Liquity v2 - Solving the stablecoin trilemma?

One of the most exciting announcements coming out of ETHCC in Paris this week was Liquity Protocol announcing v2.

After speaking to @robert_lauko I am eagerly awaiting to see how v2 could potentially solve the ever elusive stablecoin trilemma.

A quick primer on the stablecoin trilemma:

Stablecoins consist of 3 major traits:

  • Scalable

  • Decentralised

  • Stable peg

The Stablecoin Trilemma
The Stablecoin Trilemma

Its common for stablecoins to be strong in 1 or 2 of these traits, however we are yet to see a stablecoin achieve all 3 traits to build the ideal stablecoin

Liquity will be attempting to solve the stablecoin trilemma by innovating on the decentralized reserve backed delta-neutral hedged style of decentralised stablecoin that has previously been attempted by protocols such as Angle or UXD.

Reserve backed stablecoins are a promising design for stablecoins as they are inherently more scalable than other types, such as over-collateralized stablecoins with decentralised collateral (LUSD for example). However, there are challenges with keeping the peg tight and the system collateralised as the price of the reserve backing asset begins to fall during market downturns.

When a user wants to mint a decentralised reserve stablecoin, they must deposit some of the reserve asset to mint the stablecoin. Lets run through an example to make this clear:

Alice holds 1E which is worth $2000 at current prices. She then decides that she wants to sell this ETH to realise her profits but does not want to sell to a centralised fiat-backed stablecoin and take on the counterparty risk that is associated with those.

Alice can then come to Liquity v2 and deposit her 1E ($2000) for 2000 v2USD. This now means that Alice is essentially short ETH and Liquity hold 1E and a $2000 liability owed to Alice.

If the market price of ETH is increasing, everything is great as the 2000 v2USD Alice holds are now backed by >$2000 worth of ETH.

When the market is trending down, this is when the issues with decentralised reserve stablecoins arise. If ETH falls below $2000, the v2USD Alice holds will be unbacked and wont be worth $1 each. This can lead to a death spiral which has been the result of past efforts at this design.

Past efforts have attempted to counteract this problem via inflationary token incentives (bad for token price) or by trying to hedge the reserve collateral long position held by the protocol. This has usually been attempted via in-built perpetual futures or via centralised exchange futures contracts.

Neither of these attempts have proven successful, primarily due to the reliance on funding rates and the reduced appetite for leverage during times of high market volatility or downturn.

So when the protocol needs actors to hedge the collateral the most, they are not willing to do it.

Liquity are looking to innovate on the previous attempted delta-neutral hedging style of reserve backed stablecoins by focusing on the demand for leverage when the market is volatile.

This is achieved by leveraging two novel mechanisms:

Innovation 1:

Users: Demand for leverage reduces as the market is more volatile or trending down. This is a logical reaction by market participants as capital preservation becomes priority & risk taking reduces during market downturns.

Liquity have thought about how you can increase the demand for leveraged long positions as the market is falling and claim they have discovered a way to create principal protected leveraged positions.

Principal protected (PP) positions are enabled via a dynamic premium that is paid by a user who opens one of these positions. Depending on the collateralization ratio of the reserve and user demand, the system automatically adjusts the premium to make PPs more or less attractive to new participants looking to open a position.

Leverage is enabled as price of the collateral increases, the reserves that have been deposited by v2USD minters also increases in value, these extra reserves that are no longer needed to back the stablecoin and can be used to pay out the hedgers leveraged positions.

If the price of the collateral falls, the premium also reduces, making these positions more desirable and should increase the demand for these positions (which adds to the backing of v2USD).

These premiums are then collected by the protocol to finance the principal protection.

By offering principal protected leverage positions, Liquity believe they will be able to tap into the proven demand of crypto participants ‘buying the dip’ on leverage, however now these users can do this with only their premium on the line as they know their principal will be protected.

*This also means that the lower the price goes towards the v2USD backing, the lower the premium and in-turn the higher the leverage for people who are longing the collateral. This enables stakeholder alignment and should mean that the demand for leverage increases as price falls….which is exactly what is required for delta-neutral reserved back stablecoins to function correctly.

Innovation 2:

Liquity will be building a specialised secondary market that a principal protected position holder can try to sell their position p2p on a secondary market - ideally for a premium above the principal protected amount.

If a position is not being bought by other market participants off the secondary market, Liquity will subsidise this position to increase its attractiveness until it is purchased. This results in the protocol only having to subsidise those positions which need it most until they are sold to another actor. These subsidies then remain within the protocol until the position is redeemed.

In the last few months, we have seen a plethora of new stablecoin projects launch, most of them are Liquity v1 forks with different collateral types (usually stETH). These projects are leveraging the current LSDfi narrative, however they do not innovate or attempt to solve the stablecoin trilemma.

After watching Roberts presentation at ETHCC and wrapping my brain around the game theory dynamics of Liquity v2 I am excited to read the white paper and see the details of v2. Liquity have built the most decentralized and robust stablecoin on the market, LUSD, I believe this is the team that could finally solve the stablecoin trilemma with Liquity v2:

Scalability - Reserve backed stablecoin

Censorship resistant - ETH or some form of staked ETH as collateral

Stable peg - Principal protected leverage to hedge the reserve backing and a secondary market for these principal protected positions to be sold p2p rather than redeemed.

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