The Decentralized Stablecoin Narrative: A Deep Dive into Liquity Protocol's LUSD

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"Banks are a risk to fiat-backed stablecoins" Is this the start of the Decentralized Stablecoin Narrative?? A Mega Deep Dive into Stablecoins and @LiquityProtocol's $LUSD 🧵

Gist of the thread: 1️⃣ Overview of Stablecoins 2️⃣ Overview of the USDC saga 3️⃣ Introduction to Liquity 4️⃣ Liquity Mechanics I. Troves II. Stability Pools III. Liquidations & Recovery Mode 5️⃣ LUSD <> USD peg mechanism 6️⃣ $LQTY token Grab a coffee and enjoy this read:

Quick note: In the process of writing this thread, a ton of threads about $LQTY popped up overnight. I'll be tagging those threads too & chads behind them at the end if you're interested.

1️⃣ Brief overview of Stablecoins Stablecoins are cryptos that aim to maintain a stable value, typically pegged to the value of a fiat currency like the US dollar or a commodity like gold. This stability makes them useful for transactions and as a store of value.

Stablecoins can be broken down into 4 primary categories: 1. Fiat-backed stablecoins (e.g. USDC, USDT, USDP) 2. Crypto-backed stablecoins (e.g. LUSD, SUSD) 3. Commodity-backed stablecoins (e.g. PAXG, XAUT) 4. Algorithmic stablecoins (e.g. FRAX)

This thread will focus on fiat-backed and crypto-backed stablecoins. Fiat-backed stablecoins are generally considered centralized stablecoins since they are backed by traditional assets such as USD, which are held by a centralized issuer or custodian.

USDC is an example. Its treasury reserves ($32.4B) are custodied at BNY Mellon and managed by BlackRock. Cash reserves were held at BNY Mellon ($5.4B), SVB ($3.3B), Signature Bank (for minting/redemption) and Customers Bank ($1B).

Crypto-backed stablecoins are mostly decentralized as they are issued and maintained by decentralized protocols that operate on blockchains and are not controlled by centralized entities. Liquity's LUSD is one such example which I'll dive into.

2️⃣ Brief overview of the USDC saga SVB announced its sale on loss-making bonds, realizing ~$2B in losses and following which, announced its efforts to raise capital. This led to a bank run. Circle unfortunately, had a $3.3B exposure to SVB.

Over the weekends, FUD revolving the collapse of USDC quickly circulated. But that was unlikely to happen. This thread explains the situation: twitter.com/NorthRockLP/status/1634469058182791168?s=20

On 12 March, the FDIC guaranteed SVB depositors access to all their money on Monday, despite its $250K insurance cap. This thread covers the update: twitter.com/MacroAlf/status/1635048179073953792?s=20

Despite USDC regaining its peg on Monday, it's circulating supply had dropped by over $3B from the previous week due to redemptions. The USDC depeg also impacted a handful of other stablecoins: twitter.com/CurveCap/status/1635308286185709568?s=20

The USDC depeg pointed out counterparty risk of centralized custodians, and the risk that centralized collateral poses to decentralized stables. DAI, FRAX, MIM depegged due to USDC. And now a new narrative is forming - Decentralized stables with decentralized collateral.

3️⃣ Introduction to Liquity Founded in 2020, Liquity is a decentralized borrowing protocol that allows borrow $LUSD against ETH entirely interest-free.

Liquity is backed by reputable investors and partners such as Polychain Capital, Pantera Capital, 1kx, Tomahawk VC, Robot Ventures and more.

Liquity is governance-free to ensure that the protocol remains fully decentralized. Liquity's front-end is entirely decentralized by pretty much "outsourcing" it to third parties and creating a fully distributed ecosystem. They currently have 15+ front-ends

Frontend operators are rewarded with a share of $LQTY tokens generated by their users. "Kickback Rate" is the percentage of $LQTY rewards that a frontend operator chooses to share with Stability Pool depositors using their frontend. I'll explain the Stability Pool below.

4️⃣ Liquity Mechanics I. Troves Troves are similar to vaults in MakerDAO, allowing users to take and manage their loans. Your Ethereum address will be linked to a Trove (1 Trove per addr) and contains two balances: an asset balance in ETH and a debt balance in LUSD.

Like other borrowing platforms, your collateral ratio represents the % dollar value of collateral to debt. This % changes by adding collateral or repaying debt, and ETH price fluctuations (assuming $LUSD remains stable)

Some things to note when borrowing on Liquity: - Min. Collateral ratio is 110% (150% on Recovery Mode) - A borrowing fee of 0.5% - 5% based on demand - A liquidation reserve of $200 (like a deposit)

II. Stability Pools Stability Pools are a source of liquidity that maintains system solvency in the event of Trove liquidations. It is funded by users transferring LUSD into it, known as Stability Providers.

When a Trove is liquidated, LUSD is burned from the Stability Pool's balance to repay the debt, and the Trove's collateral is transferred to the Stability Pool. Stability Providers lose a pro-rata share of LUSD deposits but gain a pro-rata share of liquidated collateral.

Stability Providers earn from: - Liquidation gains (theoretically, a proportional share of the 10% in excess collateral) - $LQTY rewards (based on pool share & front-end kickback rate) Risks to note that may impact "liquidation gains": - Oracle failures - Flash crashes

III. Liquidations & Recovery Mode Troves below the min. collateral ratio of 110% gets liquidated to ensure $LUSD remains backed. The Trove's debt is canceled and absorbed by the Stability Pool and its collateral distributed among Stability Providers.

The $200 in Liquidation reserve/deposit mentioned earlier will go to the user that initiates the liquidation process to compensate for gas and as a reward (in addition to 0.5% of the Trove's collateral).

Recovery Mode occurs when the Total Collateral Ratio (TCR) of the system falls below 150% (which can happen when ETH plummets) Troves with a collateral ratio <150% can be liquidated, and the system blocks borrower transactions that would further decrease the TCR.

Recovery Mode incentivizes borrowers to raise the TCR >150% and incentivize LUSD holders to replenish the Stability Pool. Liquidation losses are capped at 110%, and the remainder 40% is claimable by the borrower

Therefore, the full borrow flow:

5️⃣ LUSD <> USD peg mechanism LUSD is pegged to USD through hard and soft peg mechanisms. The hard peg mechanisms include a price floor at $1 (minus redemption fee) and a price ceiling at $1.10 due to the min. collateral ratio of 110%.

A soft peg mechanism treats LUSD=USD when determining Trove collateral ratio, thus anchoring LUSD<>USD parity in the system. A base rate formula determines the redemption fee, which starts at 0% and increases with every redemption, decaying to 0% if no redemptions occur.

Liquity expects arbitrageurs will prevent LUSD from reaching $1.10 and if it ever hits that ceiling, it will rebound very quickly.

5️⃣ $LQTY token $LQTY is the secondary token that captures fee revenue to incentivize early adopters and front-end operators. It is not a governance token - Liquity has no governance. Its max supply of 100M tokens are distributed as follows:

$LQTY can be earnt by: 1. LPing for the LUSD<>ETH Uniswap pool (1.33M $LQTY allocated as rewards) 2. Becoming a Stability Provider or Frontend Operator (32M $LQTY allocated as rewards

$LQTY can be staked to earn a proportional amount of borrowing and redemption fees in LUSD and ETH. The 7d avg. APR is 29.95%

Illustration of fund flow between protocol and users:

💡Closing Thoughts💡 Centralized custody solutions are not very safe and nothing is "too big to fail". USDC supply has dropped by over 5B after the saga and it points us to alternative stablecoins (alt-stables 👀) like LUSD.

Also, here's a great thread by @CryptoKaduna about $LQTY that popped up while I was still writing this. twitter.com/CryptoKaduna/status/1635612347732721665?s=20

And another great thread by @DeFi_Cheetah about $LUSD mechanics twitter.com/DeFi_Cheetah/status/1635537683111088129?s=20

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