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Liquity/LUSD X-Chain Strategy

Liquity/LUSD X-Chain Strategy


February 10, 2023

The Liquity protocol is mainnet only, powered by immutable contracts, enabling LUSD to score a reputation as one of the most resilient stablecoins. While the protocol is powered by unchangeable code, the LUSD stablecoin it outputs can be bridged to layer 2 where it’s been making forays lately, particularly Optimism and Arbitrum: it’s the topic of today’s article, focusing on the cross-chain strategies for Liquity and LUSD.

Cross-chain strategies?

Cross-chain strategies are what make or break a protocol in the long run. Expending too quickly across many networks often results in exploding infrastructure and maintenance costs, as well as potentially many instances with low usage that might be not “worth it”. 

In the matter, SushiSwap is a prime example, as it is one of the protocols being the most aggressive in its cross-chain expansion strategy. SushiSwap has been deployed to 19 different chains, out of which only 8 have over $1M TVL, and 7 chains are even sitting below $100K TVL. Thus, apart from mainnet, the historical chain for Sushi, out of the 18 additional chains launched, only 3 can be truly considered successful: Arbitrum, Polygon, and Gnosis.

SushiSwap Chains
SushiSwap Chains

On the other hand, while staying on the Ethereum mainnet only is the safest option, it prevents smaller wallets from interacting with the protocol/token since the gas costs are impacting their profits too much: something that affects also Liquity, since the protocol itself is mainnet only.

Therefore, expanding a protocol across chains is a game of balance between: 

  1. the additional risks posed by the added chains (bridges, IOU, etc.), 
  2. the cost to maintain a presence there, 
  3. and the benefits that can be gathered if the protocol gains traction on the newly launched network.

On this, Liquity is no different, although the protocol has its specificities: because of the code immutability, Liquity can only exist on mainnet, and LUSD can only be created (borrow-minted by depositing ETH collateral) on mainnet too. Despite these limitations, there are many cross-chain opportunities for LUSD and Liquity. This article will outline a strategy to harness them.

When it comes to cross-chain for LUSD, there are three main objectives as well as one imperative that will each be covered in their dedicated section:

  1. Making LUSD more accessible, enabling smaller holders to get LUSD exposure with reasonable transaction costs.
  2. Grow LUSD liquidity and develop its use cases
  3. Broaden access to the Liquity protocol itself, thanks to L2-based mainnet pooling/batching solutions like Aztec Connect.
  4. Achieving all of the above without hindering the resilience of Liquity and LUSD.

I/ LUSD & LQTY go where Liquity can’t

LUSD is a unique stablecoin offering the strongest guarantees and minimizing counterparty risk: it’s overcollateralized (with ETH only), redeemable, and loan terms cannot be changed (immutable contracts). While mainnet users are happy to harness its resilience, smaller holders can be priced out of the associated gas costs… no longer, thanks to Optimism and Arbitrum!

Indeed, layer 2 solutions, such as Optimism and Arbitrum offer $1< transactions, enabling smaller portfolios to harness LUSD too without worrying too much about the impact of transaction costs on their strategies.

Liquity is mainnet only

Before we go further, allow us to clarify one last time what it means and why that is.

LUSD’s unmatched resilience stems from the fact that it is the only stablecoin of this scale powered by immutable contracts: no modification can ever be made, neither to the Liquity protocol nor to the LUSD contract, ever: it’s technically impossible.

While this property has obvious and immense security benefits, it also has a cost: any change to be made to the Liquity protocol would require deploying a new instance of it and users to migrate, just like when Uniswap released the V2 or V3.

So, technically, Liquity could be re-deployed on Optimism, for instance. However, the LUSD outputted there would not be LUSD (let’s call it oLUSD) and couldn’t be reconciled with LUSD as it would require adjustments to be made to the base LUSD contract (on mainnet).

But LUSD & LQTY can be bridged!

So, to cater to smaller holders who also deserve resilience, there is another option, which started to be implemented last year as LUSD was arriving on Optimism.

The principle is quite straightforward, as most DeFi users are already used to:

  • LUSD tokens are locked in a bridge contract on mainnet
  • To output an IOU LUSD token on the target chain, such as Optimism.

The process obviously works the other way around: an LUSD-IOU on the target chain can be burned to recover the base LUSD on mainnet, although the process takes a week, a delay is required for the Challenge Period serving to help secure the assets stored on an Optimistic network. There is already a solution available to avoid this delay, Stargate, discussed below.

Thanks to the bridges, LUSD can exist on layer 2, enabling smaller holders to easily acquire it on their local DEX venue too. The process is exactly the same for LQTY.

Bridging LUSD to layer 2 is neat to democratize access to it, but it’s only the first step. Once LUSD exists on a given chain, it’s time to consider what can be done with it there – it’s precisely the topic of our next section. 

II/ Grow LUSD utility and use cases

Growing utility and use case for a token on a new chain is pretty much like re-starting from scratch, the whole suite must be covered:

  1. First, it starts by growing its liquidity, the lifeblood of a token required for all further use cases. [⇒ This is where LUSD is at on Arbitrum now]
  2. With a minimal amount of liquidity, various non price-feed sensitive use cases can be catered for.
  3. Finally, once the liquidity has grown and volume has been sustained, a ChainLink price feed can be obtained, enabling more advanced integrations such as the usage of the token as collateral. [⇒ This is where LUSD is at on Optimism now]

All three go hand in hand, as liquidity (1) enables basic integrations (2) securing the volume required to obtain the Chainlink price feed and more advanced integrations (3). Besides, densifying the ecosystem surrounding LUSD by creating additional earning opportunities that might attract holders that are not coming to the network just for the more limited gas costs.

1) A new chain starts always with a liquidity source

Growing liquidity is the very first requirement to make the most of LUSD’s presence on a new chain. Thus, the existing decentralized exchange infrastructure present on the network, as well as its efficiency in enabling projects to develop and sustain liquidity is a key requirement for a successful launch of LUSD on a new L2.

🚲️ LUSD’s Optimistic Game 

Optimism was the first L2 where LUSD was available as the Velodrome exchange was started on May 31, 2022. Velodrome focused its launch strategy on partner protocols, providing veVELO allocations to projects already active on Optimism, such as Liquity. 

In the case of Optimism, joint efforts of partners to bootstrap the ecosystem resulted in sustaining $6.7M of stableswap liquidity and $1.2M of volatile liquidity for LUSD:

The dense liquidity available for LUSD on Optimism helped to grow trading volume and owner count of the chains, enabling further integrations covered just below. Besides, the Velodrome V2 update is right around the corner and will enable new strategies and even denser liquidity for LUSD and LQTY on Optimism.

🛡️ Liquity’s seat at the Round Table

On Arbitrum, LUSD’s presence is more recent, as the stablecoin made its first strides on the network right before the end of last year, with the launch of LUSD/ETH pool on Camelot. A LUSD stableswap pool might soon follow to complement the LUSD’s Arbitrum liquidity offering.

Several Arbitrum DeFi protocols have already expressed interest in harnessing LUSD’s presence on the network, so stay tuned for further integrations and liquidity initiatives.

2) Growing LUSD’s network presence

Growing and diversifying LUSD’s first range of use cases is more network-specific, as it usually involves other DeFi projects harnessing LUSD’s properties to better serve their own use case. For instance, Synthetix harnessed LUSD through a “Wrappr” to help stabilize sUSD’s price on Optimism for over a year.

The progressive diversification of liquidity for LUSD, as it occurred on Optimism with pairings with 4 different stablecoins on top of ETH helps further grow the trading volume, a key requirement for ChainLink to provide a price feed.

Various decentralized leveraged trading protocols on Arbitrum are exploring harnessing LUSD for their vault, to cater for users more sensitive about centralization-related risks: these product usually provides a supply side, where users can deposit LUSD for a yield, and a demand side, offering LUSD-based leverage on desired tokens.

In the wake of the success of the MAGIC ecosystem, Arbitrum is also home to a dense NFT/Gaming ecosystem in which LUSD could be included.

3) Harnessing ChainLink’s price feed for advanced use cases

LUSD’s sustained liquidity and sizeable trading volume on Optimism made it eligible for a ChainLink price feed, necessary for advanced use cases such as LUSD as collateral. 

Since the LUSD’s ChainLink USD Optimism price feed is live, more complex integrations have been pursued, and the first are already implemented.

LUSD can be used as collateral and borrowed on the money market Sonne Finance, with 60% LTV, or used with Mean Finance to DCA into your favorite tokens. Further integrations are being worked on, such as the addition of LUSD to Aave’s v3 on Optimism, making it possible to envision LUSD on PoolTogether if the community so chooses.

Making LUSD increasingly available on L2 broadens access to the stablecoin, enabling all types of holders to harness its resilience. Yet the main protocol remains on mainnet, and is still unwelcoming to smaller holders becoming of mainnet gas costs, or used to… before Aztec Connect!

III/ Broaden access to the Liquity Protocol itself

Indeed, there is a way to enable users priced out of mainnet-Liquity to still interact with a protocol in a gas-efficient manner: Aztec Connect. 

Simply put, Aztec Connect enables users to interact with the Liquity Protocol from an Aztec-based rollup, offering cheap transaction costs and privacy-preserving features. Users' interactions are then batched and reflected on the mainnet.

Aztec Connect: interact with Liquity from a privacy-preserving zk-rollup

Aztec Connect is a novel solution, progressively rolling support for more and more DeFi protocols. On Aztec-L2, Liquity users will be able to interact with their trove (borrow and repay) and the stability pool (stake/unstake). Yearn Finance is also supported on Aztec Connect, meaning that LUSD holders will be able to use the Yearn LUSD vault without leaving the rollup!

Aztec Connect’s Liquity integrations are stated to release during the first quarter of this year. 

The integration will feature full functionality as mainnet (mint, repay, stake in stability pool) but will restrict borrowers in the choice of their collateral ratio to enable efficient bridging. There will be two types of troves available: 275% collateralization ratio and 400% collateralization ratio.

This limitation stems from the infrastructure used to make this technical feat possible: “sub” troves created through Aztec are pooled together as a collective troves on mainnet. It acts like a collective branch of Liquity for smaller wallets that pools the users borrowing needs and bridges it to the Liquity protocol on mainnet.

The system works with shares of the two given troves, enabling users to enter or exit the position. New debt is taken at the current collateral ratio. It’s therefore not possible to improve the collateral ratio of the troves with new deposit, but if the positions are deteriorating, new ones can be deployed if needed, and users will be able to exit or migrate.

Direct on/offramp of LUSD to Aztec Network

Aztec Connect’s integration of the Liquity protocol will also feature an on/offramp directly to the zk-L2, enabling users to purchase or sell LUSD from fiat currencies, thanks to Mt Pelerin.

To make this new integration as convenient and easy to use as possible, the Liquity, Aztec and MtPelerin teams are joining forces to sponsor the gas costs for bridging Aztec L2 <-> Ethereum mainnet, as well as the fees related to on/offramping LUSD with Mt Pelerin for an initial phase.

We have seen the first step of the L2 expansion strategy of LUSD unfold with liquidity and use cases on Optimism and Arbitrum. It's exciting that a next step will be achieved with the integration of Liquity in Aztec Connect: it marks the first time users can interact with the protocol from a gas-friendly rollup.

Besides, this integration enables the full preservation of Liquity’s resilience (since everything remains, in the end, on mainnet), while broadening its access. Indeed, the protocol sturdiness is one of its critical features - let’s explore next how this can be preserved and additional risks - introduced through bridging - can be reduced.

IV/ Do all of the above, safely

Bridging a protocol like Liquity across chains can add additional risks to the system and users mainly on these chains. To minimize risks and grow the LUSD ecosystem in a sustainable manner these points need to be considered by the teams working on these integrations.

  1. Chains should be picked wisely to reduce the overall risk scope
  2. Scale of LUSD’s L2 presence should stay balanced or be capped
  3. Ideally, risks posed by LUSD’s presence on L2 should be hedged

We’ll detail each of the three in a dedicated section:

Picking chains wisely (=reduce risk scope)

The first and most obvious way to contain additional risks posed by a cross chain strategy is to actively reduce the additional risk scope as much as possible, meaning: launching on as few chains as possible, and ideally the ones with the models offering the most guarantees.

Thus, some chains are less viable  from the get-go when it comes to Liquity’s cross-chain expansion, because they are not a good fit value-wise, or their technical specifications hinders the potential resilience of LUSD/Liquity if bridged or deployed there. These include networks like Binance Smart Chain, Avalanche, Solana, Polygon, Kava, etc.

For Liquity, Ethereum scaling solutions are the best fit. Amongst the L2, we have seen most activities on optimistic rollups (Optimism and Arbitrum) as this is where the bulk of the L2 activity happens in the Ethereum ecosystem right now. A lot of progress is also happening on zkEVM based approaches like zkSync, Polygon zkEVM, etc.These are promising candidates to replicate the outlined cross-chain strategy to.

Monitor the risks posed by LUSD’s presence on L2 for Liquity

When it comes to bringing LUSD to layer 2, there is simply one main risk: the possibility of having LUSD “stuck” on L2, while they are needed to liquidate on mainnet, such as during a sizeable sell-off of ETH. This risk can be hedged in various ways depending on the network’s limitations:

  1. First, it’s only a problem when bridging LUSD back to mainnet takes a long time, such as on optimistic-based networks. On zk-based network, withdrawing is quick, and thus an issue is less of a concern.
  2. Secondly, it’s a perfectly manageable challenge, as the supply of LUSD on L2 can be monitored and incentives adjusted to lower demand if needed.

Finally, keep in mind that while having LUSD supplied to the Stability Pool is preferable to handle liquidations, the Liquity protocol is perfectly apt to liquidate even with an empty Stability Pool, using a redistributive mechanism.

When looking at the Stability Pool LUSD balances, it’s also important to consider contracts like the one of the B.protocol, one of the top suppliers of the Stability Pool, which frequently harvests the ETH obtained back to LUSD, helping to further ensure continued LUSD supply in the pool even when markets are heated up.

WN - LUSD-xchain-defillama.png

DeFiLlama provides clear data on the LUSD distribution across chains and protocols.

Like all things DeFi, anyone can track the share of the LUSD supply deployed on L2s, allowing holders to adjust their strategies accordingly. As of February 07, there is about 300 000 LUSD on Arbitrum and 5.2M LUSD on Optimism, meaning that the share of LUSD on L2 is around 2.5%. The effective risk posed by the “LUSD stuck on L2 during a liquidation event” scenario should remain minimal, as long the supply of LUSD on L2 is below 25% of the circulating supply.

The time needed for LUSD on specific L2s to reach back mainnet is also to be taken into account, as it changes depending on the L2 specifications, for instance:

  • By default, bridging back from Optimism or Arbitrum takes 7 days
  • While on a zk-based network, withdrawing assets is a quick process (~15 minutes).

Hedge the risks posed by LUSD’s presence on L2: fast bridging with Stargate

There is another more active way to hedge the risk posed by LUSD’s presence on optimistic-based rollups where withdrawals take a week: speeding up the withdrawal process — which is exactly what Stargate does.

Instead of the usual one-week delay of the official bridge to go back to mainnet, Stargate is able to process the withdrawal of LUSD from Optimism/Arbitrum to mainnet in 10 minutes. Depending on the required volume, the rate might get less favorable, but it’s still a neat addition for LUSD L2 users, as it creates an additional buffer of LUSD that can be almost instantly bridged back if needed.

While Stargate is not the most useful to bridge assets to Optimism and Arbitrum, since it can be done at 1:1 in 15 minutes using the official bridge, it’s invaluable to bridge them back quickly.

What about Aztec Connect & other pooled access devices?

The Aztec Connect Liquity integration is a bit different, risk-wise, than the usual process of bridging LUSD or LQTY to an L2 like Optimism and Arbitrum

With pooled integrations, end-users interact with the Liquity protocol (on mainnet) directly. At the end of the day, Aztec Connect Bridge acts as an interface to the supported mainnet protocols. It changes a few things about how to approach risks in that situation, also the overall logic stays similar.

Overall, the risk is largely compartmentalized to Aztec's L2. Indeed, since it’s only acting as a batcher and interface to Liquity, all the guarantees of the base Liquity protocol are upheld. The bulk of the additional risk posed by this integration lies in Aztec L2 itself. 

Indeed, if there is a technical failure of the rollup, users could end up with LUSD deposits stuck in the Stability Pool (or even stuck as converted to ETH already). Finally, it’s also a matter of size! 

If the Aztec Troves become sizeable, their inertia could work against them: with an ETH price depreciating strongly, these troves could end up anchoring Liquity’s Total Collateralization Ratio at a low level, making Recovery Mode more likely to happen. If the two Aztec troves are sizeable, it could also put added pressure on the Stability Pool as their liquidations could require a non-trivial share of the LUSD deposited.

This risk is quite well hedged already since the Aztec Connect integrations only offers two leverage levels, both pretty conservative. With the data and ETH price of February 07:

  • 275% collateralization ratio ⇒ Liquidation triggered for an ETH < $ 592
  • 400% collateralization ratio ⇒ Liquidation triggered for an ETH < $ 407

Meaning that Aztec’s Troves will not enter liquidation territory unless the ETH price is divided by  three at least: a decent margin of error.

L1 execution (pooled access) vs L2 execution (bridged tokens)?

This article outlined a strategy how Liquity can be brought to L2s and increase the utility for its users. Further, we walked through concrete examples for each of these stages that are already live on L2s There are of course some exciting new opportunities to consider, such as the arrival of the zkEVM-based networks this year: zkSync, Scroll, Starknet, Polygon zkEVM & more.

As outlined, we believe the best way forward for Liquity is to focus on fewer, well-aligned chains, and grow use cases there. The activity on Arbitrum and Optimism looks very promising, and we encourage other projects e.g. like PoolTogether to look into the new possibilities that LUSD opens up. Let’s spread the word together and bring LUSD resilience to L2s.

Key Takeaways

Designing a cross-chain strategy is a game of balance, as cross-chain initiatives are often driven by the protocol's growth ambitions. But launching a protocol or token on a new chain is not a trivial affair (infrastructure, tooling, liquidity, etc.) and also bears the outlined risks. More often than not, protocols are overexpending, resulting in exploding infrastructure complexity, and a fragmented user base as well as liquidity for minimal benefits.

While launching new instances of a given protocol on L2/sidechains was the de-facto way of going cross-chain up to now, the increasing availability of rollup-to-mainnet batching solutions (like Aztec Connect) might change the game. Indeed, these enable the crafting of devices providing access to a given protocol from a zk-rollup. 

Pooled solutions like Aztec Connect could enable protocols to lower the cost of the cross chain strategy, while increasing their effectiveness, as all new users sourced the solution are interacting with the mainnet protocol instance in fine (= no more liquidity fragmentation).

After learning all about Liquity and LUSD’s cross chain use cases, maybe you’d like to try it out yourself? Checkout the LUSD ecosystem on L2 and explore the various opportunities available on both networks:

Written by TokenBrice, this article strongly benefited from the technical expertise of the Liquity team, as well as its attentive help to proofread the content and ensure the expression is as clear as it can be.