April 20, 2021
Since launch, LUSD deposited to Liquity’s Stability Pool has continued to grow — recently crossing 1.1B deposited. As a result, we want new users and our community to fully understand the mechanisms at play.
In this post, I’ll be going over the basics of the Stability Pool, how it works, and some things to keep in mind when depositing.
Liquity’s Stability Pool is the first line of defense in maintaining system solvency. In other words, the Stability Pool absorbs and cancels debt from defaulted (i.e. liquidated) Troves — a responsibility usually managed by collateral auctions in systems like MakerDAO.
How the Stability Pool replaces such auctions is straightforward: it allows LUSD holders to commit capital upfront in order to “buy” liquidated ETH and offset the bad debt. This is an appealing swap due to the overcollateralization of Troves. In general, Stability Providers will receive more ETH (in $ terms) than LUSD burned — enjoying a nice discount on ETH.
All a user must do is deposit LUSD to the Stability Pool and wait. Then, when a Trove gets liquidated, its ETH collateral is distributed proportionally to all Stability Pool depositors (Stability Providers) and a proportional amount of LUSD is burned across all Stability Providers to pay off the defaulted debt.
Here’s a visual:
1) Trove gets liquidated, ETH collateral is distributed to Stability Providers.
2) LUSD is burned from Stability Pool to “pay off” the Trove’s bad debt.
3) Stability Providers receive more ETH (in $ terms) than LUSD burned due to overcollateralization.
The Stability Pool democratizes access to otherwise complex and lengthy collateral auctions while also yielding another benefit: quick liquidations. Due to the quick liquidations facilitated by the Stability Pool, Liquity is able to allow for a low minimum collateral ratio of 110% —improving capital efficiency for borrowers.
Since we’ve already covered this dynamic in a previous post, I won’t cover it here. I recommend reading How Faster Liquidations Improve Capital Efficiency for more details. Moving on…
The primary reason someone might deposit to the Stability Pool is to simply acquire ETH at a discount whenever Troves get liquidated — we’re all ETH bulls here, aren’t we? But there’s another reason that sweetens the deal: LQTY rewards.
Since the Stability Pool is a fundamental piece of Liquity’s infrastructure, it’s important to ensure that Stability Providers are properly incentivized by the protocol. To do this, Liquity distributes LQTY rewards pro rata to Stability Providers for the duration of their deposit. Put differently: The more LUSD a user has in the pool and the longer they keep it deposited, the more LQTY rewards they receive. Those LQTY rewards can then be claimed and staked to earn fees generated by the protocol.
All-in-all, Stability Providers are volunteering to give up their LUSD exposure in order to ensure system solvency, acquire liquidated ETH, and earn LQTY rewards over time.
While depositing to the Stability Pool might seem like a dream come true, there are still some things to keep in mind.
First thing to keep in mind is that Liquity frontends give users a “kickback rate” on Stability Pool deposits. The kickback rate specifies how Stability Pool rewards are split between a frontend and its users. For example: A 99% kickback rate means that users receive 99% of their LQTY rewards while the frontend receives 1%. More details here.
Second thing to keep in mind is that you will be losing LUSD over time — most accidentally overlook this. The rate at which your deposit decreases depends the frequency and size of liquidations occurring over the duration of your deposit. This means that there’s no predictable decay rate for users’ LUSD.
The last thing to keep in mind is that depositing to the Stability Pool isn’t “risk free”. By committing to “buy” liquidated ETH upfront, users are also committing to buy ETH during price drops. This means that it’s possible for the ETH that users receive to be worth less shortly after receiving it due to a quick price drop — though over time this should be balanced out by less severe circumstances.
Now you’ve covered the basics of Liquity’s Stability Pool! If you’re looking to explore the Stability Pool in more detail, I recommend reading How Faster Liquidations Improve Capital Efficiency, our whitepaper, and our FAQ.