July 28, 2023
Two years after launching the one truly decentralized stablecoin in DeFi, and pioneering over $4.5b worth of interest free loans, we are delighted to announce that we are building an alternative product that aims to crack the stablecoin trilemma.
The stablecoin trilemma revolves around three essential properties: decentralization, stability, and scalability. Typically, stablecoins can only achieve two out of these three attributes.
In the realm of decentralized stablecoins, there are two primary approaches we have seen when it comes to building stablecoins: CDP (Collateralized Debt Position) based protocols and Decentralized Reserve Protocols.
CDP-based stablecoins, like Maker’s DAI, and our very own LUSD, use individual positions backed by collateral to mint stablecoins. While the properties of decentralization and security are usually quite robust with CDPs, scalability and liquidity issues arise due to constraints linked to the borrowing demand that’s required. LUSD is the most resilient stablecoin there is - leading to a lot of demand, sometimes unmatched by the number of users willing to use ETH as collateral to borrow and mint LUSD.
This supply/demand mismatch in the past has created a base pressure on LUSD's peg, which has drifted upwards when appetite for leverage is limited. In addition to this, CDP’s that are truly based around trustless assets can also have challenges when it comes to retaining a hard peg.
Liquity v1 pioneered the hard peg boundaries between $1 and $1.10 by introducing redeemability, and reducing collateral requirements. Despite this, it still does not guarantee a hard peg of $1 due to the need to have liquidity for the stablecoin on external decentralized exchanges. You can read more about LUSD's peg and resiliency here.
Decentralized reserve protocols take a different approach by utilizing a protocol-owned reserve, typically backed by a native asset like Ether. Instead of individual positions, the protocol directly manages the reserve, and minting of stablecoins. As stablecoins can directly be minted and redeemed at face value, this allows for stronger stability, and deeper liquidity as the protocol acts as the primary AMM (borrowing demand is not needed).
So what are some of these hedging mechanisms that we have seen?
The two main ones we’ve seen are recapitalizing via inflation, and delta neutral hedging. The table below gives an idea of some protocols that have tried the decentralized reserve approach, and the challenges that they have faced:
Despite the limitations of delta-neutral hedging, we’re confident that the idea of hedging a decentralized reserve is the best way forward for breaking the trilemma.
Delta neutral hedging is a method to hedge the reserve's volatile asset (e.g., Ether) against price movements to ensure stability for the stablecoin. The main challenge that protocols with a decentralized reserve have faced is that when there’s not enough demand for going leveraged long on the reserve asset - there can be very high hedging costs, which can cause a strain for the protocol.
We looked at a few ideas that involved taking protocol fees, and even diluting existing users, but we realized that the solution to this is to bring two innovations which make the hedging product very attractive. These innovations come in the form of principal protection and creating a built-in secondary market.
Liquity v2 will introduce two critical innovations. The first is principal protection, a unique feature that keeps losses in check during market downturns, making the hedging position more attractive for users even under difficult market situations. Secondly, Liquity will incorporate a secondary market into the system to minimize liabilities stemming from principal protection.
In addition to these innovations, hedging positions are perpetual and not subject to liquidation. Holders can thus exit and claim their share of the reserve’s surplus whenever they want. This exit value naturally increases when the reserve asset goes up in price (and vice versa), as the system needs less assets to back the stablecoin supply. Depending on the current ratio between the value of the reserve assets and the stablecoin supply, positions are benefitting from a higher or lower leverage.
The principal protection innovation aims to make the hedging product more attractive by offering users a mechanism to protect their positions from losses during market downturns, which could otherwise become substantial due to the inherent leverage.
When users open a hedging position, they are provided with a provision that even if the dollar value of the underlying volatile asset (e.g., Ether) decreases significantly, they can still sell their position for at least its principal amount (fixed in e.g. Ether upon creation). This is down to the premium users pay when opening a position (more on this later). This principal protection mechanism operates asymmetrically, which means that while users are protected from losses during market downturns, they can still benefit from a leveraged upside if the value of the underlying asset increases!
By ensuring that users' positions are shielded from significant losses, the leverage product becomes more appealing and reliable, increasing its overall attractiveness to users.
This also means that users should be willing to pay a premium for this leverage position - as it allows them to receive an amplified upside, while also benefiting from principal protection when it is needed at any point.
The system can thus collect the premia when users open new positions. It does so by running an auction-like mechanism and adjusting the premium to make hedging positions more or less attractive, ultimately controlling the inflow of new capital for sufficient overcollateralization.
But what would happen when there’s severe stress in the market?
In times of market stress, numerous users may want to claim their principal, potentially leading to a bank run-like situation as liabilities are not constrained and may be higher than the collected premiums. Enter innovation number 2: The secondary market.
To tackle this challenge, Liquity v2 will employ a clever mechanism incorporated in its own secondary market to subsidize positions that need assistance, significantly reducing the protocol’s overall liability.
The secondary market refers to a marketplace within Liquity v2 where users can buy and sell their hedging positions. The secondary market plays a crucial role in helping to mitigate the risk of a bank run situation. When users want to redeem their positions other than by exiting, they can list them for sale on the secondary market at the chosen price, normally at a premium above the principal and the current exit value. If there is sufficient demand from other users willing to buy these positions, the secondary market facilitates smooth transactions without impacting the system's reserves in any way.
If a user is unable to sell a position for its principal amount (or a lower price) within a specified time, the protocol steps in and gradually boosts its value until a buyer finds it attractive enough to purchase it at the principal amount. The system utilizes a portion of the collected premia to subsidize the sale. There is no value leak involved in this process as these subsidies do not leave Liquity's system; rather, funds are simply repurposed within the protocol.
This approach encourages market participants to step in and acquire the positions, preventing a sudden rush of exits that could strain the system's reserves. Only a small fraction of positions will need subsidies due to the nature of the principal protection mechanism (and how it gets priced in) and the design of the secondary market.
By making hedging positions more appealing and reducing the system's overall liability, Liquity v2 strives to achieve decentralization, stability, and scalability simultaneously.
We will have a community call in October, where we will present our ideas to the community and collect feedback. On top of that, over the coming weeks & months, we will have several pieces of content going in-depth with the challenges that v2 aims to solve, along with some open technical questions where we will need our community’s feedback.
Some of these topics include:
- The oracle situation, and challenges that exist in that sector
- The current liquid staking market, and what’s needed for v2
- The economic and technical mechanisms around v2
- The product market fit of v2, and much more!
And not to worry; as we start wrapping up the design phase of the protocol, the litepaper will be made available soon thereafter as well 🙂
As v2 aims to revolutionize the stablecoin landscape, we also want it to be a community effort - we want to collaborate with the brightest minds in our community to help develop, improve, and launch this product! In the coming months, we will reach out on Discord (#v2 channel) to get feedback from all of you on topics like protocol dynamics, pricing challenges, and validating different economic approaches. We will also be going through several rounds of UX testing to get your thoughts on the user experience of the protocol.
Wen launch, you ask? The protocol is expected to launch in Q2 2024.
So what are you waiting for?
Become part of the community that shapes the first scalable, secure, and decentralized stablecoin!
Follow us on Discord here and get involved in the #v2 channel.
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More to come soon™