In March, Liquity, an innovative decentralized borrowing protocol, secured $6 million in Series A funding, led by Pantera Capital. Unlike other DeFi lending platforms such as Maker and Compound, Liquity offers unique features that make it stand out:
- A fixed 0% interest rate instead of fluctuating rates.
- A 110% minimum collateral ratio, the lowest in the market.
- A completely governance-free and algorithmic system with an immutable monetary policy.
These features have attracted significant attention within the decentralized finance (DeFi) community. Since launching on the Ethereum mainnet, Liquity has seen an overwhelming response, quickly accumulating $2.7 billion in total value locked (TVL) in just a few weeks.
But how does Liquity manage to offer a low collateralization ratio and a 0% interest rate while ensuring the system remains stable? Let’s break it down.
What Happens When Loans Become Under-Collateralized?
A major concern in DeFi lending is what happens when a borrower’s collateral falls below the required threshold. A good example is March 12, 2020, also known as “Black Thursday.” Due to extreme market volatility triggered by the COVID-19 pandemic, Bitcoin’s price dropped by nearly 50%, causing a ripple effect across DeFi lending platforms.
Protocols like MakerDAO saw large-scale liquidations of borrowers’ collateral because their positions fell below the minimum required ratio. Many users lost their funds irreversibly as the system struggled to react to the crisis in real time.
Traditional DeFi lending platforms handle under-collateralized loans by auctioning off collateral to repay the outstanding debt. However, these auctions take hours to complete, making them ineffective during sharp price crashes.
Liquity offers a revolutionary solution to this problem. Instead of relying on auctions, it introduces a Stability Pool, a system where users agree in advance to buy liquidated collateral at a discount. This ensures that when a borrower’s collateral falls below the required ratio, the collateral is instantly distributed to Stability Pool participants rather than waiting for an auction.
How the Stability Pool Works
Users can deposit LUSD, Liquity’s stablecoin, into the Stability Pool to receive a proportional share of liquidated ETH when borrowers default. This system provides two major advantages:
- Immediate liquidation of bad loans – Unlike auction-based systems, the Stability Pool allows instant collateral settlement, reducing risks during market crashes.
- High returns for Stability Pool participants – Users not only receive ETH at a discount but also earn estimated 40-60% APR as an incentive for providing liquidity.
While the Stability Pool is not risk-free—since participants are buying ETH when prices drop—it provides an opportunity to acquire ETH at lower prices, making it an attractive option for many users.
This mechanism is the key to Liquity’s low 110% collateralization ratio, allowing users to borrow more efficiently without compromising system stability.
How Liquity Offers 0% Interest Loans
Another groundbreaking feature of Liquity is its interest-free borrowing model. Unlike other DeFi platforms that charge variable interest rates, Liquity maintains a fixed 0% interest rate for all loans.
This is possible because Stability Pool participants are rewarded through discounted ETH purchases instead of interest payments. As a result, borrowers are not required to pay ongoing interest, making Liquity one of the most borrower-friendly lending platforms in DeFi.
However, borrowing from Liquity is not completely free. There are two upfront costs:
- A small borrowing fee – This fee starts at 0.5% and varies slightly based on system conditions.
- A refundable deposit of 200 LUSD – This deposit covers gas fees in case the borrower’s collateral is liquidated.
Despite these minor costs, the absence of ongoing interest payments makes Liquity an attractive option compared to traditional DeFi lending protocols.
Liquity’s Stablecoin (LUSD) and Its Role
Similar to other lending protocols, Liquity issues its own stablecoin, called LUSD. However, unlike many algorithmic stablecoins, LUSD is fully redeemable for $1 worth of ETH at any time.
This guaranteed redemption mechanism ensures that LUSD maintains a stable value close to $1 USD. If LUSD ever trades below $1 on the open market, users can profit by redeeming it for ETH, creating an arbitrage opportunity that naturally stabilizes its price.
When a user redeems LUSD, the corresponding ETH comes from the riskiest Troves (loan positions) within the system. The process works as follows:
- A user submits a redemption request for LUSD.
- The protocol identifies the riskiest Trove with the lowest collateral ratio.
- The borrowed LUSD is used to pay off the Trove’s debt in exchange for its ETH collateral.
- The Trove owner keeps any remaining collateral but has a lower debt obligation.
This redemption system strengthens the Liquity protocol by:
- Keeping LUSD stable at $1 USD through arbitrage opportunities.
- Increasing the overall collateralization ratio of borrowers.
While Trove owners might lose some ETH exposure during redemptions, they do not suffer an actual financial loss since their debt is reduced proportionally.
Ways to Use Liquity
Liquity offers multiple ways for users to interact with the platform:
- Borrow LUSD against ETH with zero interest (minimum loan of 2000 LUSD).
- Deposit LUSD into the Stability Pool to earn rewards and purchase ETH at a discount.
- Trade LUSD for ETH when its market price drops below $1 to profit from arbitrage.
- Stake LQTY tokens to earn a share of the platform’s fee revenue.
Additionally, Liquity operates without governance, meaning that its smart contracts cannot be altered by any entity. This ensures that the system remains decentralized and resistant to manipulation.
Unlike traditional DeFi platforms that operate their own front-end, Liquity allows third-party developers to create custom interfaces. The most popular interface, Liquity.app, currently dominates with nearly 80% of Stability Pool participation.
Conclusion: A Breakthrough in Capital-Efficient Borrowing
While DeFi lending platforms have become more common, Liquity has introduced a truly capital-efficient borrowing model. By eliminating interest rates and replacing collateral auctions with an instant Stability Pool, the protocol has set new standards in decentralized finance.
Its fully redeemable LUSD stablecoin, combined with a 110% collateralization ratio, offers users a highly efficient borrowing experience. As Liquity continues to grow, it is likely to shape the future of decentralized lending with its unique approach to financial stability and user-friendly design.
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