Introduction and Motivation

In April 2021, Liquity introduced the world’s first fully decentralized stablecoin that runs autonomously without human governance. With its attractive borrowing product allowing an LTV of up to 90.9%, Liquity V1 has successfully issued over $4.75b in loans against ETH by minting its own stablecoin, LUSD. In addition to pushing the boundaries of capital efficiency and decentralization, Liquity has brought interest-free loans to the DeFi space, catering to the zero interest environment of the time.

Liquity V1 also pioneered the first CDP system with a built-in redemption mechanism to create a stablecoin with a strong downward peg protection with no dependency on centralized collateral. The redemption feature allows any LUSD holder to exchange their stablecoins for $1 worth of ETH. When LUSD is below peg, users can buy it for e.g. $0.99 off the market and sell to the protocol for $1.00 worth of collateral (see blog post).

This mechanism maintains a hard price floor around $1 through direct arbitrage, and is key for LUSD’s reputation as the most resilient stablecoin; many existing stablecoins have suffered from downward peg deviations due to high sell pressure.

On the flipside, redemptions in Liquity V1 impact the riskiest borrowers as the redeemed LUSD is used to pay back the loans with the lowest collateral ratio in exchange for an equivalent amount of ETH. The affected borrowers see their collateral and debt go down equally, implying no net loss but a reduced exposure to ETH.

Since the launch of Liquity V1, the macroeconomic situation and the interest rate environment in DeFi have changed drastically. Due to the skyrocketing market rates for stablecoins and a lack of a competitive yield source, LUSD has been subject to high sell pressure and soaring redemption volumes. Liquity V1 borrowers reacted by increasing their collateral ratios to previously unseen levels, just to avoid redemptions. This has seriously impaired Liquity V1’s ability to provide capital-efficient loans.

Being interest-free in nature and with its fixed-cost reward system, Liquity V1 has shown to work reliably in low interest environments, and it continues to be a viable option for borrowers in such scenarios. But in high interest rate situations, users tend to seek stablecoins with higher yields.

To handle such market fluctuations effectively, Liquity V2 innovates by introducing user-set interest rates: the borrowers can choose their own interest rate, whatever they are willing to pay! Through user-set interest rates, redemptions can be neatly married with dynamic interest rates. Instead of targeting the loans with the lowest collateral ratio, redemptions will now be performed in ascending order of individual interest rates. Borrowers with low interest rates thus have the highest risk of being affected by redemptions. Users can freely manage their redemption risk by adjusting their interest rates relative to their peers (or delegate the management to third parties). Offering recurring interest rates, V2 is also more attractive to short-term borrowers than Liquity V1 with its upfront loan origination fees.

Based on the borrowers’ individual risk tolerance, the market will establish a range of individual interest rates. Borrowers willing to risk redemptions may set below-average rates for capital efficiency, whereas more risk averse or “set-and-forget” borrowers may opt for an above-average rate for peace of mind. Thus, the system handles borrowing volumes in a more adaptive way while allowing the protocol to earn a variable interest revenue on a continuous basis. The protocol can thus achieve flexible interest rates purely through market forces without relying on governance or algorithmically controlled interest rates.

In contrast to Liquity V1 which only accepts ETH as collateral, Liquity V2 will further tap into a larger market by enabling users to borrow against WETH as well as several LSTs like e.g. Lido's wstETH. LSTs allow users to earn staking rewards on their staked assets while maintaining liquidity and have become increasingly popular as collateral in DeFi projects, including some of Liquity’s forks.

Due to Liquity V1’s non-upgradeability, Liquity V2 will be a separate protocol issuing a new stablecoin, called BOLD, which inherits LUSD’s most admired characteristics. BOLD will be safe, decentralized, unstoppable and directly redeemable. Beyond that, BOLD will benefit from improved peg dynamics and protocol-incentivized liquidity (PIL) on secondary markets.

Building upon Liquity V1’s proven achievements, Liquity V2 makes use of Stability Pools (one for every collateral) as its primary mechanism to liquidate undercollateralized loans with no detrimental price impact on the stablecoin. The interest payments will act as a sustainable real yield source for BOLD depositors and liquidity providers.

These improvements make Liquity V2 fundamentally incentive aligned: the more you are willing to pay as a borrower, the more revenue you contribute to drive demand, stability and liquidity for BOLD as a stablecoin. User-set interest rates enable a capital efficient equilibrium between BOLD borrowers and holders in a fully market-driven manner. Borrowers can thus effectively benefit from Liquity V2’s attractive loan to value (LTV) ratios which don’t impact their redemption risk.

When the demand for ETH-based loans or multiplication is low and the demand for stability high, Liquity V2 enables loans for as low as 0.5% p.a. On the contrary, when demand for multiplication is high, the protocol will offer ETH-loans at competitive market rates with attractive LTV ratios. With that, Liquity V2 offers a vastly improved borrowing experience, catering to a larger market while adhering to the high security standards known from Liquity V1.