August 31, 2022
LUSD is a stablecoin pegged to the U.S. Dollar. Yet, it has been trading slightly above its peg for the last few months, leaving some users confused. In this post, we'll discuss the chain of events that led to the current situation, deep-dive into LUSD's pegging mechanisms, and explore the various strategies implemented to improve LUSD's liquidity and peg.
In short, the current premium we observe on LUSD results from a structural unbalance between offer and demand. It was further aggravated by recent events leading more and more users to worry about the censorability of centralized stablecoins (like USDC or USDT) and decentralized stablecoins primarily backed by centralized ones (like DAI or FRAX).
The situation led to a considerable demand surge for censorship-resistant stablecoins that only LUSD can answer since there is no other alternative with a significant TVL. Thus, we have seen LUSD trading at a premium and slightly above peg which was was partially caused by the increased demand for LUSD.
LUSD is a stablecoin fully collateralized by ETH, the only fully trustless collateral available on the Ethereum network. While it provides incredible benefits for the overall resiliency of Liquity and to LUSD as a stablecoin particularly, it also comes with scalability challenges.
A few years ago, Maker faced a similar situation, with DAI frequently trading above peg. The community decided to sacrifice the system's resiliency in favor of peg and liquidity with the introduction of the Price Stability Module, which brought a massive amount of USDC collateral to DAI.
Because of the PSM, more than ⅔ of DAI collateral consists now of USDC, or USDC LP, which exposes DAI to severe risks if the Maker contracts were ever added to the infamous USDC blocklist.
With Liquity, the ETH collateral in the system can’t be seized or frozen. There is also no entity or DAO that can be forced to change or stop anything in the system as the code is immutable and not upgradeable. Thus, LUSD has similar unstoppable properties like Ethereum itself (besides the oracle dependency) - it is the most decentralized and largest Ethereum-native stablecoin currently available.
Since LUSD can only be minted by opening a Trove and depositing ETH as collateral, the supply of LUSD comes from Trove owners who mint and then proceed to either provide liquidity on LUSD-related pairs or sell LUSD for other assets they want to increase their exposure to, such as ETH. While the supply is plentiful when markets are heated up, and the demand for leverage on ETH is strong, it can be more sparse once bears are out.
On the other hand, the demand for LUSD comes from various sources:
This supply/demand mismatch creates a base pressure on LUSD's peg, which can trend upwards in bear markets when appetite for leverage is limited. Usually, the situation resolves itself quite quickly as positive sentiment is restored. Yet, several other catalysts have led to a sustained LUSD price premium over the last few months.
On August 08, the U.S. Treasury Department issued a blanket ban on Tornado Cash's crypto mixing service: it was the first time a government ever tried to criminalize a piece of code, a smart contract.
There was a surge of interest in the censorship-resistant solutions that Ethereum has to offer to avoid price volatility. The news surprised many and led to a panic as holders of centralized stablecoins or other stablecoins relying heavily on centralized issuers realized a similar scenario could unfold and affect them too. Users realize now that there aren’t many alternatives apart from LUSD as builders of stablecoins have prioritized scalability and peg-stability over decentralization over the last years.
Thus, we've seen an unprecedented flight to the safety of stablecoins like LUSD or RAI from DAI, USDT and USDC holders. Some swapped their positions to LUSD, even when losing 3-5% of its value because of the peg difference. Even whales joined the feast, with some swaps in the seven figures range putting additional pressure on the peg:
With the Merge approaching and the PoW-ETH fork coming with it, some DeFians are also looking at LUSD as a way to profit off the situation, putting additional pressure on the LUSD peg. There are some scenarios proposed by the community, such as the one presented in 0xSato's thread.
Yet, without official support from ChainLink nor any major centralized stablecoins, it does seem like a gamble. On Liquity's side, since the ChainLink price feed will be frozen, the system will switch to the secondary oracle Tellor. There's a slight chance the data reporters and TRB stakers will continue pushing updates. If they do, it means ETH-PoW will have a price on Liquity-PoW, most likely leading to either mass redemptions or mass minting and selling LUSD.
Without stablecoins nor bridges, DeFians gambling the ETH-PoW fork will be left with centralized exchanges supporting ETH-PoW as their only exit gateway back to mainnet (ETH-PoS).
We’ve explored the topic on the merge and its impact on Liquity in the following Twitter threads:
With the stage set, let's take a step back and look at the pegging mechanisms at play for LUSD. We often mention that LUSD is hard pegged below $1.00 and above $1.10 and soft pegged within the 1.00-1.10 range: let's get explicit about what it means in practice.
When LUSD is trading below $1, strong and almost mechanical incentives will bring it >=$1; this is what we call the "hard peg." In that scenario, the incentive comes from the redemption mechanism, enabling users to exchange LUSD for ETH. Since the Liquity protocol considers LUSD to be worth $1, redemptions can become very profitable if LUSD trades below the dollar.
Consider, for instance, that LUSD is trading at $0.98. An arbitrageur would buy LUSD off the market (pushing the price back up) and redeem LUSD for ETH with a profit (which also reduces LUSD supply, helping it reach back its peg). There is a redemption fee to account for too, but as LUSD drops further away from $1, this arbitrage trade becomes more and more profitable.
Due to the efficiency of this mechanism, we hardly ever see LUSD below peg.
Another property of the Liquity protocol, the minimal collateralization ratio, set at 110%, ensures that LUSD cannot sustain prices above $1.10, offering another hard peg above this figure.
Indeed, suppose LUSD trades above $1.10. In that case, anyone can profit simply by minting the maximum amount of LUSD they can and selling them on the markets. In that scenario, the arbitrageur would profit even if their Trove gets liquidated.
Since the trades adds LUSD in circulation that are instantly sold, this arbitrage puts a significant pressure downward on LUSD’s peg. It’s profitable as long as LUSD above $1.10, thus creating a price ceiling or hard peg.
The incentives are a bit more nuanced and less mechanical between those two price points covered by the hard pegs, making it a soft peg. Here's an overview:
If people believe LUSD will eventually reach its peg, then any price >1.00 creates an incentive to borrow and sell LUSD, which becomes stronger as we get closer to the $1.10 hard peg. Thus, we’ve never really seen LUSD sustain a price >1.05 for long period of time, since at this price level, users who mint LUSD get an instant 5% premium as they sell the LUSD for anything they want to invest to.
Since LUSD has a $1.10 price ceiling, the closer we get to this point, the less profitable the arbitrage trade is. At $1.01, there is a potential $0.09 profit per LUSD in an uptrend. At $1.09, it's down to $0.01 per LUSD, rendering a LUSD purchase at this price point much less attractive.
The closer LUSD gets to $1.10, the less buying pressure there is, and if it ever reaches $1.10 a massive selling pressure is to be expected thanks to the price ceiling described above.
With a LUSD at $1.00, Liquity's maximum leverage ratio for users longing ETH is 11x (110% min LTV). As the price of LUSD increases, so does the maximum leverage achievable by borrowers. For instance, with a LUSD at $1.05, the maximum leverage doubles to 22x.
Therefore, the higher LUSD price is, the more attractive it becomes for Trove owners who are long ETH to scale up their position. As they do so, they mint and sell LUSD, pushing the price down (Open Trove > Mint LUSD > Swap to ETH > Add Collateral > Mint LUSD > Swap to ETH, etc.).
The Stability Pool is an attractive opportunity for LUSD holders, offering almost risk-free yields in both ETH & LQTY. It’s usually the preferred income source for LUSD holders, as roughly 50% of all LUSD in existence are deposited into the Stability Pool currently (90/180M).
However, as the LUSD price rises, it becomes more attractive for Stability Pool depositors to shift to a liquidity-providing position, which helps bring LUSD back down.
Indeed, entering a liquidity providing position 100% from LUSD means selling a share of these LUSD for the pairing asset, which helps pushing the price back down. Moreover, since the LP is abitraging the LUSD price, the transaction is profitable (assuming the position can be closed at parity or at at LUSD price < entry price)
For more details on the peg mechanisms, check this dedicated article.
As we have seen in the previous paragraphs, the price of LUSD is driven by market forces (supply and demand) and there are several incentives that help to bring the peg back to one when the price is between the hard peg of $1-$1.10.
Besides the built-in mechanics users and the community can further improve the peg by increasing the liquidity for LUSD - the more liquidity there is the less volatile the peg should become and the easier it becomes for users to take advantage of the different strategies which will bring LUSD back to the $1.00 mark.
A truly decentralized stablecoin relies on a shared responsibility for a vibrant and liquid ecosystem around LUSD. It’s great to see that a lot of projects are supporting the LUSD ecosystem and we would like to highlight what is currently in the works to improve the liquidity situation.
It’s great to see that LUSD+3CRV pool is regularly one of the top 10 pools on Curve from a volume and usage perspective. This gives the pool a nice base yield, Additionally, the LUSD+3CRV pool already got quite some love from the community which voted for this pool and directed some additional rewards to it.
We decided to support the efforts of the community and devoted some of our team treasury to increase the yield on Curve. We are planning to increase our CRV holdings to 1M CRV as a contribution to the ecosystem. Currently, this is planned as a temporary measure until the pool has grown to sustain itself.
We've also successfully pleaded with CurveDAO to be able to vote-escrow the CRV acquired, enabling us to support the gauge of Curve pools involving LUSD as well as gaining governance power on Curve. The Liquity treasury wallet was the first multisig contract to ever plead for a veCRV whitelisting. Several other projects have followed our footsteps since.
Frax recently launched its new base pool, featuring FRAX and USDC. It is available as a base pool for other assets to pair against. It led to a swarm of FRAXbp metal pools, including a LUSD/FRAXbp, which already features a CRV gauge and quickly grew to $9M TVL.
More is coming for this pool, as the Frax community voted to add FXS gauge to the metal pools, a vote that should be executed shortly. To further support LUSD's Curve pools and help them find their balance, we are exploring different avenues how we can support these efforts.
Since its launch and initial protocol airdrop in June, the Optimism DEX Velodrome has seen some serious action, and the Liquity team was consistently at the forefront of it. The team has put the initial veVELO NFT airdrop to work: it helped grow a sizable LUSD/USDC pool, now around $5M TVL. And the team is looking into strategies on how to grow the pool further with e.g. treasury voting activities.
To further increase the utility of LUSD on Optimism, new LUSD pools have been added against sUSD and MAI. We're also currently in the process of asking for an OP grant to support further LUSD's liquidity on Optimism, as well as support a fast bridging solution enabling quick withdrawal from Optimism to mainnet (and thus bypassing the seven days delay of the official bridge). Join the conversation and support LUSD on optimism.
While Curve is currently the most important DEX for LUSD's liquidity, exciting developments are being created on top of Balancer, the most notable being LUCY. This new stable swap pool will feature LUSD and be able to provide liquidity as well as harness the Stability Pool yields.
It uses B.Protocol’s bAMM to settle ETH gains from liquidations into LUSD quickly. Therefore, it should grow both LUSD's and the Stability Pool liquidity if successful -exciting times!
Another initiative the team was supporting lately is to provide options to use LUSD as collateral on relevant money markets and lending protocols. While it does not support liquidity directly, it will create interesting arbitrage opportunities that will prove useful to help bring it closer to its dollar peg.
The most notable one is our proposal to add LUSD as a borrowable asset on Aave, now live. Having LUSD as a borrowable asset on Aave is quite complimentary to Liquity, as Aave supports many different types of collateral, enabling holders of wBTC or LINK for instance to borrow LUSD.
While LUSD will not be usable as collateral on Aave, it is the first step to reaching this end goal. Further down the line, enabling the efficiency mode on LUSD/stablecoin pairs on Aave will create further arbitrage opportunities beneficial to the peg.
Having LUSD as a borrowable asset on Aave enables any Aave user to make a directional trade on LUSD’s price if desired. For instance, if LUSD is at $1.04, a user with LINK collateral could borrow LUSD from Aave, sell it to another stablecoin to lock it is profits, and simply wait for the price to reach back $1.00 or $1.01 to buy back LUSD to repay his debt. The stablecoin earned in the process could even be re-deposited on Aave to mitigate the borrowing cost and further secure the position.
Mimo Capital, another lending protocol, is also considering the addition of LUSD as collateral. On Mimo, users can deposit collateral such as ETH or wBTC to borrow PAR, an €-pegged stablecoin. While Mimo is also accepting USDC as collateral, the community is now looking to diversify away from it and into more decentralized stablecoins such as LUSD.
An envisioned 110% minimal collateral ratio would enable sizable leverage. It will be a guarded launch with a $1M initial debt limit that can be raised with another DAO vote.
Finally, another €-based borrowing service, Angle, is also considering adding LUSD as collateral, on both mainnet and Optimism:
Last but not least, the release of the LUSD Chicken Bonds is approaching. It will help to capture a permanent balance of LUSD that will be used to support LUSD's liquidity on Curve further.
We hope this primer provides you with additional context on how the LUSD peg works and gives you an overview of all the initiatives across DeFi which will further stabilize the peg and strengthen the Liquity ecosystem.
If you'd like to support the Etherum-native stablecoin LUSD, put your governance tokens to work! You can vote for the LUSD-related pools on Curve with your veCRV or vlCVX or on Velodrome if you own veVELO. Who knows what kind of treasures genuine supporters of the only disaster-proof stablecoin might stumble upon?