Directing Protocol Incentivized Liquidity with LQTY

Liquity v2 is slated to launch on Ethereum in November, with audits already underway. As we approach the launch, there is one more important aspect of the new protocol that has yet to be discussed in depth: protocol incentivized liquidity (PIL). It is a novel mechanism which directs a portion of v2 revenue to on-chain targets. Its goal is to create sufficient BOLD liquidity as well as to stimulate the growth of the ecosystem as a whole, all under the direction of LQTY stakers. 

In this post, you’ll learn more about:

• How protocol liquidity incentives are funded
• How staked LQTY directs incentives
• How PIL is aligned with Liquity’s existing philosophy
• Why PIL matters

Multi-collateral support, user-set rates, and a new redemption mechanism are all exciting features in their own right, but they will require predictable on-chain liquidity for BOLD to shine. 

With sustainable “real yield” at the disposal of the Liquity community, this becomes a reality.

Where do Protocol Incentives Come From?

Every Trove, or open debt position, accrues interest in BOLD every second. The entirety of these interest proceeds are continuously split between two streams: Stability Pool Rewards and Protocol Liquidity Incentives. The percentage split between the two will be hardcoded to 75% and 25%, respectively, with the deployment of Liquity v2. This split is a reflection of the importance of having BOLD available for instant liquidations, and how reliable liquidations ultimately drive down the cost of BOLD’s risk premium. So long as there are active borrowers in the system, there will be a budget for the PIL mechanism. A TL;DR of this can be found here.

How are Incentives Distributed?

Liquidity incentives accrue and are then distributed on a weekly cadence across any number of eligible initiatives, or target addresses. Their distribution is a function of gauge weighting: users with voting power can both propose and weigh initiatives as they see fit. These users can select from any combination of initiatives, and their selections remain set across future voting periods until they change it.

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The above diagram highlights two examples of potential initiatives, BOLD pools on either Uniswap or Curve, but the agnostic design of the module means that any number of potential targets can be proposed. Initiatives could expand to include compensating individual addresses for their market making; utilizing Uniswap v4 hooks; rewarding LQTY voters for their activity; incentivizing BOLD borrowers across lending markets—and so on. It would even be possible to further incentivize Stability Pools during periods of heightened collateral volatility, if needed. 

In short, the PIL module provides the Liquity community with a means to decide on what is best to stimulate the growth of BOLD, without forcing them into a limited universe of options based on the status quo of November 2024.

Stake LQTY for Voting Power

Staking your LQTY in Liquity v2 unlocks a unique, dual-reward opportunity. Not only do you gain influence over the future of Liquity v2, but your stake also continues to function in Liquity v1, earning you LUSD and ETH rewards from perpetual borrowing and redemption fees. This powerful synergy ensures you capitalize on both the stability of v1 and the innovations of v2.

Users accrue voting power over protocol liquidity incentives by staking the LQTY token. Once staked, a user’s share of total protocol voting power is determined by a time-weighted calculation. Their staked LQTY is essentially boosted the longer they remain staked. This voting power boost is not dependent on a locking mechanism, hence a user can unstake at any time, but at the cost of losing this “extra” voting power. This model ensures that defection grows more expensive over time, in comparison to something like existing voting escrow systems where the users get an increased voting power in exchange for a longer lock duration .

Votes can take two forms:

• A vote for an Initiative
• A veto vote 

Any initiative that receives more vetoes against than it does votes for will not be eligible for any directed incentives and may be deregistered as an initiative going forward. Note that the veto amount must be three times the minimum qualifying threshold to be taken into account, and that voters cannot simultaneously vote for and veto against the same initiative. Both types of votes can occur throughout the first six days of a given voting period, but only vetoes can be submitted throughout the course of the final seventh day.

Is PIL Governance?

It’s worth addressing the main implication of the above: governance, in Liquity?

Liquity has established a reputation for immutability and governance minimization. Whereas other DeFi protocols have introduced vectors for social engineering and off-chain censorship into their core contracts, Liquity v1 has stood steadfast as a rejection of that trend. All parameters were fixed at deployment over three years ago, and they will remain as such until the final Ethereum block. This commitment to an immutable and impartial core will remain true with Liquity v2.

Implementing PIL without a governance module would have forced the hardcoding of its target liquidity pools and their ratios. With the rapid pace of development of DeFi applications today, it would prove difficult to try and predict whether certain AMM venues or asset pairings would still be as relevant in a decade as they are today. 

The introduction of PIL in Liquity v2 will indeed require the deployment of an on-chain governance module, but this module is solely responsible for the allocation of protocol incentives as users see fit. It has no control over any of the core protocol parameters, all of which will be immutable after launch. Whether its role in the growth of BOLD adoption winds up being net-positive or simply neutral, the PIL mechanism will remain secondary to the underlying activity of minting decentralized dollars against (staked) Ether collateral.

It's important to note that Liquity v1 and LUSD will continue to operate alongside Liquity v2 and BOLD, providing users with options that best align with their preferences. For those who appreciate the original Liquity design, LUSD remains a viable choice.

Why PIL Matters

As we approach the launch of Liquity v2, it's crucial to recognize the significance of Protocol Incentivized Liquidity (PIL) in the broader context of decentralized finance. PIL acknowledges a fundamental truth in DeFi: secondary liquidity doesn't come for free. By implementing this feature, Liquity v2 addresses the "cold start" challenge with a sustainable, community-driven solution while preserving the core principles of decentralization and immutability that have defined the Liquity protocol to date.

What sets PIL apart is its transparent, on-chain mechanism that empowers the community to fine-tune BOLD liquidity without compromising the protocol's fundamental operation. Unlike other protocols that rely on opaque methods such as treasury funds, extensive governance decisions, or founder interventions, Liquity v2's approach is clear, sustainable, and scalable. By delegating protocol revenues to the Liquity community for this purpose, PIL aims to provide BOLD holders with the assurance of an efficiently priced, on-chain secondary market for the stablecoin.

This innovative approach to liquidity management demonstrates Liquity's commitment to evolving while staying true to its core values. As the Liquity protocol evolves, PIL is poised to play a crucial role in ensuring the success and stability of BOLD, ultimately contributing to the growth and resilience of the entire Liquity ecosystem. With these advancements, Liquity v2 is not just launching a new version of the protocol; it's setting a new standard for community-driven, sustainable liquidity in the world of DeFi.

Check out our code for how PIL governance works here: Github‍
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