Hi. Thanks for the article. Could you please expand (or link some other explanations) for the following?
- Can you provide an example of a spiral death case?
- Reasoning behind the minimum borrowing amount of 2000 LUSD.
- You speak of high efficiency. Is this because of the 110% colateral ratio? Isn’t capital efficiency limited in stablecoins with CDP designs? (specially compared to algorithmic ones)?
Hi, Zhizhi. No problem at all! I'm glad you came up with some great questions that I'd be happy to answer.
When I'm referring to Liquity's capital efficiency, I'm speaking relative to other protocols offering collateralized debt positions (think MakerDAO, Abracadabra Money, and others that I mention in the article), since Liquity has one of the lowest (minimum) collateralization ratios at 110% (1 $LUSD can be minted for every $1.1 worth of $ETH collateral put up). And as you say, capital efficiency is most definitely limited with stablecoins that are collateralized (like $USDC) or overcollateralized (like $LUSD) as compared to algorithmic stablecoins (like $FRAX currently; I say currently since they are moving to a collateralized model). Essentially, collateralized debt positions (CDPs) are just that: collateralized (usually overcollateralized, actually), taking away from capital efficiency but potentially contributing to other elements such as peg stability. I think you'd find the stablecoin trilemma quite interesting, and there are many articles online on this concept that you can find. Reading them would help understand the trade-offs different stablecoins make in order to find their "fit." In Liquity's case, it sacrificed scalability for peg stability and decentralization.
The minimum debt is set to 2000 LUSD for a few reasons. First, the trove reserves 200 LUSD for a potential liquidation incentive, so it makes sense that the minimum debt is high, as if it were something like 600 LUSD, around 34% of your debt would be inaccessible (which is obviously highly impractical). Further, by making the debt ceiling 2000 LUSD, it raises the requirement for $ETH collateral to be deposited into the system, and this means that the 0.5% of $ETH collateral liquidators would receive if they were to liquidate the position would be an amount (when combined with the 200 reserved LUSD) sizable enough to outweigh gas costs and pocket the difference (essentially making it economically attractive to carry out liquidations). For example, 0.5% of $2200 in $ETH (the minimum $ETH collateral in dollar terms) is $11, while 0.5% of something like $900 in $ETH is just $4.5. Lastly, the reason for this minimum debt is to increase redemption profitability. As you probably already know, anyone can redeem $LUSD against the lowest collateralized trove (for $ETH), and if the trove has a minimum debt of 2000 LUSD, redeeming against it (for $ETH) would make it "attractive" enough to do so. For example, if the lowest collateralized trove has debt of let’s say 2000 LUSD, and the trove be liquidated since the collateral dropped to $2200 in $ETH, redeeming against it (which would make economic sense if $LUSD is below peg) would allow the redeemer to acquire a significant/sizable amount of $ETH, to the point where it is seamless to realize a substantial profit through the redemption, since if the lowest collateralized trove has debt of 200 $LUSD, the redeemer may not even bother to redeem, since if $LUSD was off peg by 0.3%, by redeeming and pocketing the difference the redeemer would get less than $1 in that scenario (which would not only result in no profit, but a loss, since gas costs still need to be paid). Essentially, by making the minimum debt 2000 LUSD, it makes redeeming against the lowest collateralized trove worthwhile and always economically feasible (where gas costs and a small profit are realized).
TL;DR for the above: the minimum debt is 2000 LUSD to ensure liquidating and redeeming is carried out/works well. The team also ran simulations and determined the "optimal" minimum debt to be 2000 LUSD.
So, for a death spiral scenario, I can't really think of any concrete ones. But the only real "point of failure" I see for the protocol is 1) Chainlink AND the backup Tellor oracles failing, and 2) the 200 $LUSD reserve and 0.5% of the $ETH collateral aren't enough of an incentive to liquidate troves (due to gas costs, opportunity costs, and profitability potential related factors).
Thanks, Imajinl. I was curious about the 2000 LUSD minimum because other protocols that mint their stablecoins in a similar way (for example, Vesta Finance in Arbitrum) do not have such a high number. It is true that Vesta has other differences as well, such as allowing multiple collaterals.
Regarding the death spiral scenario (maybe that’s not the best terminology here), LlamaRisk (you probably know about them), set out some risks in their article (although it is true that this is one is focused on chicken bonds and their impact on Curve): https://cryptorisks.substack.com/p/asset-risk-assessment-liquity-chicken
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!!
No problem! Thanks for the kind words.
Great article!
Ty ser! I'm glad you like it.
Hi. Thanks for the article. Could you please expand (or link some other explanations) for the following?
- Can you provide an example of a spiral death case?
- Reasoning behind the minimum borrowing amount of 2000 LUSD.
- You speak of high efficiency. Is this because of the 110% colateral ratio? Isn’t capital efficiency limited in stablecoins with CDP designs? (specially compared to algorithmic ones)?
Hi, Zhizhi. No problem at all! I'm glad you came up with some great questions that I'd be happy to answer.
When I'm referring to Liquity's capital efficiency, I'm speaking relative to other protocols offering collateralized debt positions (think MakerDAO, Abracadabra Money, and others that I mention in the article), since Liquity has one of the lowest (minimum) collateralization ratios at 110% (1 $LUSD can be minted for every $1.1 worth of $ETH collateral put up). And as you say, capital efficiency is most definitely limited with stablecoins that are collateralized (like $USDC) or overcollateralized (like $LUSD) as compared to algorithmic stablecoins (like $FRAX currently; I say currently since they are moving to a collateralized model). Essentially, collateralized debt positions (CDPs) are just that: collateralized (usually overcollateralized, actually), taking away from capital efficiency but potentially contributing to other elements such as peg stability. I think you'd find the stablecoin trilemma quite interesting, and there are many articles online on this concept that you can find. Reading them would help understand the trade-offs different stablecoins make in order to find their "fit." In Liquity's case, it sacrificed scalability for peg stability and decentralization.
The minimum debt is set to 2000 LUSD for a few reasons. First, the trove reserves 200 LUSD for a potential liquidation incentive, so it makes sense that the minimum debt is high, as if it were something like 600 LUSD, around 34% of your debt would be inaccessible (which is obviously highly impractical). Further, by making the debt ceiling 2000 LUSD, it raises the requirement for $ETH collateral to be deposited into the system, and this means that the 0.5% of $ETH collateral liquidators would receive if they were to liquidate the position would be an amount (when combined with the 200 reserved LUSD) sizable enough to outweigh gas costs and pocket the difference (essentially making it economically attractive to carry out liquidations). For example, 0.5% of $2200 in $ETH (the minimum $ETH collateral in dollar terms) is $11, while 0.5% of something like $900 in $ETH is just $4.5. Lastly, the reason for this minimum debt is to increase redemption profitability. As you probably already know, anyone can redeem $LUSD against the lowest collateralized trove (for $ETH), and if the trove has a minimum debt of 2000 LUSD, redeeming against it (for $ETH) would make it "attractive" enough to do so. For example, if the lowest collateralized trove has debt of let’s say 2000 LUSD, and the trove be liquidated since the collateral dropped to $2200 in $ETH, redeeming against it (which would make economic sense if $LUSD is below peg) would allow the redeemer to acquire a significant/sizable amount of $ETH, to the point where it is seamless to realize a substantial profit through the redemption, since if the lowest collateralized trove has debt of 200 $LUSD, the redeemer may not even bother to redeem, since if $LUSD was off peg by 0.3%, by redeeming and pocketing the difference the redeemer would get less than $1 in that scenario (which would not only result in no profit, but a loss, since gas costs still need to be paid). Essentially, by making the minimum debt 2000 LUSD, it makes redeeming against the lowest collateralized trove worthwhile and always economically feasible (where gas costs and a small profit are realized).
TL;DR for the above: the minimum debt is 2000 LUSD to ensure liquidating and redeeming is carried out/works well. The team also ran simulations and determined the "optimal" minimum debt to be 2000 LUSD.
So, for a death spiral scenario, I can't really think of any concrete ones. But the only real "point of failure" I see for the protocol is 1) Chainlink AND the backup Tellor oracles failing, and 2) the 200 $LUSD reserve and 0.5% of the $ETH collateral aren't enough of an incentive to liquidate troves (due to gas costs, opportunity costs, and profitability potential related factors).
Thanks, Imajinl. I was curious about the 2000 LUSD minimum because other protocols that mint their stablecoins in a similar way (for example, Vesta Finance in Arbitrum) do not have such a high number. It is true that Vesta has other differences as well, such as allowing multiple collaterals.
Regarding the death spiral scenario (maybe that’s not the best terminology here), LlamaRisk (you probably know about them), set out some risks in their article (although it is true that this is one is focused on chicken bonds and their impact on Curve): https://cryptorisks.substack.com/p/asset-risk-assessment-liquity-chicken