Liquity is a decentralized finance (DeFi) lending protocol launched on the Ethereum blockchain in April 2021. As a fresh entrant into the DeFi lending space, it introduced a compelling innovation: interest-free borrowing against ETH collateral. Unlike traditional lending platforms that charge variable or fixed interest rates, Liquity enables users to borrow LUSD—a dollar-pegged stablecoin—without accruing any interest over time.
This unique value proposition has positioned Liquity as a strong alternative to established protocols like MakerDAO, offering greater capital efficiency and a more streamlined user experience. By accepting only ETH as collateral, Liquity enhances decentralization while simplifying risk management and user interaction.
How Liquity Works: The Core Mechanism
Liquity operates through a system of collateralized debt positions known as Troves. Users lock ETH into a Trove and mint LUSD up to a maximum loan-to-value ratio of 110%. This means that for every $110 worth of ETH deposited, users can borrow up to $100 in LUSD. The minimum debt per Trove is set at 2,000 LUSD, and there’s no expiration date for repayment as long as the required collateral ratio is maintained.
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The absence of interest payments fundamentally changes the borrower’s cost structure. Instead of paying ongoing fees, borrowers pay a one-time issuance fee when minting LUSD, which dynamically adjusts between 0.5% and 5% based on system conditions.
Liquidation and the Stability Pool: A Novel Risk Mitigation System
One of Liquity’s most innovative features is its Stability Pool, which serves as the first line of defense against undercollateralized loans. When a Trove falls below the 110% minimum collateral ratio (MCR), it is automatically liquidated by the protocol.
Unlike auction-based liquidation models used by other platforms, Liquity uses an algorithmic approach: the debt from the liquidated Trove is canceled by burning an equivalent amount of LUSD from the Stability Pool, while the entire ETH collateral is transferred to the pool. This process ensures immediate solvency without relying on external bidders or market liquidity.
Participants who deposit LUSD into the Stability Pool—known as Stability Providers—earn rewards in the form of liquidated ETH. These rewards are distributed proportionally based on each provider’s share of the pool. While they lose some LUSD during liquidations, they gain ETH at a discount, creating a powerful incentive to support the system.
This mechanism not only improves capital efficiency but also strengthens the stability of LUSD by ensuring consistent demand for its redemption and rebalancing during market volatility.
Risk Management and Recovery Mode
Despite its robust design, Liquity must contend with extreme market events such as flash crashes. During the May 2021 crypto market downturn, over 300 Troves were liquidated due to a sudden drop in ETH price. Approximately 7.9% of the Stability Pool was utilized to absorb these liquidations, acquiring ETH at an average price of $1,916.91.
To handle systemic stress, Liquity activates Recovery Mode when the Total Collateral Ratio (TCR) drops below 150%. In this mode, the minimum collateral requirement increases to 150%, and even well-collateralized Troves can be liquidated—starting from the riskiest (lowest collateral ratio) to the safest. This encourages undercollateralized users to top up their positions and incentivizes others to replenish the Stability Pool.
Additionally, a liquidation reserve of 200 LUSD is held in each Trove to cover gas costs associated with liquidation transactions. This deposit is fully refundable if the user repays their debt voluntarily, but forfeited upon liquidation. The initiator of a liquidation receives this reserve plus 0.5% of the collateral as compensation, promoting decentralized participation in maintaining system health.
Zero Interest Rates and LQTY Tokenomics
A defining feature of Liquity is its 0% interest rate model. Unlike MakerDAO, which uses variable rates to stabilize DAI’s price, Liquity eliminates borrowing costs entirely. This decision shifts value creation away from protocol-owned interest revenue and toward user benefits.
Instead of charging interest, Liquity mints and distributes LQTY tokens as rewards to Stability Providers. These tokens are not used for governance or protocol security but serve as a means to redistribute fees generated by borrowing and redemption activities.
Users can stake LQTY tokens to earn a portion of these revenues, with rewards distributed proportionally. Importantly, staked LQTY remains liquid and unlockable at any time, enhancing flexibility for participants.
This economic model creates a fairer distribution of value between borrowers and supporters of the system, fostering long-term engagement without introducing complex governance layers.
Price Stability Mechanism: Anchoring LUSD to $1
Liquity employs a multi-layered approach to maintain LUSD’s peg to the US dollar:
- Issuance and Redemption Fees: Borrowers pay a variable fee when minting LUSD, while redeemers pay higher fees when converting LUSD back to ETH. This discourages short-term speculation and stabilizes supply.
- Algorithmic Fee Adjustment: As redemption activity increases (indicating high demand for ETH), issuance fees decrease to encourage new borrowing and counteract downward pressure on LUSD’s price.
- **Hard Price Cap at $1.10**: If LUSD trades above $1.10 on external markets, arbitrageurs can profit by opening new Troves, minting LUSD, and selling it externally—thereby increasing supply and bringing the price down.
- **Arbitrage Below $1**: If LUSD trades below $1, users can buy it cheaply on exchanges, redeem it for $1 worth of ETH via Liquity, and pocket the difference risk-free.
Crucially, Liquity does not rely on oracles for LUSD pricing—it only consumes Chainlink’s ETH/USD price feed. This minimizes attack surfaces and ensures continued operation even if external data sources fail.
Frequently Asked Questions (FAQ)
Q: What makes Liquity different from MakerDAO?
A: While both allow ETH-backed stablecoin loans, Liquity offers 0% interest rates, uses a Stability Pool instead of auctions for liquidations, and has no governance—making it fully immutable once deployed.
Q: Is my LUSD always worth $1?
A: Yes, within the protocol, 1 LUSD = $1 USD. On external markets, temporary deviations may occur, but arbitrage mechanisms quickly correct them due to built-in profit incentives.
Q: Can I lose money providing stability?
A: Stability Providers risk temporary loss of purchasing power if ETH price drops sharply after receiving liquidated collateral. However, they earn yield over time through ETH rewards.
Q: What happens if the Stability Pool runs out?
A: In extreme scenarios, debt and collateral would be redistributed among active Troves based on their stakes. However, this scenario is highly unlikely due to strong incentives for continuous funding.
Q: Why only accept ETH as collateral?
A: Limiting collateral to ETH increases decentralization and reduces complexity. It avoids reliance on lower-quality or centralized assets, aligning with Liquity’s core philosophy.
Q: How does Liquity handle high Ethereum gas fees?
A: To reduce congestion, liquidations are batched. Additionally, a 200 LUSD reserve covers gas costs, ensuring timely execution without burdening users during peak network usage.
Final Thoughts: Is Liquity a Viable DeFi Lending Alternative?
Liquity presents a bold reimagining of decentralized lending—one that prioritizes simplicity, fairness, and capital efficiency. By removing interest charges and streamlining risk management through algorithmic design, it appeals to both speculative borrowers seeking leverage and conservative participants willing to support system stability.
Its immutability ensures trustlessness and resistance to political interference, while its elegant incentive structures align user behavior with protocol health. With growing adoption and resilience tested during major market downturns, Liquity stands as a credible alternative in the evolving DeFi landscape.
Whether you're looking to unlock liquidity from your ETH holdings or participate in decentralized risk mitigation, Liquity offers a compelling suite of tools—all without compromising on decentralization or transparency.
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Core Keywords: Liquity, LUSD, interest-free lending, Ethereum DeFi, Stability Pool, Troves, decentralized borrowing, zero interest loans