Liquity V2: A De Facto Reference Rate for DeFi

DeFi borrowing rates have largely been set in one of three ways:

• By Governance (e.g., MakerDAO)
• By Predetermined Utilization Curves (e.g., Compound, Aave, Llama Lend)
• By Preset Fee (e.g., Liquity v1)

All three models leave little room for true rate discovery, as borrowers lack direct autonomy over the rates imposed by protocols. In essence, the rates on these protocols are “take it or leave it”.

Liquity V2 presents an alternative model. Borrowers are no longer mere takers of pre-set rates. Instead, they become makers of their own interest rates, allowing for a true rate market to emerge.

Crypto has always been about free markets, and we’re excited to give power back to users with the first true market-driven borrowing rate for ETH.

Empowering Borrowers

Why is it important that borrowers in Liquity V2 can set their own interest rates? Let’s take a quick look at how most DeFi money markets and CDP stablecoins work today.

Money markets are just that: markets. However, the rates paid by borrowers, and those paid out to lenders depend upon predetermined utilization curves that can be volatile and untethered from the wider ecosystem of borrowing avenues. Furthermore, these utilization curves are often static and arbitrarily chosen, which may not suit all market scenarios.

Lenders may instantly influence the rates by depositing or withdrawing funds from the respective pools. As seen below, once a borrower opens a position, their rates remain ever changing as market utilization dictates how much they pay. Not only are these rates quite volatile, their possible range will have been decided at some point in the past.

What’s the risk for lenders (i.e., market suppliers)?

While lenders are paid for illiquidity risk via such a utilization function, they are not necessarily earning the entire spread that could be available to them (more on this here). Thus, lenders take on the risk of not being able to withdraw their funds without being paid appropriately.A recent example of this came about with CRV depositors on Llama Lend.

As a result of the CRV token dropping in price faster than liquidations could be properly executed, the CRV/crvUSD pool was left undercollateralized. With the utilization ratio of the pool breaching 100%, borrow rates spiked up to over 100%, and CRV depositors were left unable to withdraw their collateral. This episode underscores the utilization risks inherent in money markets as well as the importance of effective liquidation mechanisms.

With Liquity V2’s redemption mechanism, liquidity providers in V2’s secondary pools are not exposed to the risk of being unable to withdraw their assets, as they can always redeem for the underlying collateral (eg. ETH). 

‍How About Collateralized Debt Positions (CDPs)?

‍Leading CDP based stablecoins) face a similar conundrum: interest rates set by governance preclude the formation of a true market. From the borrower’s perspective, it’s simply “take it or leave it”, leaving room for short-term decision making that may not always be in the best interest of all stakeholders. Not to mention the fact that these changes are always lagging, reacting to events which happened days, if not weeks, earlier. An example of this on Maker can be seen below:

For the average borrower on both these platforms, it means taking on the burden of additional risk and market inefficiencies that these protocols create. This unpredictability makes it challenging for borrowers and lenders to plan their financial strategies effectively.

So how does Liquity V2 buck this trend?

To date, there’s not been an effective method of discovering a benchmark DeFi market interest rate for ETH. Rates on the protocols mentioned above are always fluctuating based on various factors like governance decisions, algorithmic adjustments, and utilization factors.

Liquity V2 changes this by being completely market driven, allowing truer rates to be created through free market forces. This capitalistic approach can both create and complement a de facto reference rate for borrowing against ETH within DeFi.

In Liquity V2, interest rates are set in a proactive, rather than a reactive, manner.
Imagine a borrower who anticipates lower interest rates due to broader macro conditions - under the examples above, they’d continue to be subject to the rates imposed on them. Under Liquity V2, borrowers can set their rates based on their expectations, providing greater control and predictability.

If this theoretical borrower is wrong, however, and the cost of borrowing against ETH should be higher than what they’ve opted to pay, they open themselves up to the risk of being redeemed against. Because redemptions in Liquity V2 are executed on the basis of a trove’s interest rate rather its current loan-to-value ratio, “excessive” minting of cheap BOLD will be rectified by arbitrageurs picking off the lower bound of the protocol’s rate positions.

Moreover, this innovation is not limited to Liquity users alone. Other DeFi protocols can refer to the market-driven rates that Liquity V2 provides, using them as a benchmark or reference rate. This can help create a more cohesive ecosystem for rates across DeFi, where rates are determined by actual market participants rather than arbitrary decisions.

Liquity V2 provides a decentralized building block where users are in full control over the rates that they pay, and one where the terms are set in stone; there is no governance involved in the core system. For borrowers who value capital efficiency, it also provides a forward looking venue where you can ‘price in’ expectation of rates according to your outlook. User-set interest rates thus enable a market segmentation from a cost-versus-risk perspective, which is not possible in existing borrowing venues.

‍Access to a new market

‍For lenders, Liquity V2 provides access to a sovereign stablecoin that provides real, sustainable yield (in the form of interest fees paid) that perfectly fits into this market-driven framework. BOLD’s collateral exposure will be limited to just ETH (and select LSTs), with no subsequent additions possible after deployment thanks to its immutability. Liquity V2 will give power back to users - enabling them to define how much they’re willing to pay for liquidity against their ETH exposure, while also giving them full predictability over their costs.It will create a market where borrowers are not just participants, but true market makers that help set the standard for DeFi borrowing.

‍Meet us in Brussels!

‍The Liquity team will be at Stable Summit and ETH CC where we’ll do in-depth talks on Liquity V2. We will also be co-hosting a Spaces at the venue everyday (more on this soon), where we’ll talk about the daily happenings in Brussels.Whether you’re a passionate DeFi enthusiast, ecosystem builder, or even a LP, we’d love to meet you! Feel free to get in touch via our socials.