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“Though we are apt to take it for granted, it is by no means of the essence of money that within a given territory there should exist only one kind… there are always significant differences in the demand for different forms of money and money substitutes of varying degrees of liquidity.”
– F.A. Hayek, “Denationalisation of Money,” Third Edition, 1990, p. 77
In Latin, trivium refers to “the place where three roads meet.”
In this post, I’ll discuss how Liquity Protocol’s (LQTY-USD) upcoming v2 stablecoin protocol, which aspires to solve the stablecoin trilemma, can potentially be interlaced with both its v1 borrowing protocol and its associated stablecoin, LUSD (LUSD-USD), as well as its related Chicken Bonds protocol, to mutually benefit vis-a-vis apportioned liquidity incentives.
For the sake of brevity, I will assume the reader is familiar with these various products, so I will not go into great detail on their defining traits. One is thus encouraged to refer to the associated documents for LUSD and Chicken Bonds as linked above, and to read up on the preliminary information that has been provided with regards to Liquity’s forthcoming v2 stablecoin protocol, in order to better understand the ideas shared below.
Overview
An unanswered question as it relates to Liquity’s v2 stablecoin protocol is whether there will be any connection with it and its v1 borrowing protocol.
Particularly, LQTY holders are waiting in suspense to see if they will somehow stand to gain from v2’s protocol revenue, as they currently receive all of v1’s protocol revenue in the form of LUSD borrowing fees and ETH (ETH-USD) redemption fees, depending on how much LQTY they have staked.
As it stands, we don’t know if or how LQTY, and by extension the v1 borrowing protocol more broadly, may reciprocate with the v2 stablecoin protocol. Hence, this post seeks to propose three ideas for how the three products originating from the Liquity team – Liquity v1, Chicken Bonds, and Liquity v2 – can imaginably meet at a crossroads for shared gain.
Note that details regarding the v2 stablecoin protocol’s revenue model are currently unavailable, but since we know it won’t be collateral-based like the v1 borrowing protocol and will instead utilize a reserve-backed approach, an overarching assumption of this post is that it could favorably incentivize holders of the v2 stablecoin to sustain the necessary backing for an in-built reserve from a portion of its revenue, while allocating a portion of its revenue to uphold synergy with v1 and Chicken Bonds too.
I. Introduce boosted LQTY via Chicken Bonds
“Yield from liquid staking has the potential to form the base of structured products in the coming future… liquid staking rewards are relatively stable and predictable, making them a reliable source of cash flow to create structured products.”
– Danny Chong, “Where Liquid Staking Meets Tokenization,” CoinDesk – Opinion, 9/29/23
In a recent and extensive interview with a few members of the Liquity team, a discussion ensued as to whether the LQTY token in its staked state can be used for other purposes, akin to how there are liquid staking tokens to represent staked ETH, for example. In response, it was mentioned by the Liquity team members that this is currently not available, though it was noted that the idea, if pursued, “could carry us a long way.”
Interestingly, there exists the capability to offer a liquid staking derivative for LQTY via the associated yet separate Chicken Bonds protocol. This derivative, akin to its proof of concept in the form of boosted LUSD (bLUSD), would be known as boosted LQTY (bLQTY), since it would offer auto-compounded yield as represented by its rising market price floor. A similar concept was developed several months ago by Yearn Finance (YFI-USD) in the form of yLQTY, though its very limited number of holders suggests that it does not appear to have gained much traction as of yet.
Unlike bLUSD, bLQTY could be a more simpler design, as there would be no need for an in-built shifting functionality for peg maintanence, since LQTY is not a stablecoin. Presumably, offering bLQTY should be possible when considering the Liquity team contemplated introducing a Generalized Chicken Bonds implementation for other DeFi protocols in the future based on its lessons learned from bLUSD.
As proposed herein, a portion of v2’s revenue may be directed to incentivizing liquidity for a bLQTY + LQTY pool, akin to the 3% “Chicken In” fee with bLUSD, such that the corresponding “Chicken In” fee may then be reduced for bLQTY. Accordingly, LQTY holders could indirectly benefit from some of v2’s revenue vis-a-vis the rollout of bLQTY, and bLQTY could represent a kind of enshrined liquid staking token that encompasses all three of Liquity’s products, conceivably facilitating its use as a collateral option across other DeFi protocols as well.
II. Liquidity Incentives for bLUSD
Like the proposal above for bLQTY, a portion of v2’s revenue may be directed to incentivizing liquidity for the existing bLUSD + LUSD3CRV trading pool. This would augment the 3% “Chicken In” fee for bLUSD that already incentivizes this pool, further boosting the appeal of acquiring bLUSD and/or providing liquidity for it.
Since bLUSD is already integrated as collateral in Gravita Protocol, a friendly fork of Liquity’s v1 borrowing protocol, this idea could drive its use for such a purpose and could perhaps compel other DeFi protocols to consider integrating it as a whitelisted collateral asset too. This idea may also revitalize interest in bLUSD, which has dwindled since the beginning of this year per its treasury dashboard.
III. Liquidity Incentives for the v2 stablecoin and LUSD
Building on the aforementioned ideas, a portion of v2’s revenue may similarly be directed towards incentivizing a liquidity pool for the v2 stablecoin and LUSD.
“The crucial point it must keep in mind will be that, to keep a large and growing amount of its currency in circulation, it will be not the demand for borrowing it but the willingness of the public to hold it that will be decisive.”
– F.A. Hayek, “Denationalisation of Money,” Third Edition, 1990, p. 62
Since the v2 stablecoin is intended to be more scalable than LUSD, it will naturally compete with more centralized stablecoins and their derivatives, and eventually the v2 stablecoin may even supplant these highly liquid alternatives because of its added benefit of being censorship-resistant.
Consequently, it would be sensible to pair the v2 stablecoin with LUSD, as this would cultivate a “ying and yang” balance between the two since LUSD has proven its resilience as the most decentralized, collateral-based stablecoin on Ethereum, particularly since banking concerns around centralized stablecoins heightened earlier this year.
Notably, since the v2 stablecoin will be linked to staked ETH, it will compromise a bit on decentralization since liquid staked ETH derivatives come with their own smart contract risks, and what form(s) of staked ETH the v2 stablecoin protocol will be reliant upon have yet to be disclosed. Hence, since LUSD is backed by ETH alone, it mitigates this issue in terms of its decentralization, though it is restrained in terms of its scalability.
To add, a bonded version of the v2 stablecoin via Chicken Bonds may not be necesssary, since it will inherently be designed to be more capital efficient and thus more liquid than LUSD. As such, a pool composing of both stablecoins may be sufficiently incentivized to foster their utility beyond their respective intra-protocol reserve and stability pools.
In fact, it will be essential for both stablecoins to be incentivized for use outside of their corresponding protocol’s in-built yield sources, as this will bolster their demand for being held and used in circulation, which will ultimately sustain the growth of their circulating supplies. This is especially critical when considering centralized stablecoins and their derivatives are providing their holders higher yields as a consequence of their exposure to treasury bonds offering rising interest rates; it is for this reason, for example, that some have postulated that LUSD has been trading below its $1 peg in recent months.
Conclusion
Liquity’s v2 stablecoin protocol is expected to launch sometime in 2024, enabling users to employ some form(s) of liquid staked ETH derivatives to mint the v2 stablecoin itself.
By designing the v2 protocol in such a way that some portion of its revenue is directed towards upholding the utility of Liquity’s v1 borrowing protocol vis-a-vis Chicken Bonds and liquidity incentives for both the v2 stablecoin and LUSD itself, the Liquity team would reinforce the strategic cohesion and synergistic capacity of its three product offerings, ergo paving the path for wider co-marketing possibilities.Although LUSD will be less scalable than the v2 stablecoin, it is important for the Liquity team to keep in mind that it has an established Lindy effect due to its immutable and uncompromised existence that now exceeds two and half years since its debut on Ethereum mainnet in April 2021, and its continued utility should therefore be supported.
On a related note, Ethereum Foundation researchers such as Justin Drake have similarly indicated that future proposed improvements to Ethereum, such as MEV burn, are intended to foster the use of “pristine, raw ETH” as collateral in DeFi protocols, and as such, LUSD is in a class of its own among stablecoins.
In the above-cited interview with Liquity’s team members, it was remarked, “What Bitcoin is for money, Liquity is for stablecoins.” Although this was in reference to the distinct decentralization properties of Liquity’s v1 borrowing protocol and LUSD, I hope this post reflects how this quote may be applicable from a broader point of view: Liquity’s three product offerings can supplement their individual innovations to collectively advance Liquity’s adoption and market share in a global stablecoin market that some say may ultimately surpass a $1 trillion market capitalization in the coming years.
To conclude, it is my estimation that Liquity’s upcoming v2 stablecoin protocol, alongside its v1 predecessor and Chicken Bonds protocol, are not mutually exclusive developments and can potentially complement one another as a trivium of structured products interwoven by liquidity incentivies predicated on real yield that could truly uplift Liquity’s renown in DeFi at large.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
