Interest Rate Management in Liquity V2

Interest Rate Management in Liquity V2

In Liquity V2, users set their interest rates themselves, and only they can change them.

This introduces a novel primitive to DeFi, as traditionally interest rates have been set by governance decisions or market forces. Let’s explore how to use it.

Opening a Loan

As with any CDP protocol, opening a loan requires depositing collateral - in V2, you can choose from WETH, wstETH, and rETH. Based on the collateral's value, you can then borrow, or more accurately, mint the stablecoin. On Liquity V2, this stablecoin is BOLD.

In the above example, we deposited 50 wstETH and want to borrow 22’000 BOLD. This determines the Loan-To-Value (LTV) ratio, which is crucial to manage in order to avoid liquidation. We see a LTV of 12.57% and a liquidation price of $528. This means that if the price of wstETH drops below $528 you will be liquidated. However, with wstETH trading at $528, this LTV is relatively safe, making a sudden drop to the liquidation level highly unlikely. On the other hand, if we mint more BOLD against the same collateral, the LTV increases significantly (seen below).

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With an LTV of 77.14%, our risk of liquidation is significantly higher, as wstETH only needs to drop below $3’240 for it to occur.

Key Takeaway: The LTV determines your risk of liquidation, and you can influence it by adding or removing collateral, as well as minting or repaying BOLD. Choose your LTV based on your risk tolerance and how actively you plan to monitor and adjust your position.

Setting your Interest Rate

This is where things get interesting. With Liquity V2, you now have a third parameter to control: the interest rate.

The interest rate sets the cost of your loan over time, denominated in BOLD. Additionally, it plays a crucial role in determining your risk of redemption.

Let's take a closer look at how to set your interest rate.

The rate can be adjusted using a slider or by typing it in manually.

Changing the rate affects two key aspects:

• Your loan cost: a higher rate means a higher cost.
• Your risk of redemption: a higher rate corresponds to a lower risk.

In essence, the more you're willing to pay for the loan, the higher your cost but the lower your redemption risk becomes.

Interest rates can be adjusted any time, however, there is an 7-day upfront fee charged to minimize race conditions to avoid redemptions. The fee only applies at the start of the loan and in case the user adjusts the rate more frequently than every 7 days afterward.

How Redemptions Work

Redemptions serve as a peg stability mechanism, designed to bring BOLD back up to $1 if it falls below. Unlike other DeFi mechanisms, this one doesn't rely on centralized assets or third-party managers, prioritizing resiliency and decentralization instead.

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Redemptions typically occur through arbitrage when BOLD trades below $1, as they're not profitable otherwise. Therefore, when BOLD is above $1, the risk of redemption is nearly zero.
One can think of a redemption as someone swapping their BOLD for your collateral, while at the same time paying off your debt.

They are executed in an ordered way, starting from the user paying the lowest rate, taking into account all 3 collateral markets. The split per collateral is determined by the portion of BOLD supply outside their respective Stability Pools.

In the example below, BOLD is redeemed against 5 users from all 3 markets. The split between the markets is determined by the relative “outside” BOLD supply for each.

When a user is redeemed, they don't incur any loss or fee. In fact, they may even make a small profit, as the fee paid by the redeemer is sent to them. However, they do lose their collateral exposure (ETH or LSTs) and will need to re-purchase it.

How to Avoid Redemptions

Apart from the price of BOLD, the key parameter to monitor is the debt in front of you.
You can view this on the interest rate panel.

This shows how much BOLD would need to be redeemed before it's "your turn".  The more debt in front of you, the safer you are, and vice versa. The histogram shows the interest rate distribution of Troves for this collateral type.

If you want to be keep your rate as low as possible, you should be actively doing 2 things:

• Monitor the price of BOLD, since no redemptions should happen when >$1
• Monitor stablecoin rates at other CDP’s and lending markets - two good sources are Defillama and Superlend.

Automated Interest Rate Management‍

Soon after launch, we expect specialized rate delegates to offer rate management services.
For a small fee, you'll be able to delegate rate setting to them, freeing you from having to manage this aspect of your loan yourself.

[We will update this section once the rate management is live. If you want to become a rate manager, do hit us up on Discord]

Key Takeaway: Your interest rate determines both the cost of your loan and your risk of redemption. Lower rates reduce your cost but increase your redemption risk. Set your rate in line with how actively you want to manage it.