For nearly three years, Liquity has stood as a cornerstone within DeFi. With over $4.5 billion in loans issued, and its status as the most forked stablecoin protocol, its impact is undeniable. 

We share a steadfast commitment to the principle of decentralization, resulting in a protocol that stands immutable and autonomous in the face of fluctuating market conditions. While this journey has been marked by success, it has also brought to light some challenges like addressing evolving user needs (demand for liquid staking tokens), and future-proofing against macroeconomic dynamics (interest rates).

This introspection, combined with recent market trends, has highlighted several key areas for improvement. With the insights gained from the last few years, we're embarking on a fresh journey of innovation. 

As we open this new chapter, we’re proud to introduce one of our most significant innovations to date: user-set interest rates. This feature represents a significant leap forward with CDPs, empowering users with unparalleled control, while also addressing current challenges and future dynamics.

Crafting a superior CDP model

Initially, we explored the idea of a novel Reserve-backed stablecoin. However, after extensive research and repeated modeling over several iterations, we realized that the final product would face a difficult product-market fit due to economic uncertainties and lack of market maturity.
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Furthermore, the past three years have provided us with invaluable insights: the primary challenge has transitioned from scaling borrowing demand, which was at the heart of our reserve-backed approach, to scaling stablecoin demand in an environment with rising interest rates.
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This shift, along with the understanding gained from Liquity’s original product, has illuminated areas where our current system can improve, and highlighted opportunities for innovation within our codebase.

While numerous forks have emerged, most have barely improved on our original design. They have primarily focused on adding new collateral types and governance complications aimed at short-term gains rather than long-term resilience. However, we do recognize that governance, if limited to peripheral or non-critical aspects of the system, can actually be advantageous, especially in areas like managing external liquidity.

So what improvements does the new protocol bring?

The new protocol will offer the best borrowing experience, a highly resilient Ethereum-native stablecoin,  and sustainable on-chain yield. It will be adaptive to any market environment, while also having minimal centralized exposure.

Let’s take a quick look at some of the key enhancements it introduces:

- User-set interest rates: Unlike other CDPs and money markets where interest rates are typically set algorithmically or by governance, the new protocol gives users the power to choose their interest rate. However, this freedom comes with strategic considerations as borrow rates affect the loan position’s redemption order (more on this below). This flexibility allows users to tailor their borrowing experience based on their risk profile, providing them with full control over their open positions.

- Better redemption protection: User-set interest rates also largely alleviate the redemption concerns seen in Liquity; as redemptions will now be based on an ascending order of interest paid. Users can avoid getting redeemed by paying higher interest rates (rather than keeping a high collateral ratio).  This new borrow-rate model will also make redemptions less likely in general, as interest payments determine the yield paid out to stablecoin depositors within the Stability Pool.

- Adaptive to all economic conditions: Unlike Liquity’s fixed one-time borrowing fee, the introduction of user-set interest rates makes the system dynamic and responsive to a changing economic environment. Users will be able to adjust their interest rate at any time throughout the lifecycle of their loan, or delegate it to a third party manager or smart contract.
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- Improved peg dynamics: The new protocol’s introduction of dynamic borrowing rates and a market-responsive monetary policy will provide an additional lever to manage the stablecoin’s peg.
Instead of having a fixed one-time rate that does not actively counteract over-pegging, there will now be in-built mechanisms in place to help the peg below and above $1.

‍- Multiple LSTs and ETH as collateral: The new stablecoin can be borrowed against various LSTs and ETH, while allowing borrowers to keep the generated yield. This means that the new stablecoin will be completely Ethereum-native with no ties to fiat or TradFi assets.

‍- Built-in liquidity incentives: Maintaining liquidity is costly and time consuming. While a liquid market for LUSD developed over time, the new protocol aims to get there quicker. It will funnel a portion of the interest fees to select pools, thereby providing built-in, sustainable and continuous liquidity incentives.

- Sustainable real yield:  In the new protocol, stablecoin holders will be able to earn real and sustainable yield coming from interest fees and liquidation gains. This will offer a sustainable and fully on-chain yield-venue for depositors. The Stability Pool yield in the new protocol will be reactive to changing market conditions ensuring enhanced sustainability of stablecoin demand and a reduced likelihood of strong sell events, like what happened to LUSD in Q2-Q3 2023.

- Capital efficiency: Liquity was designed to push the boundaries of capital efficiency by introducing the minimum collateral ratio of 110% and improved liquidation mechanisms. However, due to the redemption pressure, it's not been able to live up to its goals consistently. Our new product aims to change that.

- Ecosystem for builders to build on top of: We are strongly convinced that the introduction of this new DeFi primitive, centered on user-driven interest rates, not only enhances its direct appeal to users but also opens doors for developers and protocols. A key feature of the product is the ability for user-set interest rates to be delegated, enabling interest rates to be managed by third party managers or smart contracts. This functionality encourages developers and protocols to build novel integrations (eg. a tool to manage interest rates) on top of our infrastructure, fostering innovation.

So how is this new protocol an evolution on CDP models seen to date?

Compared to CDPs of yesteryear, the new product aims to solve the crucial aspect of balance between borrowing and stablecoin demand. This is achieved through the introduction of user-set interest rates.
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In contrast to Liquity, borrowers on the new protocol will have the freedom to set their own interest rates, and change them at any time. This autonomy not only caters to diverse borrower preferences, but also impacts their risk levels. By choosing higher interest rates, borrowers can reduce the likelihood of being affected by redemptions, thereby aligning their individual incentives with the stablecoin peg dynamics of the system.
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This approach is mutually beneficial: it provides borrowers with the tools to adjust to an ever-changing market, while promptly reflecting those shifts in the monetary policy of the protocol itself. For example, when there is significant sell pressure on the stablecoin and redemptions pick up, borrowers can protect themselves by increasing their borrowing rates. The resulting higher fee payments serve as direct revenue to the Stability Pool, driving demand for the stablecoin which subsequently helps the stablecoin peg and lowers redemption risk. Thus, the protocol has built-in incentives to reach an equilibrium between the demand for the stablecoin and the supply created through borrowing.
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Furthermore, the protocol achieves this balance while maintaining a decentralized approach, diverging from peers that have “centralized" collateral assets or modules. This is especially interesting for users who value trust minimization; the protocol will not have any counterparty or collateral risk connected to fiat or real world assets as it is only backed by LSTs and ETH. The addition of LST’s will broaden the protocol’s appeal to a more diverse group of borrowers, increasing the addressable market while future-proofing it.
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Within the Liquity ecosystem, users will now have access to multiple borrowing options tailored to their preferences and risk profile. Liquity offers a robust, battle-tested framework that prioritizes ETH as collateral, ideal for long-term borrowing, while the new protocol introduces user-set interest rates and diverse ETH variants, appealing to those with different borrowing needs. This means that the Liquity ecosystem ensures that all users, regardless of their risk appetite and goals, find a suitable option for their ETH or LSTs.

Setting the stage for future discussions

By creating this new protocol, we aim to pioneer a more adaptable and capital-efficient CDP protocol without sacrificing resiliency.
In the coming weeks and months, we will be releasing detailed articles that will delve deeper into each improvement, providing insights and data-driven analyses of how these features will shape the future of CDP-based borrowing protocols. Some of these topics include:
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- User-set interest rates and the borrowing enhancements 
- The inner workings of the stablecoin
- The LSTs that will be used as collateral
- The new best-in-class approach to non-centralized frontends
- and more

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