In-Depth Look at Liquity V2

Introduction and Motivation

Liquity V1, launched in April 2021, introduced an innovative, governance-free borrowing protocol. It allowed users to borrow the stablecoin $LUSD at zero percent interest using Ether as collateral. The protocol became well-known for its efficiency, security, and minimal governance.

Despite its success, V1 had limitations that the new Liquity V2 aims to address. Liquity V2 introduces innovations designed to improve capital efficiency, peg stability, and user flexibility with their new stablecoin $BOLD. The motivation behind V2 is to create a more resilient, user-friendly protocol that aligns better with the evolving decentralised finance ecosystem. By building on the strengths of V1 and addressing its limitations, Liquity V2 sets a new standard for decentralised borrowing protocols.

User-Set Interest Rates

One of the standout features of Liquity V2 is the ability for borrowers to set their own interest rates. Previously, in Liquity V1, $LUSD redeemers would automatically target the riskiest troves with the lowest collateral ratio. When borrowing volume outweighs the demand for holding LUSD, it increases selling pressure and redemptions. This leads to borrowers increasing their collateral ratios, making the whole system capital-inefficient.

Liquity V2 replaces that LTV-based approach with an interest-based one. This dynamic system allows borrowers to choose rates between 0.5% and 1000%, offering greater control over their borrowing costs. Redemptions will then target borrowers with the lowest interest rates first instead of focusing on their collateral ratio. This flexibility helps maintain the stability of $BOLD, Liquity’s new stablecoin, by encouraging market-driven adjustments to interest rates based on current conditions. Higher rates can stabilise $BOLD’s price when it is below the peg, while lower rates can reduce borrowing costs when BOLD is above the peg.

Unlike MakerDAO, which uses a governance-driven system to adjust interest rates, and crvUSD, which employs a dynamic peg mechanism, Liquity V2 empowers borrowers with the autonomy to set their own rates. This market-driven approach eliminates the need for slow governance processes like MakerDAO and eliminates volatile interest rates that are set by an algorithm like crvUSD. This flexibility is a significant advancement in the DeFi space, offering a more adaptive, predictable and responsive borrowing environment.

Improved Peg Dynamics and Risk Management

Liquity V2’s adaptive redemption logic targets weaker collateral assets more aggressively to manage risks. This approach keeps the protocol resilient by maintaining effective liquidations and reducing exposure to less reliable assets. By focusing on weaker assets, the protocol can better stabilise the value of $BOLD, ensuring its peg remains close to the intended value.

Liquity V2 expands collateral options to include multiple LSTs, each with its own borrowing market and risk parameters. This diversification allows borrowers to leverage different assets while benefiting from the auto-compounding staking yields of LSTs. Each LST’s market is managed independently, with risk reflected through the size of its respective Stability Pool.

This means borrowers are only affected by the collateral they use, ensuring a failure in one market does not impact others. This segregation also aligns the risk profiles of different collaterals, contributing to $BOLD's overall stability. The protocol can tailor risk management and interest rates to each specific asset by having distinct markets, improving overall efficiency and stability.

Enhanced Borrowing Experience

Unlike its predecessor, Liquity V2 does not charge upfront fees, making it more appealing for short-term borrowers and those seeking fast leverage. Instead, borrowers pay interest over the duration of their loans, providing greater flexibility and cost-effectiveness. This approach lowers the barrier to entry for new users and enhances the borrowing experience by reducing initial costs.

Liquity V2 introduces the concept of 1-click leverage, allowing users to quickly increase their borrowing power with minimal steps. This feature simplifies the process of taking on more debt, making it more user-friendly and efficient. Additionally, transferable troves enable users to transfer their debt positions easily, providing greater flexibility in managing their loans. These innovations streamline the borrowing process, making it more accessible and adaptable to individual needs.

Stability Pool and Yield

Liquidity V2 introduces a continuous, sustainable yield for Stability Pool depositors (Earners) through interest payments in $BOLD. This mechanism ensures a consistent demand for holding BOLD, supporting its long-term stability. Earners benefit from a steady income stream, making participation in the Stability Pool more attractive and reliable.

The V2 Stability Pool offers several improvements over its V1 counterpart. In V1, the Stability Pool was primarily funded by users depositing $LUSD to cover under-collateralised loans. While effective, this system lacked a continuous yield mechanism. V2 enhances this by providing ongoing interest payments in $BOLD, ensuring a more sustainable and attractive return for depositors. This change not only increases the pool's attractiveness but also supports the long-term stability and demand for $BOLD.

Liquity V2 also diverts a portion of interest revenue to liquidity providers to ensure sufficient liquidity on decentralised exchanges. This incentivised liquidity aims to maintain about 10% of the $BOLD supply available across multiple Automated Market Makers, such as Curve and Uniswap. By incentivising liquidity, the protocol ensures that users can easily trade $BOLD, enhancing its usability and stability.

Minimal Governance

Continuing the philosophy from Liquity V1, Liquity V2 minimises governance, restricting it from distributing liquidity incentives through gauge voting. The protocol’s smart contracts are immutable and non-upgradeable, ensuring predictability and security for users. This approach reduces the risk of governance-related issues and ensures the protocol remains stable and reliable over time.

Conclusion

Liquity V2 significantly improves the DeFi borrowing landscape with its user-set interest rates, expanded collateral options, enhanced capital efficiency, and sustainable yield mechanisms. By addressing the limitations of its predecessor and introducing innovative features, Liquity V2 aims to provide a more robust, user-friendly, and resilient decentralised borrowing and stablecoin system.