Liquity v2: why user-set interest rates

Liquity v2 aims to create an efficient and attractive market between borrowers and stablecoin holders by introducing a new DeFi primitive: user-set interest rates!

Right now in DeFi, we have:

• Fixed one-time origination fee / no interest rates - e.g. Liquity v1
• Governance based interest rates - e.g. MakerDAO
• Algorithmically controlled interest rates - e.g. crvUSD

All these systems have different trade-offs:

• Fixed rate protocols cannot adjust to high interest rate environments
• Governance can be slow and arbitrary
• Algorithmic controllers create volatile and unpredictable rates.

To date there is no protocol that has created an efficient interest-rate market between borrowers and stablecoin holders.... till now.

User-set interest rates are a unique innovation designed to not only overcome Liquity v1 main challenges, but to also offer an edge over existing CDP protocols and lending markets.
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With v2’s introduction of user-set interest rates, we believe that this market-driven approach will lead to an equilibrium between borrowers and stability seekers, fostering sustainable demand. In contrast to money markets where there is a significant spread between lenders and borrowers, Liquity v2’s unique user-set interest rate mechanism will enable swift, adaptive adjustments that tighten the disparity between the two.

This results in a more efficient market where interest rates are a true reflection of current market conditions. Over time, we anticipate that DeFi interest rates will converge towards the Liquity v2 model, establishing a new standard for borrowing and capital efficiency within DeFi.

To see how user-set interest rates work and why borrowers would want to pay a higher rate than 0%, we first need to understand what keeps Liquity’s stablecoin stable in the first place.

A quick lesson in Liquity mechanics

In April 2021, Liquity v1 pioneered the first CDP system with a built-in redemption mechanism and introduced a stablecoin with a strong downward peg protection with no dependency on centralized collateral. The redemption feature allows any LUSD holder to exchange their stablecoins for $1 worth of ETH. When LUSD is below peg, users can buy it for e.g. $0.99 off the market and sell to the protocol for $1.00 (see blog post). 

While this mechanism maintains a hard price floor around $1 (minus fees) through direct arbitrage, it impacts the riskiest borrowers since the redeemed LUSD is used to pay back the loans with the lowest collateral ratio in exchange for an equivalent amount of ETH. The affected borrowers see their collateral and debt go down by the same value, implying no net loss but a reduced exposure to ETH.

Why has this been an issue?

Due to rapidly increasing market rates in the last few months, borrowing volumes have outweighed the demand for holding LUSD, resulting in excessive selling pressure and thus redemptions. As a consequence, many LUSD borrowers have increased their collateral ratios to previously unseen levels, just to avoid redemptions. This has seriously impaired Liquity v1’s ability to offer capital-efficient loans in the current environment of excessively high DeFi interest rates. 

Being interest-free in nature and with its fixed-cost and reward system, Liquity v1 has shown to work reliably in low interest environments, and it continues to be a viable option for borrowers in such scenarios. But in high interest rate situations, users tend to seek stablecoins with higher yields. 

It has become clear that variable interest rates are better suited to deal with a variety of market scenarios in a sustainable and flexible way. At the same time, we also realize the importance of the redemption mechanism to prevent a stablecoin from losing its peg: many existing stablecoins have suffered from downward peg deviations due to high sell pressure. 

Enter the innovation: user set interest rates

Through user-set interest rates, redemptions can be neatly married with dynamic interest rates: instead of targeting the loans with the lowest collateral ratio, redemptions in Liquity v2 will be performed in an ascending order of individual interest rates. Borrowers with low interest rates thus have the highest risk of being affected by redemptions. Users can freely manage their redemption risk by adjusting their interest rates relative to their peers (or delegate the management to third parties; more on this below).

Redemption example in Liquity v2

Based on the borrowers’ individual risk tolerance, the market will establish a range of individual interest rates. Borrowers willing to risk redemptions may set below-average rates for capital efficiency, whereas more risk averse or “set-and-forget” borrowers may opt for an above-average rate for peace of mind. Thus, the system handles borrowing volumes in a more adaptive way while allowing the protocol to earn a variable interest revenue on a continuous basis.

As opposed to most existing CDP protocols, the interest revenue in v2 will be used to incentivize stablecoin demand and liquidity autonomously with minimal human governance.

For safety and efficiency reasons most of the revenue is funneled to the Stability Pools, incentivizing stablecoin demand as well as protocol solvency. In addition to that, a sizable part of the revenue is sent to LPs on external AMMs to ensure sufficient stablecoin liquidity as PIL (protocol incentivized liquidity) across multiple pairs. As fees are collected in the form of interest, this ensures a continuous and smoothed flow of incentives to SP and LP depositors.

And this brings us to BOLD
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In light of this, we’re excited to announce the new stablecoin at the heart of Liquity v2 will be named BOLD. This name mirrors our resolve to pioneer a paradigm shift in DeFi, enabling a market driven mechanism where interest rates are no longer dictated by the few, but chosen by the many. The interest rates set by users’ also influence how BOLD's peg mechanics work.
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User-set interest rates can adapt to various market conditions and stabilize BOLD’s peg, reducing the expected redemption volumes compared to Liquity v1. When BOLD trades above $1, borrowers will tend to reduce their rates due to the lower redemption risk. This makes borrowing and leveraging on ETH (and LSTs) more attractive, while holding BOLD becomes less attractive. Conversely, when BOLD is below $1, borrowers are exposed to a higher redemption risk and are likely to increase their interest rates. Borrowing thus becomes less attractive, while demand for BOLD increases as the interest payments result in higher yield for the stablecoin, pushing its price upward.

Instead of driving collateral ratios to unreasonable levels, user-set interest rates should enable a capital efficient equilibrium between borrowers and stablecoin holders in a fully market-driven manner. Borrowers will be able to actually benefit from Liquity v2’s attractive loan to value ratios,  and get as much funds against the chosen collateral as their liquidation risk tolerance permits.

With this advancement, we expect v2 to offer competitive borrowing and stablecoin holding rates. Depending on the utilization and integration of the stablecoin in broader DeFi, the Stability Pool yields may even exceed the average borrow rates, something that isn’t possible on money markets where borrowers always pay higher rates than what the lenders receive.

As a borrower, you will be able to choose any interest rate you like, to pay whatever you want. Similar to entering the collateral and borrowing amounts, you will also enter the interest rate you are willing to pay, and change it any time (or delegate management to a third party).

Borrowers can delegate their interest rates to:

• A manager - a 3rd party which actively and continuously adjusts the rate for a group of users, with a clear goal / rate percentile. 
• A smart contract - an Ethereum contract address autonomously managing the borrow rate for its users following a preset logic.
• Any EOA - this can be a hot wallet or a friend doing this for you.

In all cases, the only permission this delegate will have is to adjust the rate in a predetermined range. Nothing else.
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User-chosen interest rates will be a big leap forward - but this is by no means the only innovation Liquity v2 will ship with.
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Stay tuned for our upcoming article which emphasizes the other borrowing enhancements in greater detail, and join our Discord for discussions.