Liquity - Technical Summary
Liquity is a decentralized governance-free protocol that allows Ether holders to obtain unprecedented liquidity against their collateral without having to pay interest. After locking up ETH as collateral in a smart contract, the user can get liquidity by minting LQTY, a redeemable USD-pegged stablecoin. The individual liquidity positions called “troves” are open-ended with no fixed repayment schedule. Each trove is required to be collateralized at a minimum of 110%, which is significantly lower than the collateralization requirements of existing DeFi platforms. High-collateral borrowers and Stability Pool depositors provide stability to the system and are rewarded for their role by receiving collateral surplus gains from liquidated troves.
A novel liquidation mechanism allows Liquity to be more capital efficient than its competitors while remaining robust against price shocks. When a trove falls below the minimum ratio, the system liquidates its debt by burning an identical amount of QUI tokens held in a Stability Pool.
The Stability Pool is Liquity’s primary mechanism to instantly absorb undercollateralized troves. It is maintained by users who deposit LQTY in exchange for the future collateral of liquidated troves. In case of a liquidation, the collateral is distributed proportionately among all depositors and is expected to yield a net gain to the pool: the collateral is almost always worth more (in USD) than the LQTY tokens that are burned to offset the debt. This holds because the liquidation is triggered below a collateral ratio of 110%, but with a very high probability above 100%.
Despite the financial incentives to deposit LQTY tokens to the Stability Pool, it can happen that the size of the pool is not sufficient to fully absorb every liquidated trove. In such a situation, the system redistributes the remaining defaulted troves to all existing troves, in proportion to their collateral amounts. By redistributing the riskiest positions to the safest and extra incentives during times of low collateralization, Liquity quickly stabilizes itself via direct feedback loops.
Similarly to fiat-backed stablecoins, LQTY is redeemable at face value against the underlying collateral. Whenever 1 LQTY trades below $1, holders and arbitrageurs are incentivized to redeem 1 LQTY for $1 worth of ETH. This helps to stabilize the price of LQTY through direct arbitrage rather than by relying on indirect monetary interventions like variable interest rates set by governance. When redeemed, the system uses the LQTY to repay the riskiest trove(s) with the lowest collateral ratios and transfers the respective amount of ETH to the redeemer.