July 29, 2020
The Liquity system is designed with two core focuses: increasing capital efficiency and lowering costs for borrowers. Ultimately, our goal is to provide the most attractive borrowing conditions for users.
That said, in any borrowing protocol there are risks. In this post we will discuss two risk areas, with the goal of educating users in order to prevent losses and ensure system stability.
The first borrowing risk that all users should be aware of is liquidation risk.
When users create a trove, they deposit Ether into a smart contract and are able to mint LUSD, our USD pegged stablecoin. As with any on-chain borrowing facility, the amount of collateral always needs to be higher than the amount borrowed. To ensure that the entire stablecoin supply remains fully backed by collateral, troves that fall under the minimum collateral ratio of 110% (referred to as “undercollateralized”) are subject to liquidation.
Upon liquidation, a two-step process is initiated:
First, the system utilizes the Stability Pool funds to cancel any debt. The Stability Pool acts as the first line of defense for maintaining system stability. At any time, users can deposit LUSD to the Stability Pool. When a trove is liquidated, the outstanding debt of that trove is calculated, a corresponding amount is taken from the Stability Pool and is burned. In exchange, the Stability Pool holders receive the collateral from the liquidated trove.
For example, let’s say the price of ETH is $100. Bob has a trove with 1.1 ETH, which has a collateral value of $110 and a debt of 100 LUSD
. If the price of ETH falls to $99.99, Bob’s trove will still have 1.1 ETH as collateral and a debt of 100 LUSD, but its collateral is now only worth $109.99. Bob’s trove has fallen below 110% collateral and can now be liquidated.
Alice has put 100 LUSD in the Stability Pool. Eve has deposited 100 LUSD to the Stability Pool. The Stability Pool has a total of 200 LUSD. When Bob’s trove is liquidated, 100 LUSD are burned, and the Stability Pool receives 1.1 ETH, valued at $109.99. Bob has lost his collateral, but still has the 100 LUSD that he originally borrowed. The Stability Pool now has a balance of 100 LUSD and 1.1 ETH. Alice and Eve now each have a Stability Pool deposit of 50 LUSD and a collateral gain of 0.55 ETH.
If the system does not have enough funds in the Stability Pool to cover the debt of a liquidated trove, the second stage of liquidation follows — the redistribution mechanism -, which redistributes Bob’s debt and collateral to all trove holders in proportion to their collateral amount. You can read more about this mechanism in our whitepaper, section 4.2.
For Bob, the liquidation results in a loss of collateral, but he still gets to keep the original 100 LUSD that he borrowed.
Another type of liquidation is possible under Recovery Mode, which you can read more about in our whitepaper, section 5. However, most liquidations will follow the model outlined above.
It’s important for users to always keep their collateral above 110% to avoid being liquidated. The implied penalty for liquidation is up to 10%, which should incentivize users to keep their trove above this level. It’s worth noting that this is still a lower penalty than other systems such as MakerDAO, which has a liquidation penalty of 13%.
However, there are some other good reasons to keep a trove above 110% collateral to avoid being subject to redemptions, which we will outline below.
The second risk to borrowers comes from redemptions. In Liquity’s system, all LUSD stablecoins are directly redeemable for the underlying collateral, ETH. This means that any holder of LUSD can redeem their stablecoin for ETH at face value.
When a user wants to redeem, their LUSD is used to cancel debt from the riskiest trove in the system (i.e. the trove with the lowest collateral ratio), and the user receives a corresponding amount of ETH from that trove.
For example, let’s assume the price of ETH is $100 and the current base rate (more on base rate can be found in our whitepaper section 3.3) is set to 0.
Bob has a trove with 1.15 ETH valued at $115 and an outstanding debt of 100 LUSD. Bob’s collateral ratio is 115%, which is the lowest collateral ratio of all troves in the Liquity system.
Alice has 10 LUSD which she decides to redeem for ETH. Alice redeems her LUSD.
Bob’s debt is reduced by 10 LUSD which is burned and $10 worth of collateral is taken from his trove. Bob now has 1.05 ETH valued at $105 and a debt of 90 LUSD. His collateral ratio is now 116.7%. Alice now has a balance of 0.1 ETH.
Bob has lost some collateral but also a corresponding amount of debt. Redemptions don’t include any additional penalty for the borrower, but they have the effect of deleveraging the position and increasing the overall collateral ratio of the system.
We expect that the only time users will want to redeem LUSD directly for ETH is when LUSD is trading for less than $1, meaning redemptions will result in arbitrage gains for the redeemer. As such, users can use the market price of LUSD to assess the risk of being hit by redemptions. When the price of LUSD is at or above $1, the likelihood of redemptions decreases. As the price of LUSD goes down, users should increase their collateral to reduce their risk of being deleveraged through redemptions.
In conclusion, users should always keep their troves above 110% to avoid losing their collateral. In addition, most users will want to keep their troves collateralized significantly over 110% to avoid being subject to redemptions. However, it’s important to note that even in the case of a trove being hit with a redemption, the user is not being penalized in the same way as during a liquidation, as they will always keep their collateral surplus, even if all of their debt is cancelled. Trove holders who want to maintain their leverage ratio should be aware of their collateral ratio relative to all other troves in the system to minimize the risk of redemptions.