurs, the liquidation reserve of 200 LUSD will be obtained by the initiating liquidator. Although the liquidation reserve does not require users to pay extra when borrowing, it will be calculated in the debt and will also be included in the calculation of the treasury mortgage rate. Therefore, the amount deposited in the treasury in the above figure is still used as an example. When the mortgage rate drops below 110% due to price fluctuations and liquidation occurs, the value of the liquidated collateral at this time is not 110% of the 2000 LUSD owned by the borrower, but the total debt is 2210 LUSD corresponding to 110% of U.S. dollars value. At this time, the borrower has lost all ETH, and only 2000 LUSD is left in his hand. Based on the price when ETH is liquidated, the actual loss rate of the borrower is 17.73%, namely:

(0.671 * 3622.92-2000)/(0.671 * 3622.92) * 100%

Of course, the actual loss rate calculated for different loan amounts is not the same. A higher loan amount will reduce the loss rate caused by the liquidation reserve.

Although the liquidation reserve may cause the loss rate to be liquidated to be no less than expected, compared to the 150% mortgage rate required by MakerDAO, Liquity’s mechanism is already a great improvement. It is a great improvement for borrowers. That said, the safe space for liquidation due to price fluctuations has also increased by 40%.

Deposit LUSD or pledge LQTY to get extra income

In addition to providing loans to borrow LUSD, Liquity also provides an LUSD stable pool that improves the utilization rate of funds and a pool that pledges LQTY to obtain revenue. Deposited in the stable pool LUSD can get the ETH of the liquidated user according to its proportion in the pool, as well as the token LQTY that rewards Liquity; the LQTY obtained from the stable pool can be pledged again to obtain user loans and redemption. cost of.

The stable pool will receive ETH and LQTY. The acquisition of ETH is related to the liquidation situation. When ETH is acquired, the LUSD deposited in the pool will be destroyed. Since the mortgage rate is 110% at the time of liquidation, users will get 110% worth of ETH at the same time when 1 LUSD is destroyed, and users can profit 10% from it. If ETH continues to fall at this time, and the ETH that has just obtained the value of $1.1 drops below $1, the user will suffer a floating loss. In order to prevent this possibility, B.Protocol is Liquity’s stable pool provider to automatically convert ETH back to LUSD and deposit it back to the stable pool, locking in liquidation profits for users and saving gas costs. But if the user is a believer who is optimistic about ETH for a long time, the assets may appreciate in the future.

However, as a stablecoin, it is more important to look at its use cases. The total amount of more than 600 million LUSD minted in the Liquity stable pool is more than 75%, and the external flow is less than 200 million. Users who borrowed money from Liquity are still investing in Liquity. The use case of the entire system is like a doll, and its sustainability needs to be verified.

Explain in detail Liquity's new decentralized lending gameplay, can it catch up from behind? Total circulation of LUSD (since April 2021), data source: Footprint Analytics

Robert Lauko, the founder of Liquity, responded on July 2 that the LUSD in the stable pool is a rational choice for users under the incentive of a large number of LQTY. The subsequent LQTY token incentives will be reduced, and users will change their strategies accordingly.

Another reward obtained by the stable pool is LQTY. Since it is not a governance token, the only use case of LQTY is to capture the borrowing fee and redemption fee of the agreement. Only when there are more borrowings and redemptions, LQTY can get more income. Therefore, it is more conducive to increase the value of LQTY when the entire system is not stable. It can be seen that the current daily ETH and LUSD obtained from staking LQTY are not too many.

Explain in detail Liquity's new decentralized lending gameplay, can it catch up from behind? Accumulative income from pledged LQTY (since April 2021), data source: Footprint Analytics

Affected by currency price fluctuations in mid-May, borrowing and redemption activities increased, and the income captured by LQTY during this period increased rapidly. Starting in June, it can be seen from the total circulation of LUSD that users’ borrowing and redemption behavior has declined, and LQTY’s ability to capture LUSD and ETH has significantly decreased.

As the subsequent LQTY token incentives gradually decay, if LUSD can expand its use cases more and attract more users to borrow, Liquid’s TVL maintains a continuous upward trend, and the value of LQTY may be worth looking forward to.

Concluding remarks

Through the analysis of Liquity’s five perspectives, there will be different interpretations in different positions, which also promotes it to maintain a steady income even under severe market fluctuations. From the perspective of the borrower, whether it is from the comprehensive rate of borrowing or the loss rate that is liquidated, a larger borrowing amount and a longer period of time can more amortize costs and losses.

But from all angles, Liquity is constantly completing its mechanism. The innovative liquidation mechanism makes it different from MakerDAO in terms of efficiency and mortgage rate. The Footprint team will also compare and analyze Liquity and MakerDAO in subsequent articles. The use cases of LUSD have also been infiltrating to the outside world since September. Let us look forward to the day when LUSD will truly become a decentralized stable currency that can be widely used and has a market share.

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