diff --git a/papers/whitepaper/Liquity Whitepaper rev. 0.2.tex b/papers/whitepaper/Liquity Whitepaper rev. 0.2.tex index 35fba9e6f..e4e6547c3 100644 --- a/papers/whitepaper/Liquity Whitepaper rev. 0.2.tex +++ b/papers/whitepaper/Liquity Whitepaper rev. 0.2.tex @@ -40,15 +40,15 @@ \section{Introduction and competitive landscape} \subsection{Stablecoins and collateralized debt platforms} Cryptocurrencies such as Bitcoin or Ether have shown significantly higher price volatility than traditional asset classes like stocks or bonds. Nevertheless, many people use tokens for investments, payments, trading or pure speculation. -Fiat-backed stablecoins like Tether, USDC, Paxos and TrueUSD have emerged as a stable, but centralized alternative to volatile tokens. Additionally, crypto-backed stablecoins have become increasingly popular and a fundamental driver for the recent Decentralized Finance (DeFi) movement. Acting as collateralized debt platforms, MakerDAO, Equilibrium and Synthetix allow holders to lock up volatile tokens in exchange for freshly generated stablecoins. Owners can thus unlock some of the current economic value of their volatile tokens while remaining fully invested. Beyond that, token holders can achieve leverage by using the obtained liquidity to lock up additional collateral and get even more liquidity. +Fiat-backed stablecoins like Tether, USDC, Paxos and TrueUSD have emerged as a stable, but centralized alternative to volatile tokens. Additionally, crypto-backed stablecoins have become increasingly popular and a fundamental driver for the Decentralized Finance (DeFi) movement. Acting as collateralized debt platforms, MakerDAO, Equilibrium and Synthetix allow holders to lock up volatile tokens in exchange for freshly generated stablecoins. Owners can thus unlock some of the economic value of their tokens while remaining fully invested. Beyond that, token holders can achieve leverage by using the obtained liquidity to lock up additional collateral to get even more liquidity. \subsection{Shortcomings of collateralized debt platforms} -Collateralized debt platforms do not rely on lenders to provide liquidity as they can mint the stablecoins themselves. With no refinancing costs, such systems can generate liquidity for free. Yet, most platforms charge recurring fees for borrowing (as high as 20.5\% p.a\footnote{Stability fee charged by MakerDAO in summer 2019}) which accumulate over time. The variable fees (stability fees) are meant to regulate coin supply in order to maintain the peg of the issued stablecoin, and correspond to an interest rate in traditional banking. Affecting new and existing loans alike, interest rates only have an indirect impact on monetary supply and are rather ineffective in the short term. While existing borrowers may not have the means to repay their loans as an immediate reaction to an interest raise, short-term speculators and leverage seekers might not be greatly affected by interest rates in the first place. +Collateralized debt platforms do not rely on lenders to provide liquidity as they can mint the stablecoins themselves. With no refinancing costs, such systems can generate liquidity for free. Yet, most platforms charge recurring fees for borrowing (as high as 20.5\% p.a\footnote{Stability fee charged by MakerDAO in summer 2019}) which accumulate over time. The variable fees (stability fees) are meant to regulate coin supply in order to maintain the peg of the issued stablecoin, and correspond to an interest rate in traditional banking. Affecting new and existing loans alike, interest rates only have an indirect impact on monetary supply and are rather ineffective in the short term. While existing borrowers may not have the means to repay their loans as an immediate reaction to rising interest, short-term speculators and leverage seekers might not be greatly affected by interest rates in the first place. -In theory, governance token holders are expected to govern the economic parameters of the systems (e.g. set the fee rate) in the best interest of the protocol. In practice, on-chain governance has been a difficult and heavily debated topic, with notoriously low turnouts, potentially misaligned incentives, and a high concentration of power in the hands of a few. +Often times, governance token holders are expected to manage the economic parameters of their systems (e.g. set the fee rate) in the best interest of the protocol. In practice, on-chain governance has been a difficult and heavily debated topic, with notoriously low turnouts, potentially misaligned incentives, and a high concentration of power in the hands of a few. -In addition to charging stability fees, current platforms typically require the individual borrower’s position to be significantly overcollateralized\footnote{130\% (Equilibrium), 150\% (MakerDAO) or even 750\% (Synthetix).}. This makes the positions capital inefficient, especially when considering that borrowers tend to maintain much higher collateral ratios in practice than the minimum\footnote{The overall total ratio of MakerDAO and Equilibrium is usually between 250\% and 500\%.}. Existing platforms require overcollateralization due to the liquidation mechanisms that these systems apply to positions that become undercollateralized. Both collateral auctions and fixed-price selloffs have turned out to be inefficient by design, leaving room for improvement. +In addition to charging stability fees, existing platforms typically require the individual borrower’s position to be significantly overcollateralized\footnote{130\% (Equilibrium, MakerDAO ETH-B), 150\% (MakerDAO ETH-A), or even 750\% (Synthetix).}. This makes the positions capital inefficient since borrowers tend to maintain much higher collateral ratios in practice than the minimum\footnote{The overall total ratio of MakerDAO and Equilibrium is usually between 250\% and 500\%.}. Existing platforms require overcollateralization due to the liquidation mechanisms they apply to positions that become undercollateralized. Both collateral auctions and fixed-price selloffs have turned out to be inefficient by design, leaving room for improvement. -Finally, current crypto-backed stablecoins are not generally redeemable at face value and cannot guarantee a hard price peg due to the lack of direct arbitrage cycles\footnote{See https://medium.com/@hasufly/maker-dai-stable-but-not-scalable-3107ba730484.}. There is no issuance or redemption mechanism that would enable arbitrageurs to make guaranteed profits by buying freshly minted stablecoins or selling them back to the protocol whenever the price deviates from the peg. Instead, the systems rely on a less effective soft peg mechanism, which stabilizes the exchange rate by making the loans more or less attractive through variable fees. Crypto-backed stablecoins are thus usually subject to higher price volatility than fiat-backed stablecoins.\\ +Finally, crypto-backed stablecoins are not generally redeemable at face value and cannot guarantee a hard price peg due to the lack of direct arbitrage cycles\footnote{See https://medium.com/@hasufly/maker-dai-stable-but-not-scalable-3107ba730484.}. There is no issuance or redemption mechanism that would enable arbitrageurs to make guaranteed profits by buying freshly minted stablecoins or selling them back to the protocol whenever the price deviates from the peg. Instead, the systems rely on a less effective soft peg mechanism, which stabilizes the exchange rate by making the loans more or less attractive through variable fees. Crypto-backed stablecoins are thus usually subject to higher price volatility than fiat-backed stablecoins.\\ To summarize, existing collateralized debt platforms have the following downsides: \begin{itemize} @@ -75,7 +75,7 @@ \subsection{Interest-free liquidity} Users are free to utilize their stablecoin, LUSD, to participate in the broader DeFi market consisting of many different products which are designed to generate yield. \subsection{Low collateralization ratio (110\%)} -When an individual position’s collateral ratio falls below a certain threshold, a lending system must take special action to ensure the stablecoin supply remains fully backed. In existing systems, this is done by liquidating the position in an interactive process. Selling the collateral from undercollateralized positions at a fixed price is inefficient by design as it requires a significant discount to the current collateral price to ensure that it can be sold quickly in difficult situations. Collateral auctions replace discounts by an economically fair but potentially lengthy and error-prone\footnote{On March 12 (“Black Thursday”) and 13, 2020, 35 000 ETH worth \$8.32 million were withdrawn through zero bids in MakerDAO’s collateral auctions due to the dramatic increase of the Ethereum gas price. See https://medium.com/@whiterabbit/black-thursday-for-makerdao-8-32-million-was-liquidated-for-0-dai-36b83cac56b6} bidding mechanism. The longer it takes to sell the collateral\footnote{The duration of the auction usually depends on the number of bidders, which creates an unfortunate tradeoff since a large number of bidders is good for the auction, but potentially leads to longer auctions and higher exogenous price risks.}, the higher the risk that its value might drop further. Auction-based systems thus have to set their liquidation ratio\footnote{The ratio between the current collateral value (in USD) and the debt below which a liquidation may occur. The liquidation ratio may or may not equal the minimum collateral ratio needed to open a position.} high enough to provide an extra margin for subsequent price drops during liquidation. +When an individual position’s collateral ratio falls below a certain threshold, a lending system must take special action to ensure the stablecoin supply remains fully backed. In existing systems, this is done by liquidating the position in an interactive process. Selling the collateral from undercollateralized positions at a fixed price is inefficient by design as it requires a significant discount to the current collateral price to ensure that it can be sold quickly in difficult situations. Collateral auctions replace discounts by an economically fair, but potentially lengthy and error-prone\footnote{On March 12 (“Black Thursday”) and 13, 2020, 35 000 ETH worth \$8.32 million were withdrawn through zero bids in MakerDAO’s collateral auctions due to the dramatic increase of the Ethereum gas price. See https://medium.com/@whiterabbit/black-thursday-for-makerdao-8-32-million-was-liquidated-for-0-dai-36b83cac56b6} bidding mechanism. The longer it takes to sell the collateral\footnote{The duration of the auction usually depends on the number of bidders, which creates an unfortunate tradeoff since a large number of bidders is good for the auction, but potentially leads to longer auctions and higher exogenous price risks.}, the higher the risk that its value might drop further. Auction-based systems thus have to set their liquidation ratio\footnote{The ratio between the current collateral value (in USD) and the debt below which a liquidation may occur. The liquidation ratio may or may not equal the minimum collateral ratio needed to open a position.} high enough to provide an extra margin for subsequent price drops during liquidation. Liquity applies a novel two-step liquidation mechanism aimed at instantly liquidating undercollateralized positions. Since the acquirers are known in advance, there is no need to find a buyer for a collateral buyout on the spot when a position becomes undercollateralized. This advantage allows for a considerable reduction in the collateralization ratio, while keeping stability high. The system also relies on sufficient collateralization of all positions in aggregate, rather than on the collateral of individual positions. @@ -97,13 +97,13 @@ \subsection{Censorship resistance} Frontend operation is provided by third parties which make the system decentralized and resistant to censorship, while benefiting from growth incentives. Frontend Operators can either download the web interface provided as a launch kit or opt for creating their own custom user interface and integrate it with other services. \subsection{Growth and early adopter incentives} -Users that drive growth and robustness by contributing to system stability get rewarded with LQTY, the system's secondary token. These tokens can be staked in order to earn a proportion of the protocol revenue stemming from issuance and redemption fees. The protocol continuously issues LQTY to front ends and to users who have deposited LQTY to the Stability Pool. LQTY is issued according to a release schedule that halves the number of tokens distributed each year, favoring early adopters. +Users that drive growth and robustness by contributing to system stability get rewarded with LQTY, the system's secondary token. These tokens can be staked in order to earn a proportion of the protocol revenue stemming from issuance and redemption fees. The protocol continuously issues LQTY to front ends and to users who have deposited LUSD to the Stability Pool. LQTY is issued according to a release schedule that halves the number of tokens distributed each year, favoring early adopters. The allocation of LQTY between Frontend Operators and users is based on a kickback rate that can be freely set by the front end operator between 0\% and 100\%. Front ends will thus compete via the kickback rates, making the system attractive to users and early adopters. \section{System functionality} \subsection{Borrower operations } -Anyone may obtain liquidity anytime in an entirely permissionless manner after depositing ETH into a \textbf{trove\footnote{Each trove is linked to a specific Ethereum address. An Ethereum address can only own one single Trove.} }.The deposited ETH collateral gets locked up in the trove and allows its owner to withdraw up to \textbf{90.91\%}\footnote{Called loan-to-value ratio or LTV.} of its current dollar value in the form of LUSD stablecoins. In other words, the trove must always maintain a \textbf{minimum collateral ratio (MCR)} of 110\%, defined as the ratio of the current dollar value of the collateral to the withdrawn liquidity. Borrowers can repay or borrow more liquidity within the limits of the MCR whenever they wish. Within the same limit, they can retrieve their collateral. Moreover, a Trove can be topped up with more collateral as needed. \\ +Anyone may obtain liquidity anytime in an entirely permissionless manner after depositing ETH into a \textbf{Trove\footnote{Each Trove is linked to a specific Ethereum address. An Ethereum address can only own one single Trove.} }.The deposited ETH collateral gets locked up in the Trove and allows its owner to withdraw up to \textbf{90.91\%}\footnote{Called loan-to-value ratio or LTV.} of its current dollar value in the form of LUSD stablecoins. In other words, the Trove must always maintain a \textbf{minimum collateral ratio (MCR)} of 110\%, defined as the ratio of the current dollar value of the collateral to the withdrawn liquidity. Borrowers can repay or borrow more liquidity within the limits of the MCR whenever they wish. Within the same limit, they can retrieve their collateral. Moreover, a Trove can be topped up with more collateral as needed. \\ \textit{Liquidation Reserve}. When a borrower opens a new Trove, an amount of 50 LUSD is reserved and held back by the protocol as a compensation for the gas costs if the Trove needs to be liquidated at some point. The 50 LUSD is added to the Trove's debt, leading to a minimum collateral requirement of 55 USD worth of ETH\footnote{This requirement also makes it harder to spam the system by creating very small Troves.}. When a borrower closes their Trove, the Liquidation Reserve is refunded, i.e. the corresponding 50 LUSD debt on the Trove is cancelled. The borrower thus needs to pay back 50 LUSD less to fully pay off their debt. \\