Total collateralization has fluctuated quite widely, while mostly remaining above 300%. While collateral types that are more volatile than Ether usually command higher collateralization ratios, the average is mainly dragged down by stablecoins such as USDC and USDT, which require very low safe collateralization ratios.
High collateralization ratios are mainly required due to relatively inefficient/slow collateral auctions. By the time a liquidation is executed, the collateral could have fallen further in value significantly, which necessitates a higher margin of safety.
The incident in March 2020, in which the price of Ether sharply crashed, showcased flaws in the mechanism (which have been fixed by making it slower). Network congestion prevented most liquidation bots not successfully bidding in the auction, which enabled some liquidators to acquire Ether collateral for $0 (to the detriment of the owner of the collateralized debt position). As a result, the process has been made slower, with the duration of auctions has been extended from around 10 min to 6h (while being recently reduced to 4h).
No direct redemption mechanism
In systems like MakerDAO there is no possibility of direct redemption against the collateral by anyone which rules out direct arbitrage cycles, making it harder to maintain a tight peg (see Hasu). There have been recent improvement proposals though that instantiate a protocol controlled treasury — the Peg Stability Module — that acts as a CDP — automated market maker hybrid to alleviate that issue (anyone can mint/redeem DAI at 1:1 gross of fees as long as there is capacity in the direction of the trade).
Liquity is primarily designed as an interest-free collateralized borrowing mechanism, while leveraging the LUSD stablecoin as an enabler but not its primary product. The mechanism provides a differentiated and often superior proposition than fixed or variable interest lending, particularly for long-term borrowers (given fees are one-off). One of the core innovations is a more efficient batched liquidation process, which allows for lower collateralization, increasing capital efficiency and thus utility to users demanding leverage.
An immutable set of smart-contracts coordinates and incentivizes the different stakeholders involved: 1) borrowers (who provide collateral in ETH), 2) holders of the LUSD stablecoin (with an option to stake in the “Stability Pool”) 3) liquidators (who trigger liquidations), and 4) frontend operators.
The design specifically optimizes for low barriers of participation. The liquidation mechanism significantly reduces the capital requirement for liquidators (they only need to call a smart contract). LUSD holders willing to take additional risks and earn rewards from liquidations can stake LUSD in the Stability Pool without needing sophisticated infrastructure (such as liquidation bots in other systems).
Next to liquidations, Liquity utilizes a unique redemption mechanism to establish a price floor.
Co-founder Robert, concisely presented the mechanisms at EthGlobal, so we recommend watching the explanations first-hand here.
Zero-coupon leverage over indefinite time: The better fixed rate borrowing
In Liquity, no interest is charged, while instead one-off issuance and redemption fees are to be paid. While fees are dynamic between 0.5% — 5% depending on the rate of redemptions, which serves as a sensor for the stability mechanism (see below), they are known to the user at the time of opening or redeeming positions. As a result, users can adequately plan without sudden changes in cost over the lifetime of their position.
From the borrowers’ perspective, this setup basically mirrors a zero-coupon bond — they receive the loan amount net of the fixed issuance fee, with the difference that the loan is over an indefinite time period. Thus, the longer one retains the loan position, the lower the implied interest rate over time, which is especially favorable for long-term borrowers when compared with alternative products.
Liquity can offer loans with one-off fees only due to 1) the mechanism’s ability to mint stablecoin debt without re-financing costs and 2) due to the availability of “hard-peg” mechanisms without the need of interest-rate manipulation.
These mechanisms incentivize as well as enable rapid and direct arbitrage to restore the peg, when facing volatility. This is contrary to the previously described time-lags in ongoing governance intervention for managing a peg.
Price floor at USD 1 through direct redemption mechanism
The native stablecoin LUSD is redeemable against the underlying collateral held by the borrowers at any time at face value (e.g. $1 worth of Ether for 1 LUSD). The system uses the LUSD to repay the riskiest Troves (Liquity’s CDPs) with the lowest collateral ratio, and transfers the respective amount of Ether from the affected positions to the redeemer.
Price ceiling at USD 1.1 due to 110% min. collateral
On the flipside, if LUSD’s price appreciates beyond USD 1.1 arbitrageurs can take out a loan, and sell the freshly minted LUSD, pushing down the price again. As long as the trader booked profits net of fees beyond 1.1, he does not need to mind the threat of liquidations, as 100% of the collateral would be returned in the form of LUSD in that case.