DeFi Deep Dive #7: Liquity Finance

A Series Profiling Protocols Featured on DeFi Llama

In the recent crypto market crash, a number of lending protocols emerged seemingly stronger. Unit Protocol, subject of our very first DeFi Deep Dive, was so in demand during the correction that USDP traded above $1 for much of the period.

Another protocol that weathered the storm well was Liquity, a decentralized borrowing protocol allowing lenders to provide Ether as collateral with 0% interest. Under normal circumstances they operate under a 110% collateralization ratio, a very low ratio for the industry, and a ratio which potentially allows up to 11x leverage.

Users who lend Ether to receive LUSD open what they call a trove. All troves require a refundable deposit of $200 LUSD be included to cover gas costs. Users can collateralize as they like, provided their collateral ratio exceeds 110%.

That is, if you open a trove with a deposit for $30,000 worth of ETH, a loan of $10,000 would be 300% collateralized and relatively safer against a price drop. A loan of $27,000 would be closer to the 110% minimum and a relatively small price drop in Ethereum would subject such a trove to liquidation.

Loans are backed not just with the collateral, but also with a Stability Pool. Anybody can deposit directly to the Stability Pool to serve as a Stability Provider. Deposits into the Stability Pool shrink over time, while gaining a share of liquidated collateral. The expectation is that the liquidated collateral exceeds the shrinkage. Stability Providers also receive rewards of $LQTY, the protocol’s native token used for staking.

Liquity provides the following as an example of how a liquidation works:

Now, a Trove with debt of 200,000 LUSD and collateral of 400 ETH is liquidated at an Ether price of $545, and thus at a collateral ratio of 109% (= 100% * (400 * 545) / 200,000). Given that your pool share is 10%, your deposit will go down by 10% of the liquidated debt (20,000 LUSD), i.e. from 100,000 to 80,000 LUSD. In return, you will gain 10% of the liquidated collateral, i.e. 40 ETH, which is currently worth $21,800. Your net gain from the liquidation is $1,800.

We got to see the system stress tested during the crash of May 19th. In addition to regular liquidation, Liquity has a concept of Recovery Mode. If the entire system’s total collateral ratio falls below 150%, then pools up to a collateral ratio of up to 150% are subject to liquidation procedures.

During the crash, the protocol briefly entered Recovery Mode twice, and a total of 189 Troves were liquidated under Recovery Mode mechanics, with an additional 121 liquidated under normal conditions. Overall the protocol functioned as designed throughout the events with overall collateralization never dipping under the 150% threshold.

One interesting aspect of Liquity’s business is that they promise to never operate a direct frontend to the services. They deployed the contracts, but rely on a variety of frontend interfaces to connect with Liquity’s protocol with a kickback of their choosing. As of publication, 22 different frontend operators were listed as running frontends for Liquity, mostly with 99% kickback rate.

Liquity protocol has proven quite popular. Over $2.5 billion has been locked in the system, rebounding nicely from the effects of the most recent crash. LUSD is gaining adoption across the DeFi ecosystem, including rumors of increasing adoption within the Curve ecosystem. Liquity currently ranks 12th on DeFi Llama and may continue its impressive growth as DeFi gains in popularity.

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