In the current decentralized finance (DeFi) ecosystem, the Liquidity Protocol provides a unique and efficient way to lend and borrow. This article will introduce in detail how the Liquidity protocol works, its advantages, and how to use this protocol for lending.
Why Choose Liquity for Lending?
The Liquity protocol offers interest-free loans, a feature that makes it stand out among other lending systems. Compared to other platforms, Liquidity is more capital efficient, meaning less collateral is required for the same loan. Users can lock their Ethereum (ETH) as collateral, borrow from Liquity and withdraw LUSD, then repay the loan in the future. This way, users can access liquidity without selling Ethereum.
Increase Ethereum Positions: If a borrower predicts that the price of Ethereum will rise in the future, they can use the Liquity Protocol to increase their Ethereum position by up to 11x, thereby increasing their exposure to price changes. Borrowers can borrow LUSD using Ethereum as collateral and sell the LUSD on the open market to purchase more Ethereum. By doing this repeatedly, you can achieve this goal.
Note: This is not advice on how to use Liquidity. Leverage can carry risks and only experienced individuals should consider using it.
Collateral and Treasury (Trove)
Definition of Collateral: Collateral is any asset provided by a borrower as security for a debt in order to take out a loan. Currently, Liquidity only supports ETH as collateral.
Trove Trove is where users obtain and maintain loans. Each vault is linked to an Ethereum address, and each address can only own one vault. The vault records two account balances: one is the asset (ETH) used as collateral, and the other is the debt denominated in LUSD. Users can change the amount of each account by adding collateral or paying off debt.
How interest-free lending is implemented: The Liquidity protocol charges one-time borrowing and redemption fees. This fee is algorithmically adjusted based on the most recent redemption time. For example, if more redemptions occur in the near future (which means LUSD may be trading below $1), borrowing fees will increase, discouraging borrowing.
Calculation of borrowing fees
Each time a user withdraws LUSD from the vault, Liquidity deducts a one-time borrowing fee from the amount withdrawn and adds it to the user’s debt. Borrowing fees are variable (algorithmically determined), with a minimum borrowing fee of 0.5% under normal operating conditions. In recovery mode, the fee is 0%.
Example: Assuming the borrowing rate is 0.5% and the borrower wants to withdraw 4,000 LUSD from its outstanding vault, the borrower will need to pay a fee of 18.91 LUSD. After deducting the liquidation reserve and borrowing fee, the borrower will receive 3,781.09 LUSD .
Loan process
Open a Treasury (Trove)
To borrow, users must open a vault and deposit a certain amount of collateral (ETH) into it. Users can then withdraw an amount of LUSD such that their collateralization ratio is no higher than 110%. Minimum debt is 2,000 LUSD.
Calculation of collateralization ratio: Collateralization ratio is the ratio between the USD value of the collateral in a vault and its debt in LUSD. As the price of Ethereum changes, the vault's collateralization rate will fluctuate over time. Users can influence the collateralization rate by adjusting the amount of collateral and/or debt in the vault (i.e. adding more ETH collateral or paying off part of the debt).
Example: Let’s say the current price of Ethereum is $3,000 and a user decides to deposit 10 ETH. If a user borrows 10,000 LUSD, the vault’s collateral ratio will be 300%. If a user borrows 25,000 LUSD, their ratio is 120%.
Minimum Collateralization Ratio (MCR) and Recommended Collateralization Rate
The Minimum Collateralization Ratio (or MCR for short) is the lowest ratio of debt to collateral that would not trigger liquidation under normal operations (i.e. normal mode). This is the protocol parameter set to 110%. To avoid liquidation during recovery mode, it is recommended to keep the ratio above 150% (e.g. 200% or a safer 250%).
Liquidation and Redemption: Liquidation Reserve: When a user opens a vault and obtains a loan, Liquidity needs to reserve 200 LUSD. This fund will be used to compensate the gas fee of the sender of the Ethereum transaction. If there is no liquidation of the vault, the liquidation reserve will be fully refunded when the user closes the vault by repaying the debt.
Redemption Process: When redeeming LUSD, the ETH provided to the redeemer will be distributed from the vault at the minimum collateralization rate (even if it is higher than 110%). If a user-owned vault is at the minimum collateralization ratio at the time of redemption, some of the collateral will be given up, but the debt will be reduced accordingly.
Example: Suppose the user owns a vault with 2 ETH mortgaged and a debt of 3,200 LUSD. The current price of ETH is $2,000. This gives a mortgage ratio (CR) of 125% (= 100% (22,000) / 3,200). Assuming this is the lowest CR in the Liquity system, then look at two examples of partial and full redemptions:
Example of a partial redemption: Someone redeems 1,200 LUSD for 0.6 ETH, thereby paying off a debt of 1,200 LUSD, reducing it from 3,200 LUSD to 2,000 LUSD. In return, 0.6 ETH worth $1,200 is transferred from the user’s vault to the redeemer. The user's collateral dropped from 2 ETH to 1.4 ETH, while the collateral ratio increased from 125% to 140% (= 100% (1.42,000) / 2,000).
Example of a full redemption: Someone exchanges 6,000 LUSD for 3 ETH. Given that the amount redeemed is greater than the user's debt minus 200 LUSD (the portion used as liquidation reserve), the user's debt of 3,200 LUSD will be fully liquidated and the collateral will be reduced by $3,000 of ETH, leaving the user with 0.5 ETH of collateral. (= 2-3,000/2,000).
How does Liquity offer collateral ratios as low as 110%?
By making liquidations instant and more efficient, Liquidity requires less collateral to make security comparable to similar protocols that rely on lengthy auction mechanisms to sell liquidated collateral.
Usage of Leverage: Users can sell borrowed LUSD for ETH on the market and use ETH to top up vault collateral again. This allows users to borrow and sell more LUSD, and by repeating this process, the desired leverage can be achieved.
In summary: The Liquidity protocol provides users with an efficient, interest-free lending method, and ensures the safety and liquidity of funds through innovative mechanisms. Whether you are an investor looking to increase your Ethereum position or a user in need of liquidity, Liquidity is an option worth considering.