Tokenomics 101: Liquity Protocol $LUSD & $LQTY
The Holy Grail of Decentralized, Resilient Stablecoins in DeFi and Perhaps Even the MakerDAO Killer?
Introduction
Ponzi scheme. A term that TradFi frequently uses to describe crypto. People in TradFi take pride in being invested in a "safe" and "resilient" monetary system. Little do they know that banks have been the embodiment of an abject Ponzi scheme since the early 1800s.
Let me introduce you to a little-understood system known as “fractional-reserve banking.”
Fractional reserve banking is a system wherein banks are allowed to lend out many times more than funds they hold in reserve. The reserve requirement is the minimum percentage of customer deposits that banks are required to keep on hand, while the remaining amount is available for lending. This system allows banks to create money through lending, as new loans create new deposits and expand the money supply. How is this system a Ponzi scheme? Well, this system relies on an ever-increasing flow of new deposits to keep the system afloat, and akin to Ponzi schemes, when there are not enough inflows of deposits to the bank (when new inflows cannot pay the outflows in the form of withdrawals), the system collapses, leading to a bank run.
The reserve rate (set by the Federal Reserve) is usually 10%, but is currently 0% at the time of writing (mid-March 2023), meaning that, theoretically, an infinite amount of money can be created out of thin air by banks with just a deposit of $1. Even though this system is important to the world's economy (because it stimulates demand), it poses a threat to the stablecoins we know and use for a myriad of reasons.
USDT, USDC, BUSD, TUSD, and USDP - the biggest centralized stablecoins in crypto - have a combined market cap of around 123 billion USD. This accounts for around 10% of the global cryptocurrency market cap, a substantial amount of which is backed by U.S. dollars in a bank account somewhere. Key word? Bank account, meaning that these deposits are subject to the same fractional-reserve system that can blow up quickly and at any time. Recently (on March 10, 2023), the fall of Silicon Valley Bank (SVB), the second-largest bank failure in the U.S., caused uproars in the cryptocurrency market since the issuer of the USDC stablecoin, Circle, had roughly 8% of its backing deposited in SVB, causing USDC to fall to as low as $0.88, 12% below parity with the U.S. dollar.
If it weren't for the FDIC (Federal Deposit Insurance Corporation), 8% of USDC's backing would be gone, vanished into thin air, effectively making USDC's real price 0.92$, having heavy consequences for holders of USDC (DeFi treasuries, institutions, retail investors, etc.). As a reader, you're probably thinking, "Yeah, but there are so many decentalized stablecoin alternatives to USDC: FRAX and DAI, to name two." One problem: these "decentralized" stablecoins are not so decentralized since most of their backing comes from centralized stablecoins. For instance, around 35% of MakerDAO's DAI stablecoin is backed by USDC, and a significant portion of circulating FRAX stablecoins are also backed by USDC.
Ignas | DeFi Research on Twitter: "We learned that $USDC is backed by cash held in banks, except... banks don't actually hold that cash." / Twitter
When we think of DeFi, we think of a completely parallel financial system. How is this the case when there is so much reliance on the same TradFi system the crypto industry aims to break away from completely?
Enter Liquity Protocol, a truly decentralized stablecoin issuer free of any bank risk. By leveraging Ethereum’s security, the protocol uses $ETH as collateral to mint their $LUSD stablecoin (pegged to the U.S. dollar) on the Ethereum blockchain. This essentially means that $LUSD is completely backed by $ETH, arguably one of the most pristine collaterals in crypto.
Apart from providing a decentralized stablecoin, the protocol offers completely interest-free loans, high capital efficiency, and lucrative yields on their stablecoin.
Tokenomics
A zoomable, high-resolution tokenomics diagram can be found here.
If you’re interested in the condensed, need-to-know tokenomics information for Liquty, check it out on Tokenomics Hub
The Liquity protocol utilizes a two-token economy: $LUSD, the native stablecoin issued by the protocol, and $LQTY, the secondary token used to incentivize the adoption of some aspects of the protocol and as the value capture token in the ecosystem. More on these two tokens later on in the article.
Liquity protocol: Troves & Stability Pool
Troves are at the core of the Liquity protocol. They facilitate the opening of collateral debt positions (CDPs). This essentially means that users can deposit $ETH tokens as collateral and mint Liquity’s stablecoin, $LUSD. Think of troves as Liquity’s equivalent of MakerDAO’s vaults, but with a few nuances.
Firstly, Liquity’s troves only allow $ETH to be deposited as collateral. This is because the protocol’s main goals are to:
Maintain peg stability
Maintain decentralization
Maintain censorship resistance
$ETH is the perfect collateral for this.
Other major stablecoin issuers such as MakerDAO, Abracadabra Money, Inverse Finance, and QiDao offer a myriad of collateral options, allowing them to scale (issue more of their stablecoins), but consequently:
Sacrifice peg stability, since the collateral may be highly volatile and have low on-chain liquidity, which increases the chances of bad debt forming, since liquidations may not be carried out due to a liquidity constraint or because it is not economically feasible anymore due to sudden drops in price.
Sacrifice decentralization, since the underlying collateral may have aspects of centralization (for example, if the collateral is USDC or USDT).Because of this, these protocols are often required to increase minimum collateralization ratios (keep collateral levels healthy so sudden drops in price won’t result in bad debt or give ample time for liquidations to be carried out), thereby decreasing their capital efficiency. Liquity’s troves, on the other hand, by only accepting $ETH as collateral, can have as low a collateralization ratio as 110% (since $ETH is relatively less volatile than most other DeFi tokens and has an abundance of on-chain liquidity).
All in all, this means that for every $1.1 in ETH tokens put up as collateral, 1 LUSD can be borrowed. Making troves highly capital efficient since you can take on more debt with less collateral.
To put this in perspective, most MakerDAO vaults have a minimum collateralization ratio of around 170%, meaning for every $1.7 in collateral put into vaults, 1 $DAI stablecoin can be minted (borrowed).
Second, and perhaps most importantly, Liquity protocol's troves allow for interest-free borrowing, i.e., you pay nothing in interest to take out a loan against your $ETH tokens.
Most stablecoin issuers (like the ones I mentioned above) usually charge variable interest rates (on the debt) that range from a few percent to more, making it unattractive to open debt positions. Not only is the interest rate a deterrent, but the variable nature of it makes the rate highly unpredictable.
This interest rate also compounds (accrues relatively quickly over time), which also increases the chances of a liquidation (which usually results in a net loss of a few percentage points on collateral due to liquidation penalties paid to liquidators), since your debt is increasing over time relative to your collateral (considering your collateral is relatively or completely stable in terms of price).
The Liquity protocol does, however, impose a one-time borrowing fee, and its range varies from 0.5% to 5%. While typically the fee is 0.5%, the article explains why it varies later on.
This one-time borrowing fee gets added to the debt upon opening a trove and is paid when the user closes it. It's worth noting that major stablecoin issuers, including Abracadabra Money and QiDao, also utilize this fee structure. For users seeking to open debt positions, this is a preferable option since it's a one-time fee and costs significantly less than variable interest rates (especially in the long term).
Third, and perhaps the only major drawback to Liquity’s troves, is the fact that the minimum amount of $LUSD that can be taken on (i.e., debt) is 2000 $LUSD.
This means that a minimum of $2200 worth of $ETH collateral needs to be deposited into the protocol. Also, 200 $LUSD is kept by the protocol from the debt taken on (for a reason explained later on in the article) and only returned as the trove is closed by the user.
Lastly, the Liquity protocol is not governed by a DAO, and its smart contracts are completely immutable. How does this relate to troves? Well, with systems like MakerDAO, $MKR (Maker’s secondary token) governs the protocol and votes on changing key parameters such as interest rates, the minimum collateralization ratio, and the onboarding of new collateral types.
What are the drawbacks of this system? Firstly, it is not always decentralized. Some whales can amass significant governance power to tip the scales in their favor (not voting in the best interests of the protocol), and the governance turnout (for these votes) is usually low. Second, these systems are manipulable through the use of flash loans, and, lastly, these governance proposals often take a long time to be formulated, discussed, and finally executed. Furthermore, relying on a system that relies on humans for governance may not prove to be effective since they may not have all the required information to make sound, astute decisions.
With systems like Liquity, however, the protocol is fully governed by algorithms - unmanipulatable, battle-tested algorithms harnessing transparent blockchain data to make the most appropriate changes to the protocol. More specifically, fees related to troves are adjusted by these algorithms based on market conditions (more on this later on in the article); next, the immutable nature of the protocol means that no interest rates or new collateral types can be introduced, and the minimum collateralization ratio cannot be changed. While this system may be optimal for decentralization, security and scalability may come as a trade-off, since any vulnerabilities or flaws in the code cannot be changed (due to the immutable nature of Liquity’s smart contracts) and ever-growing preferences for collateral debt positions cannot be satisfied, hindering any innovation that may have otherwise occurred if the system was mutable.
Out of everything you just read, one thing might have stuck with you: the absurdly low minimum collateral ratio. And you might be thinking, "surely a collateralization ratio of 110% is not safe and drastically increases the chance of bad debt forming" (and hence peg instability for the $LUSD stablecoin).
Maybe for other stablecoin issuers using conventional liquidation systems.
Liquity uses a state-of-the-art liquidation system by utilizing a novel concept called a stability pool.
This is how it works:
Holders of the $LUSD stablecoin can choose to deposit their $LUSD tokens into the pool.
When any trove’s collateralization ratio drops below 110%, anyone can initiate a transaction to liquidate that trove and receive 0.5% of the trove’s $ETH collateral and the $200 LUSD the trove set aside when the user opened the trove.
This ensures that there is always a monetary incentive to carry out liquidations. The reason that this is important is because if the collateral is worth less than the debt, there is no incentive for users to pay back the debt and take the equivalent collateral plus a liquidation incentive.
How does the liquidator know when a trove is insufficiently collateralized? Well, Liquity uses on-chain price feeds (oracles) for the price of $ETH to determine which troves can be liquidated. These oracles are provided by Chainlink, and a backup one is provided by Tellor. The image below (a screenshot from Liquity’s docs) depicts the scenario in which the backup (Tellor) oracle would be used for $ETH price feeds.
Now you know how the liquidation is initiated. But what happens to the debt? After the liquidation is initiated, the outstanding debt of the trove is effectively cancelled (burned) by using stability pool $LUSD deposits. The collateral is then seized by the protocol and returned to the stability pool. In this way, stability pool depositors get a pro-rata share of the liquidated trove’s $ETH collateral, whose notional value (at the time of liquidation) is around 9% higher than that of the $LUSD used to burn the trove’s debt (the math, if you factor in the 0.5% of $ETH collateral given to liquidators, comes out to be 9.45%, but it averages out to 9% because of $ETH’s volatility), meaning there’s always an incentive to deposit $LUSD in the stability pool since troves will always be overcollateralized.
It is also worth noting that the stability pool is further incentivized by Liquity’s secondary token, $LQTY, making deposits in the stability pool even more attractive.
Overall, the incentive to deposit LUSD into the stability pool is essentially a very competitive stablecoin yield (APR), which is composed of seized ETH collateral from liquidations and additional $LQTY emissions.
But what if there is not enough $LUSD in the stability pool to cancel the debt from a particular trove? Not to worry, anon. The devs thought of this. In an instance like this, the debt and collateral from an undercollateralized trove is equally distributed amongst all other open troves, and while, from the looks of it, it doesn’t look ideal for users with open troves, it actually results in a net gain for all other troves (at the time of the liquidation; over time, the price of $ETH may drop and this may no longer be the case).
The image below, taken from Liquity’s docs, illustrates an example where debt and collateral are redistributed among all other troves.
However, because stability pool deposits were more than sufficient, the protocol never used this secondary liquidation model, and, in the future, I don’t believe the protocol using this secondary liquidation model will be a frequent occurence. It's just a system set in place to be prepared for the worst-case scenario.
As seen in the image above, the majority (at the time of writing, around 65%) of $LUSD stablecoins are deposited in the stability pool, since that is currently $LUSD’s biggest use-case. This can be attributed to the fact that stability pool deposit APRs are very high (see image below), averaging out to around 7.9% monthly and 22% yearly. Yields like these for stablecoins are very hard to come across.
Even when the $LQTY incentives emitted to the stability pool start to taper off and inevitably run out, there will always be extra $ETH collateral present when troves are liquidated (when the collateralization ratio is < 110%) as an incentive to deposit in the stability pool.
If that is not enough to incentivize user deposits of $LUSD (the APR is perhaps lower to deposit in the stability pool than other opportunities to earn a yield on $LUSD), bots utilizing flash loans ($LUSD gets deposited in the pool to cancel debt and $ETH gets taken out in one block) can always provide $LUSD liquidity to liquidate troves. In this way, the system doesn’t need to rely on user deposits of $LUSD in the stability pool or on the secondary liquidation mechanism of redistribution of debt and collateral amongst all other open troves for liquidations to take place.
As you can see here, not only has bad debt never formed in the protocol, but all liquidations happened seamlessly, exactly at the time they were supposed to (right when the collateral ratio of the trove drops below 110%). Protocols like MakerDAO, Abracadabra, and many other stablecoin issuers have had problems with liquidations in the past, often resulting in bad debt and insolvency. Some protocols like MakerDAO mint and sell their $MKR tokens to cover this bad debt, but you can see how this is a far inferior system.
There is, however, one caveat to this liquidation model Liquity uses: Chainlink’s price feeds (as you remember, Liquity protocol uses these to carry out liquidations) are controlled by a 4-of-9 multisig and are susceptible to manipulation; however, as mentioned before, Tellor’s price feeds are used as a backup if Chainlink’s price feeds look fishy. While this alleviates some of the risk that comes with using Chainlink’s feeds, it does leave open an attack vector (if both Chainlink and Tellor manipulate feeds at the same time, perhaps due to regulatory pressure), which cannot be mitigated due to the immutable nature of Liquity’s contracts.
Liquity protocol: Recovery Mode
Recovery mode can be thought of as an "alternative, undesirable state" for the Liquity Protocol, entered when the total collateral ratio of all (aggregate) troves drops below 150%. This mode essentially aims to bring the protocol back to a healthy (safe) total collateral ratio (either by debt repayment or collateral topping up) and increase $LUSD deposits in the stability pool.
How does the protocol do this? Firstly, the protocol prohibits (blocks) any user from opening a trove that wouldn’t increase the total collateral ratio in the system. Second, the protocol won’t charge any borrow fees in an attempt to encourage users to open new troves to increase the total collateral ratio of the system. Third, any troves under a collateral ratio of 150% are deemed liquidatable. This also encourages $LUSD holders to deposit in stability pools, as more liquidations mean a higher yield. By doing the following, the protocol is able to both increase the total collateral ratio and increase stability pool deposits.
While this system is important in times of market or protocol turmoil, it is merely a mode that, if entered, would last a short time (in fact, this mode has only been entered once, for a few minutes). Furthermore, the idea of the protocol entering this actually dissuades the system from ever reaching it.
It might also be worth mentioning that liquidations in recovery mode work differently, but you don’t need to understand that. If you’re interested in understanding it, read this.
Liquity protocol: $LUSD peg
Up until now, we’ve talked mainly about the Liquity protocol. Now, let's put that newfound knowledge together to understand how Liquity’s inherent protocol design and algorithms keep $LUSD at the desired $1 peg (parity).
Before we go any further, I need to tell you about a simple mechanism in the protocol called "redemptions." In this process, anyone (usually bots) can redeem $LUSD for $ETH from the lowest collateralized trove. What this means is that redemptions are essentially another way of paying off some or all of the trove's $LUSD debt, which entitles you to a proportionate share of the trove's $ETH collateral, minus a small fee (that ranges from 0.5% to 5%; this range is adjusted based on the $LUSD peg; read more on this here) paid to the protocol.
For example, the lowest collateral trove has taken on a debt of 400 $LUSD, and the current price of $ETH (for the sake of simplicity) is $1. In this scenario, let’s also consider a redemption fee of 1%. Now, anyone can redeem $396 worth of $ETH tokens for 400 $LUSD. Where did the $4 worth of $ETH go? Well, that was the 1% redemption fee paid to the protocol. And why would someone want to do this (redeem against the lowest collateralized trove)? Don't worry, anon. We explain this in the coming few paragraphs.
Now, onto the peg.
Scenario: the price of $LUSD is greater than $1. How is the price being lowered?
1) Lower one-time borrowing fee
2) Incentivizes borrowing (opening troves) and leveraging up on your $ETH
3) Incentivizes opening troves and “walking away” when $LUSD is above $1.1
Let me break these down. One by one.
1) The protocol uses an algorithm to determine the one-time borrowing fee. If the peg is over a dollar, the borrow fee would generally become lower, incentivizing users to open troves as it is cheaper for them to do so (this is why, as mentioned before, the borrow fee ranges from 0.5% to 5%). More troves being opened would then increase supply and hence lower price; although increasing supply of $LUSD wouldn’t directly decrease price, it would lead to more people selling their newly minted $LUSD.
2) When the price of $LUSD is greater than a dollar, it automatically incentivizes users to open troves and sell their newly minted $LUSD. This way, they can sell their $LUSD for more of another stablecoin and perhaps close their position again later, when $LUSD is back at parity, pocketing the difference they made when selling their $LUSD for another stablecoin. Furthermore, users bullish on $ETH (and hence looking to take on leverage) can do so when $LUSD is above a dollar: they can open a trove, mint $LUSD, sell it (lowering the $LUSD price) for $ETH (they acquire more $ETH, since the price of $LUSD is higher than it's "supposed" to be), deposit the $ETH back into the position (increasing the maximum borrowable amount since there is more collateral), and start the process again.
3) When the price of $LUSD is above $1.1, it makes economic sense to mint $LUSD against $ETH at the minimum collateral ratio (110%) and pocket the gain by selling the $LUSD (thereby bringing the price down).
Scenario: the price of $LUSD is lower than $1. How is the price being increased?
1) Higher one-time borrow fee
2) Incentivizes paying back debt (closing troves) and deleveraging on your $ETH
3) Incentivizes redemptions against lowest collateral troves
Let me break these down. One by one.
1) If the peg is below a dollar, the borrow fee would generally become higher (remember that the borrowing fee is dynamic and can go up to 5%), incentivizing users to stop opening troves as it is more expensive for them to do so. Less troves being opened would then ensure less $LUSD is minted and, hence, sold, preventing the price of $LUSD from going further away from parity.
2) When the price of $LUSD is less than a dollar, it automatically incentivizes users to close troves. Users who opened troves but kept their debt in another stablecoin (or any other investment, for that matter) are incentivized to buy back $LUSD (pushing the $LUSD price back up) and close their debt, since it is cheaper for them to do so. Furthermore, users who took on leverage can unwind their positions (deleverage) by buying back $LUSD (pushing the $LUSD price back up) and paying back their debt, since it is cheaper for them to do so.
3) When the price of $LUSD is below $1, it makes economic sense for anyone to redeem $ETH against the lowest collateral trove. Anyone can buy $LUSD (pushing the price back up) and redeem $ETH against the lowest trove, pocketing the difference since the redeemed $ETH was worth more than the $LUSD they bought, which was below parity.
Below is a concise graphic depicting the two scenarios ($LUSD below and above the peg). For an even better understanding of $LUSD’s peg, I recommend reading this and this.
Now, there’s just one more variable we need to discuss that is essential for $LUSD to keep its peg: liquidity.
For stablecoins like $LUSD, deep liquidity (strong market depth) is pivotal for bettering the user experience (users can benefit from low price slippage and impact while trading the stablecoins) and keeping the stablecoin price close to the desired $1 peg.
As seen above, the $LUSD pool on Curve (the leading AMM for stablecoins) has around $25MM in liquidity with very healthy pool ratios (the pool doesn’t majorly consist of $LUSD tokens).
Furthermore, there are many $LUSD liquidity pools on Uniswap v3 (another leading AMM for stablecoins).
$LUSD also has millions of dollars in liquidity on other chains (bridges such as Celer allow for $LUSD to be bridged to Ethereum L2s) apart from Ethereum, such as Arbitrum and Optimism. You can see all of $LUSD’s markets here.
Great! Now you understand the robust algorithms, inherent protocol designs, and other factors that allow $LUSD to trade close to $1 parity.
Let’s conclude this section by looking at $LUSD’s performance this year down below.
As you can see, $LUSD has traded within a tight range close to the peg, but did however oscillate a little during the $USDC depeg event, but it is worth noting that it did not heavily depeg, only dropping around 100 basis points (1% or so).
Liquity protocol: Staking & Grants
As you know by now, the protocol takes all the borrowing and redemption fees generated (the borrowing fee is denominated in $LUSD, while the redemption fee is denominated in $ETH). The protocol then distributes both of these fees to the $LQTY holders who stake their tokens in their original form, so stakers receive both $LUSD and $ETH rewards pro rata to their share of the staking pool.
For a step-by-step tutorial on staking $LQTY tokens, watch this.
The protocol also runs a grant program calledLiquiFrens, aimed at growing Liquity’s ecosystem. $LQTY holders govern this program, effectively deciding which proposals get funded.
Liquity protocol: Frontends
Another key differentiator between Liquity and other dApps is the fact that Liquity doesn’t run its own frontends. Instead, Liquity outsources this to anyone interested.
Remember the additional $LQTY incentives (emissions) that stability pool depositors receive? Well, anyone running a frontend for Liquity can get a percentage of that; the percentage is defined by the "kickback rate." For example, if a frontend operator has a kickback rate of 99%, for every 100 $LQTY tokens received by stability pool users through their frontend, they get 1 $LQTY token.
Some of the popular frontend operators are shown above. In total, there are 64 frontends running for the Liquity protocol. A server is shut down in one country? No problem. Government regulations prohibit anyone from running these frontends in another country? No problem. That’s the great part about distributing the system across many frontends.
And the best part? Some of these frontend operators are altruistic, charging no fees (a kickback rate of 100%), meaning you get the maximum $LQTY yield as a stability pool depositor.
Distribution & Unlocks
There is no maximum (capped) supply for $LUSD tokens since these tokens are issued against $ETH collateral, and there is no “limit” set by the protocol to accept $ETH collateral to mint $LUSD.
The secondary token, $LQTY, however, does have a maximum (capped) supply, which is 100,000,000 (100MM) tokens. This means that $LQTY token holders cannot be diluted after the token’s emissions come to an end.
The emissions of the $LQTY token started on the protocol launch day, April 5, 2021.
Below, you can see the allocation of the $LQTY tokens (supply).
As you can probably already see, a staggering 57.6% of the supply is allocated to the investors, team, and advisors (essentially insiders) - a great deal higher than the industry standard.
6.1% of the supply was set aside for the Liquity AG endowment (the legal entity). This $LQTY allocation is currently earning a yield inside the stability pool. This allocation and the yield it earns currently fund the LiquiFrens grant program that was previously discussed.
As seen in the Bubblemaps above (learn more about the platform and what these bubbles represent here) for $LQTY, there are many EOAs (wallets, essentially) holding a significant portion of the $LQTY token (whales), increasing the chances of market dumps and price manipulation. One of these whales even holds 10% of the circulating $LQTY supply.
The vests and lockups of the $LQTY allocations don’t really matter at this point in time, since $LQTY has a very high float of almost 92%, as seen above. Currently, only a few small team unlocks and stability pool emissions are yet to hit the market; these emissions will taper off around March 2024, as seen below.
This is great for $LQTY holders and stakers since they aren’t getting diluted further, but it can also be great for price action since very little supply of $LQTY has yet to hit the market.
Value Creation & Value Capture
For DeFi as a whole, Liquity creates value through its decentralized, censorship-resistant, and resilient stablecoin, free of any bank risk. At the time of writing, Liquity is the closest any stablecoin has ever come to true decentralization and censorship resistance.
This has caught the attention of few DAOs, such as OlympusDAO, that have large treasuries holding a large quantity of reserve assets, and resulted in DAOs like Olympus using $LUSD as a trusted backing, as seen below.
Furthermore, Liquity creates value through a completely decentralized protocol that allows DeFi users to open highly capital-efficient, interest-free loans that are secured by stability pools - perhaps the most optimal liquidation system in DeFi at the time of writing.
These loans, being seamless, instant, and permissionless, allow users to borrow against $ETH collateral, allowing for increased leverage or exposure to other crypto assets, yield farming opportunities, tax benefits (as opposed to selling the underlying $ETH), and more.
Liquity also creates value for DeFi users looking to earn a yield on stablecoins through stability pools - this creates a symbiotic relationship between the protocol and users, since one earns a passive yield and the other (the protocol) secures all funds (collateral) in the system.
Liquity’s $LUSD stablecoin further creates value for DeFi users through its utilities in the Ethereum, Optimism, and Arbitrum DeFi ecosystems. Currently, $LUSD can be deposited into its Yearn vault to earn a yield that’s autocompounded, used as collateral on Angle, lent or borrowed on Aave, Silo, and used for amplifying yield on GearBox, among many other utilities. Many other utilities are presenting themselves as $LUSD is integrated into DeFi platforms.
Now, onto the protocol’s value capture.
As we have previously learned, the protocol charges one-time borrowing and redemption fees that range from 0.5% to 5% (they’re usually on the lower side of this range) in $LUSD and $ETH respectively. Of these fees, Liquity takes 100%, distributing all of it to $LQTY stakers, making the secondary $LQTY token the value capture token of the protocol.
As we can see above, even during the brutal crypto bear market we saw during 2022, Liquity was racking up revenue and distributing it to $LQTY stakers. Furthermore, the start of this new year (2023) has seen an increase in revenue generated by the protocol, which may be attributed to the crypto spring we are currently witnessing.
It’s not all sunshine and rainbows for the protocol, though. As we can see in the chart above, the protocol has been emitting more $LQTY tokens every month than revenue generated by quite a high magnitude in many of the months of the previous year - some months by a factor of 10x.
Comparing this to some other stablecoin issuers, we can see that Liquity hasn’t been doing great on the efficiency end of things, needing more token emissions (incentives) to bring in lesser revenue.
It also suggests a potential sustainability issue over the long term due to the fact that Liquity won’t be able to generate revenue without adversely affecting token holders with both dilution and a potentially worse price impact due to the $LQTY emissions (token incentives), not to mention it may not generate any substantial revenue at all without token emissions (this point is explored further towards the end of the article).
As seen above, MakerDAO has been able to generate virtually all its revenue with almost no token emissions (incentives) of $MKR this past year.
Abracadabra, while not being nearly as efficient as MakerDAO, has been able to generate in almost all months more revenue than its emissions (incentives).
However, as seen above, Liquity has seen the highest revenue growth rate in the past 30 and 90 days (676.3% and 199.4%, respectively), as compared to Maker’s 18.8% (30 days) and 67.7% (90 days) and Abracadabra’s 8.7% (30 days) and 60.3% (90 days) revenue growth rates.
Lastly, it's important to understand that Liquity’s revenue generation is not instant, in the sense that borrowing fees are only paid to the protocol when the user closes the trove, which takes time. Only redemption fees are instantly received by the protocol. And both of these fees are distributed (as previously mentioned) in their original form ($ETH and $LUSD), instead of being used to buy back and distribute $LQTY to stakers, potentially resulting in a lost value capture for $LQTY holders or stakers.
Demand Drivers
The demand for $LQTY is highly correlated to the demand to mint $LUSD.
And as we can see below, there has been a steady increase in the number of open troves since the middle of last year (2022).
This trend, however, may be transitory, since many design choices of the protocol (which allowed it to have a robust peg and be decentralized) may be a hindrance to the scalability of the protocol and hence the $LQTY demand.
The main ones include:
Minumum $LUSD debt is 2000, deterring many smaller retail investors
The secondary liquidation model and recovery mode may make some users wary of the protocol
Only $ETH collateral (this is perhaps the biggest problem for Liquity’s scalability)
Considering we are in crypto spring, which is characterized by extreme volatility, we can expect more liquidations, which lead to higher stability pool yields, which then translate to more $LUSD demand, and then the cycle mentioned above restarting wherein $LQTY’s demand increases.
Currently, staking $LQTY is yielding a 1 year average APR of 7.33% and a one-month average APR of 8% - respectable yields (relative to the staking yield returns of different DeFi tokens), considering its all revenue generated by the protocol.
$LQTY’s market cap is also 3.19 times lower than $MKR’s at the time of writing, showing that there is definitely room for growth.
Lastly, governance over the grant program is another, although relatively insignificant, demand driver for the $LQTY token.
Closing Thoughts
Overall, while Liquity has built out an impressive product and reached levels of decentralization no other stablecoin protocol has (yet), it may become a mere code repository since the immutable nature of the contracts doesn’t allow for any innovation to take place or new products to be introduced.
In my opinion, this is an existential risk for the Liquity protocol, since some other projects like Raft Finance are using Liquity’s code (hence the reference to the code repository) to build out products that can scale (perhaps without even sacrificing on the decentralization levels set by Liquity) miles beyond what Liquity would be able to do by expanding collateral types to $ETH’s LSDs like and $stETH and constantly innovating and expanding product ranges - something the Liquity team doesn’t intend on doing.
Furthermore, stablecoins are still pegged to the ever-depreciating U.S. dollar (due to inflation), and with products like Frax’s FPI (a stablecoin pegged to the CPI, essentially making it inflation-resistant), the use case for stablecoins like $LUSD may dissipate.
Insiders also got allocated a large portion of the $LQTY supply. While this doesn’t lead to centralization (since $LQTY isn’t a governance token), it did lead to some of the current circulating supply of $LQTY to be concentrated within a few whale wallets, increasing the chances of market dumps and price manipulation.
Lastly, there is a sustainability issue with $LQTY's emissions, since currently $LUSD's biggest use case is deposits in the stability pool, and when $LQTY's emissions run out, only the excess liquidated $ETH collateral is passed onto stability pool depositors, and this decreased yield may hinder deposits, decreasing demand for $LUSD and hence $LQTY.
Personally, while I believe the Liquity protocol exemplifies stablecoin decentralization and peg stability, I am quite apprehensive about the protocol’s future since there’s a good chance it can become obsolete. On the other hand, Liquity's underlying technology will be improved and moved forward in what looks like a bright future for DeFi.
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Wow. Awesome article. Thanks for putting it down all in one place like this. It’s deep deep financially interconnected rabbit hole we are going down!!
Great article!