Liquity protocol offers interest-free loans and is more capital efficient than other borrowing systems (i.e. less collateral is needed for the same loan). Instead of selling Ether to have liquid funds, you can use the protocol to lock up your Ether, borrow against the collateral to withdraw LUSD, and then repay your loan at a future date.
Borrowers speculating on future Ether price increases can also use the protocol to leverage their Ether positions up to 11 times, increasing their exposure to price changes. This is possible because LUSD can be borrowed against Ether, sold on the open market to purchase more Ether — rinse and repeat.*
*Note: This is not a recommendation for how to use Liquity. Leverage can be risky and should be used only by those with experience.
Collateral is any asset which a borrower must provide to take out a loan, acting as a security for the debt. Currently, Liquity only supports ETH as collateral.
The protocol charges one-time issuance and redemption fees that algorithmically adjust based on the last redemption time. For example: If more redemptions are happening (which means LUSD is likely trading at less than 1 USD), the issuance fee would continue to increase, discouraging borrowing.
Other systems (e.g. MakerDAO) require variable interest rates to make borrowing more or less favorable, but do so implicitly since borrowers would not feel the impact upfront. Given that this also needs to be managed via governance, Liquity instead opts for a fully decentralized and direct feedback mechanism via one-off fees.
To borrow you must open a Trove and deposit a certain amount of collateral (ETH) to it. Then you can draw LUSD up to a collateral ratio of 110%.
A Trove is where you take out and maintain your loan. Each Trove is linked to an Ethereum address and each address can have just one Trove. If you are familiar with Vaults or CDPs from other platforms, Troves are similar in concept.
Troves maintain two balances: one is an asset (ETH) acting as collateral and the other is a debt denominated in LUSD. You can change the amount of each by adding collateral or repaying debt. As you make these balance changes, your Trove’s collateralization ratio changes accordingly.
You can close your Trove at any time by fully paying off your debt.
Every time you draw LUSD from your Trove, a one-off issuance fee is charged on the drawn amount and added to your debt. Please note that the issuance fee is variable (and determined algorithmically) and has a minimum value of 0%, which means that your loan could be cost-free. A 50 LUSD Liquidation Reserve charge will be applied as well, but returned to you upon repayment of debt.
The fee is added to the debt of the Trove and is given by a
base rate , rounded to one decimal and multiplied by the amount of liquidity drawn by the borrower.
Example: The base rate stands at 1.07% and the borrower draws 1.000 LUSD. Being charged a 1.1% fee of 11 LUSD, the borrower will obtain 1.000 LUSD, but their initial debt will be set to 1.011 LUSD
Loans issued by the protocol do not have a repayment schedule. You can leave your Trove open and repay your debt any time, as long as you maintain a collateral ratio of at least 110%.
This is the ratio between the Dollar value of the collateral in your Trove and its debt in LUSD. The collateralization ratio of your Trove will fluctuate over time as the price of Ether changes. You can influence the ratio by adjusting your Trove’s collateral and/or debt.
For example: Let’s say the current price of ETH is $300 and you decide to deposit 100 ETH. If you borrow 10,000 LUSD, then the collateralization ratio for your Trove would be 300%.
If you instead took out 25,000 LUSD that would put your ratio at 120%.
The minimum collateral ratio (or MCR for short) is the lowest ratio of debt to collateral that will not trigger a liquidation under normal operations (aka Normal Mode). This is a protocol parameter that is set to 110%. So if you borrowed 100 LUSD from your Trove, you would need at least $110 worth of Ether posted as collateral to avoid being liquidated.
In Recovery Mode, things change a bit — any Troves with less than 150% collateral ratio are now eligible to be liquidated, in order to bring the total collateral ratio (TCR) of the system back up to 150%. Thus, the recommended collateral ratio is dependent on your risk tolerance. In general, the following guidelines are suggested:
In any case you should keep your ratio above 110% to avoid being liquidated in Normal Mode.
You should at least keep your ratio comfortably above 150% (e.g. 200%) if you want to minimize your risk of being affected by Recovery Mode.
It is advisable to always keep an eye on the TCR and manage your risk accordingly.
You will lose your Trove along with its entire collateral and debt, i.e. you will no longer be able to retrieve your collateral by repaying your debt. A liquidation under Normal Mode generally comes down to a net loss of 9.09% (= 10 / 110 * 100%) of your collateral’s Dollar value since you are no longer required to repay your debt and can keep the borrowed LUSD.
When LUSD is redeemed, the ETH provided to the redeemer is allocated from the Trove with the lowest collateralization ratio (even if it is above 110%). If at the time of redemption you have the Trove with the lowest ratio, you will give up some of your collateral, but your debt will be reduced accordingly.
The USD value by which your ETH collateral is reduced corresponds to the nominal LUSD amount by which your Trove’s debt is decreased. You can think of redemptions as if somebody else is repaying your debt and retrieving an equivalent amount of your collateral. As a positive side effect, redemptions improve the collateral ratio of the affected Troves, making them less risky.
Redemptions that do not reduce your debt to 0 are called partial redemptions, while redemptions that fully pay off a Trove’s debt are called full redemptions. In such a case, your Trove is closed, and you can claim your collateral surplus and the Liquidation Reserve at any time.
Let’s say you own a Trove with 2 ETH collateralized and a debt of 800 LUSD. The current price of ETH is $500. This puts your collateralization ratio (CR) at 125% (2*500/800). Let’s imagine this is the lowest CR in the Liquity system and look at two examples of a partial redemption and a full redemption:
Example of a partial redemption
Somebody redeems 500 LUSD for 1 ETH and thus repays 500 LUSD of your debt, reducing it to 300 LUSD. In return, 1 ETH, worth $500, is transferred from your Trove to the redeemer. Your collateral goes down from 2 to 1 ETH, while your collateral ratio goes up to 166.66% (= 1*500/300).
Example of a full redemption
Somebody redeems 1000 LUSD for 2 ETH. Given that the redeemed amount is larger than your debt minus 10 LUSD (set aside as a Liquidation Reserve), your debt is entirely cleared and your collateral gets reduced by $790 of ETH, leaving you with a collateral of 0.42 ETH (= 2 - 790/500).
When you open a Trove and draw a loan, 50 LUSD is set aside as a way to compensate gas costs for the transaction sender in the event your Trove being liquidated. The Liquidation Reserve is fully refundable if your Trove is not liquidated, and is given back to you when you close your Trove by repaying your debt.
By making liquidation instantaneous and more efficient, Liquity needs less collateral to provide the same security level as similar protocols that rely on lengthy auction mechanisms to sell off collateral in liquidations.
You can sell the borrowed LUSD on the market for ETH and use the latter to top up the collateral of your Trove. That allows you to draw and sell more LUSD, and by repeating the process you can reach the desired leverage ratio.
Assuming perfect price stability (1 LUSD = $1), the maximum achievable leverage ratio is 11x. It is given by the formula:
maximum leverage ratio =where MCR is the minimum collateralization ratio.
If Troves are liquidated and the Stability Pool is empty (or gets emptied due to the liquidation), every borrower will receive a portion of the liquidated collateral and debt as part of a redistribution process.