ETHWarsaw 2023: Robert Lauko & Cedric Waldburger, Liquity - Leverage with less Risk

okay so let's start another talk on on stable coins uh by Robert and Cedric so let's give them a warm welcome good morning all right good morning so we're going to talk about a few interesting topics one of them being leverage um but before we in with the complicated stuff uh quick intro Robert and I have been working together on a few different projects in the past uh we met while we were both working on definity uh that's the foundation behind ICP uh then we started liquid chicken bonds um we're going to talk a bit more about liquid and also we've always enjoyed giving presentations together this picture is from 2016 uh when we were trying to explain to a group of people that had never heard the term blockchain what it is and why it's useful and so 7 years later we're we're still on stage and today we're going to talk um about some of the innovations that go into bold which is going to be uh the newest project that we're working on together but first a couple things about liquid quick hands up who has used liquidy cool great that's cool to see um so then I'm not going to go into too much detail but basically liquidity is uh a way to get zero interest loans that's really been the innovation that Robert came up with the way it works is uh you go on one of the front ends that you can find on the liquid. org page you deposit some ethereum into a loan uh sorry into a trove and then you borrow against that you get a loan in liquidy US dollar that's a stable coin and instead of uh paying uh an interest every month or every year like you would do in traditional Finance web 3 makes it possible that you only pay a small fee and then you get to keep your loan for as long as you want want and the beauty of this is you can stay long your eth if you're bullish on E prices long term and at the same time you can take out a loan in the stable coin that you can also convert into actual US Dollars and we've seen people buy houses and cars and finance part of their daily life while still remaining long eth liquid has been doing pretty well um of course it's been turbulent times for us as well but we just recently hit a new all-time high for open TRS see the graph here and there were just over uh 1300 that were open a couple weeks ago so briefly the three values that we that were kind of guiding us when we built liquid de number one is decentralization that's something that's always been very close to Robert's heart and not only do we only use decentralized technology it's built on E mainnet but also we decentralized the front ends so um the website that you saw before liquid. org is not actually where you can use the dep that's only a place where you can get info about liquid and then if you want to actually open a trove take out a loan you can go on any of these uh websites what we did is we built a framework that people can use to run their own front end some um as you can see like liquidy app or CP 0x they uh pretty much use the the default front temp but then there's also been a lot of other apps like defi saver or instap that uh just used it to integrate the uh liquidy into their existing dep the second guiding principle uh is that we wanted to build it in a very mutable and reliable way um you can go and check out the contracts they were deployed in April 2021 and of course uh you cannot only verify that they haven't been changed since then but that they also can be changed and then the third guiding principle of course uh since since the app involves the stable coin is that it should be stable and for the liquid US dollar LUSD that meant remaining between a dollar and a doar and10 um the reason why it's a band is because it uh the incentives are structured so that it's between a dollar and A110 so it's not exactly packed to $1 but to that band and that worked out but at the same time as as you all know like a stable coin the closer it's packed to its real life uh counterparty in this case the US dollar the better it be and the reason why the stable value came as the third and not the first in that uh priority of principles that we used is that first and foremost we wanted to make zero interest borrowing possible so it was borrowing first and then stable coin second but since we've all seen that there's quite a bit of uh turbulence and challenges with uh stable coins even the ones that we deemed uh fairly uh safe in the last 12 months the team sat down and we started thinking about how we could solve that last piece of the puzzle can we create a fully decentralized scalable but also uh stable stable coin and uh if you look at the stable coin trma I'm sure lots of you are familiar with these uh you have the algorithmic stable coins that are typically scalable and decentralized but unfortunately haven't proven to be very stable in the past you have the Fiat based ones that are scalable and stable but of course because they have that Fiat uh Reserve they're not very decentralized and then you have the decentralized and stable ones that so far haven't been very uh scalable mostly because they depend on catalized De positions and people don't really want to take out a loan or belong a certain asset if markets are going down we all kind of know how uh this went I could probably now be put in the fiop category the algorithmic ones have mostly failed unfortunately so we thought a bit more about how can we what can we do about um this like third property that we're missing the scalability in our stable coin how can we keep it decentralized and stable but also add scalability to it and the solution typically is that we want to add a way for people to Mint the stable coin where they can uh give us one eth and and say uh eth is worth 1 $1,000 today get or mint a th000 stable coins um in return and go the other way as well the challenge with this why this has been hard for decentralized stable coins is that it requires a reserve and that Reserve needs to be managed um because now we've taken one E from you we've given you $1,000 if in the next hour the E price changes up or down we need to somehow make sure we still uh stay hatched and cover the entire outstanding debt that we've given out through our stable coin and the challenge why this has been hard and why other projects have failed so far is that hatching this Reserve is costly hatching typically requires some sort of Leverage and uh if you're not familiar with what average is quick example uh basically it means you borrow money to make a financial investment because you think the cost that you pay to borrow that money is much smaller than the gain that you can get from the additional income or capital gains so uh if you uh let's say The Ether price goes from $1,000 to $1,010 and you currently just hold eth then your position goes up exactly with 1X right like uh your one e is now worth $10 more 1% more but if you own a leveraged eth position let's say with a 10x leverage and that price change occurs then already your price changes by 10% so you now either have $11,100 or if the change goes the other direction you only have $900 worth of e so far so good but what can also happen if you take on a lot of Leverage um in this case if you had a leverage def position that's leverag by 100 X then if the price goes up great you've doubled your um uh net worth basically or your asset value but if it goes the other way so only a 1% change down from 1,000 to 990 Dollar in E your position is evaporated um because you lose $1,000 with that leverage so Leverage is something that's pretty um it's interesting a lot of people in the financial markets use it but it can also it it has this uh side of um not being linear and therefore uh sometimes um just being a lot more riskier than holding the underlying asset you you could use liquid or when you when you use Liquid what you essentially get is you get leverage right because you go and you deposit your ethereum which you still can get back you still own that position but now you also take out a loan against it so you have more assets now you have the loan plus what's in your trove and of course you could go and repeat this cycle you could now use the liquid US dollar loan that you've taken out to buy more eth and then you can go back and deposit that eth in another Trove and take out some more LUSD turn that into eth again and so forth and that's how you could leverage yourself in decentralized manner uh using liquidy there's also some tools like defy saer that automated this so you can go there and um they will do this looping this what this process is called it's called looping you can do that and because the collateralization ratio on liquid is at least 110% theoretically you can get up to 11x of Leverage so there's different types of uh leverage um all with certain pros and cons I'll quickly talk about the first two so you can either go borrow on the money market um the difference to what we just discussed with liquidy is that you would typically pay an interest rate but the process is pretty much the same and your leverage ratio is typically a bit smaller uh 1 to 5x and the risk of course is that you can get liquidated meaning that if the price drops and your position evaporates or gets wiped out then you lose your entire asset we briefly or we we spoke about borrowing via a collateralized St position now uh you could use Liquid for that um again here you could you could pay an interest rate or a small fee uh The Leverage is typically a bit higher and the risk roughly Remains the Same um of course some of these tools have built in protections against liquidations and then there's a couple more ways to get leverage as well but I'm not going to talk about them in detail but what you see is on the leverage ratio that you can get a lot more leverage um to the point where it probably gets uh pretty risky and where you want to have pretty sophisticated Tools in place to monitor the volatility of your positions all right and at this point I'll pass it over to Robert who's going to talk a bit more about a new type of Leverage so in order for us to crack the stable coin tremma we knew that we had to figure out a way around the downsides of some of these um ways to get leverage and Robert's going to talk a bit about what we're using for bold and how that works yeah thanks so much s for this great introduction and hello everybody um yes so as Cedric just said we are now introducing a novel concept of Leverage and we are doing this using or by offering our own new stable coin called bold so what is bold all about so basically it's a reserve backed stable coin which means that instead of you know borrowing it through cdps you would just mint it against the reserve one to one which means you just Prov some collateral asset which in our case will be some form of State ease we don't know which one yet so it's here just a state a placeholder so people bring their basically Stak ease to Min the stable coin but now the problem is we need to make sure that the stable coin remains over collateralized so we need another group of people to bring more State e to the system to kind of um increase uh The Leverage or sorry to increase the reserve and the over collateralization and and and by doing so those people who add more stake ease to the reserve they will get leverage in return and we'll see how that works so basically when Bob comes along and and and uh yeah brings some more uh stake EAS to the system he will get a claim he will get a prata share of this Surplus or excess collateral that will of course change over time but he has this claim and he can always like in perpetuity kind of make his claim and say Hey I want to get my prata share of this Surplus back so it's a Perpetual position and of course as I mentioned when East goes up this Surplus will of course increase as well and it will increase more than the East price because you are exposed not just to the part to the Stak asset that you deposited but you are also exposed you know to the price movement of the entire Reserve so there is this inherent leverage here and also vice versa when the East price goes down yeah you're you're your prata share your Surplus claim will also go down by more than just the East price um the leverage ratio itself is dynamic because you can think of it when this Surplus becomes very small then even a small East price movement will have a big effect a big impact on on the Surplus and thus on your own position so the leverage ratio itself will increase over time another interesting aspect of the system is that it can off offer this leverage basically for free because it already has all the assets available it has the assets that people use to M the stable coin and it can use the price exposure from those assets to kind of provide leverage to those that bring even more of the the collateral asset so this has this advantage of yeah not requiring any borrowing fee or any you know Capital cost so the system can fully pass on its seniorage gains or its like um the fact that it has those assets available to The Leverage Seekers um and now an important thing to maintain for the system is of course this over collateralization and it does so by basically attracting more people like attracting more Capital to this Reserve whenever this Surplus becomes too small like whenever the collateralization ratio of the entire system drops below a certain Target level um the protocol will try to attract more capital and by doing so it can also avoid liquidation of the existing leverage Seekers because um they are basically owning a prata share of this Surplus so even though of course when the price goes down their share will also decrease but they are not subject to liquidation as opposed to most other hedging products on the market now the question is how can the protocol attract more Capital especially in times of distress in downturns in bare markets here we are introducing a novel concept which is not so novel in trefi but pretty unique in in Defi and this is principal protection so what the system basically offers now to Bob The Leverage Seeker is that his principle let's say 10 State e in this case will be protected which means that Bob should be able to get at least this 10 e back from the system how can we do that now the idea here is that Bob will need to pay or have to pay an additional amount to get this protection because it's like an insurance and the insurance of course is something you would pay for so the system would kind of sell this principle protection by charging a premium on top of the principle in in this case let's say two State e and the way this is determined is through an auction the system always tries to maintain like a certain Target collateralization and whenever it's below the level that it wants to maintain it would kind of reduce the premium to make it more attractive and vice versa when the system is fully like plenty like in collateral then it would it can increase the premium and this premium yeah as here like shown goes to a specific fund or protection like pool where it can be used later to actually provide the protection and now it's important to keep in mind that this prum that you pay is not a s cost it's not something it's not like a fee that you pay and it's gone but it's it remains part of your investment and we'll see what it means in a sec because what it really means is that when you try to sell your position on the market this protection should also be priced in so it's not just your current claim on the Surplus but also this protection that people should price in when they buy um such a position on the secondary market and that's exactly what Bob can do I mean he can try or he can sell his position to another person Ellis and um hopefully or luckily in this case he was able to even get a higher price so here because the markets for example uh went up he could even sell his position for 13 stake de making one e gain now Ellis got the claim against the system of course now when the markets go down this becomes more difficult because now Bob's claim has um Fallen now maybe it's only five State E's current claim of the Surplus because the Surplus itself is smaller but still he has this principal protection of 10 and now if he tries to sell this position for 10 Stak e that's the minimum he wants to claim that's that's what like the system really guarantees that he can he should be able to get 10 Stak e for dis position no matter what and when he tries to sell it maybe nobody would come and and buy it because the markets are not very um liquid at the moment and this is the moment when the system would step in like after certain time out period the system would then start increase the intrinsic value of this position by increasing this prata share or this kind of claim of Bob and it does so gradually like in an auction it would now increase the five state is of Bob to 5.1 5.2 and so on until eventually um Ellis or somebody comes and buys it for 10 stake teeth because now the whole package of this 10 State East principal and the 5.

3 um State East core is worth enough or verth a bit more than st e and that's the moment when when Ellis would buy it because then it's a good value for her and of course now Ellis um owns a larger claim against the system larger than what Bob did and the system even though it had to pay some subsidies those subsidies are only a tiny fraction of the principle and the subsidies stay within the system because it's basically just moving funds around it's just moving funds from this protection pool or fund to this Reserve Surplus so we are not really leaking or the system is not leaking value it's just repurposing value to make Bob's position um become so to say verse more until it gets bought and Bob kind of gets this principle so yeah what that means as from a product perspective is that now we have an interesting yeah leverage product which uh has an amplified upside but like a kept downside because here you see even though it can go down and it can also it will go down kind of in an amplified manner there is like this cut off line where the principal protection would kick in and cap your your losses so means the worst or the most that you can lose loses the premium that you paid but not not more than that um and it's also interesting to look at how the intrinsic value and the fair value like the kind of the estimated market value of such a position would behave and here this is an example with like a bit made up numbers here you see the same position that Bob opened by investing 12 Stak e for a principle of 10 uh which initially is the same as the claim so when you open the position your initial claim would equal your principal like this 10 and then you have a premium on top these two stake de now if eer goes up let's say about 25% you will see here that your position also goes up like first of all your claim goes up because now your claim will be become higher than the principle that you paid and interestingly the premium will shrink so uh it means that as the core so as this claim and the principle of your position diverge or get like further apart the principle would become smaller but still if you look at the end result uh this 2 25% price increase results in a 37.5 increase of your the total value of your investment so you see this Amplified upside here now in the other case when the East price goes down by 25% uh you will see that your claim now becomes smaller than the initial principle so in this scenario you would not want to claim your Surplus share because it's only five while your principle of 10 is still protected but you see that even in this scenario there could still be some premium on top at least uh based on the market conditions people should still be willing to pay more for this position than just the 10 because they would price in the possibility that the claim would eventually go up and exceed the principle so it's like you can think of it as like a B on the upside and like a bond or something that um protects like your initial investment and if you kind of combine the two um there should be a premium in most cases I mean except those extreme uh situations where the premium completely vanishes but here you also see the end result that the total value um went down by less than 25% on the like this total value is the the value that you would get on the secondary market so yeah um what does that mean now for your strategy as a holder of such a position I mean there are basically three different scenarios one is the normal or most likely one so you open the position and maybe e just moved the bit side vers or a bit up or down and eventually you want to get rid of your position because you need the money um then what you would do is typically you would sell it on the secondary Market at a premium like sell it for something which is more than its principle but then there is also the happy pass where the East price goes up a lot uh which means that your your claim like Surplus will Surge and and that's also the case when eventually the premium would kind of vanish or completely go down to zero and that's the moment when you would optimally want to claim your Surplus and then there is the not so happy pass when the East price plummets and and then what you would eventually do is um obtain your principle and that's through this mechanism that I I just briefly um explained where the system would need to subsidize the position that kind of push the core up until somebody comes and buys it for the principle so the holder got like this uh principle covered yeah um I mean if we want to put this a bit into context with existing systems I think it's a pretty unique value proposition um because it means really a kept downside it's not just you know as with let's say a curve USD um a soft liquidation or a dampened uh downside that you would usually have let's say when using a power Perpetual but it's it's uh it's really like a relatively hard cut off like you know exactly what your your maximum es in terms of State ease like the principal protection is guaranteed in terms or in units of State e rather than US Dollars that's maybe important to keep in mind and the cool part is that there is no fee there is no Capital cost the you don't need to pay anything no hedging or no you know funding rate to keep this position open and you can keep it open perpetually so it's a yeah it's basically free leverage with this principle protection on top and it can be tokenized as as an nft so you can sell it on the built-in secondary Market that is offered by basically our protocol to put everything together um I mean we have this Reserve um yeah with its asset and liabilities side and what we can now kind of get out of it are three products if you want one is the stable coin which is now as Cedric like initially explained now scalable stable and um and still decentralized and then we have this very interesting Leverage product to keep it over collateralized and if we want to like provide even more we could also provide CDP based borrowing um but that's something we we are kind of currently still discussing whether we want to offer it or not it has pros and cons but here you see the three products with all their like you know benefits over existing um like um services so I guess uh this gives you a bit of an overview what we can achieve with this novel um Reserve based system yeah that's it from my end um or from our end I think if you have questions I'm happy to or we are happy to take them uh we'll have time for one question only so uh I don't know guys may be uh here so uh where's the protocol Revenue coming from yeah that's a great question so um this protection fund for example um it can be come quite large So based on you know or depending on the East price um as people open more and more positions and they will eventually close those positions without needing principal protection it means that the protection fund would kind of acquire more and more funds and eventually there is a situation where you can probably kind of cut off some part of it like maybe like make a gain that's not needed now for the protocol because now it has made like it has plenty of funds in this pool so that that's one way of yeah making gains okay let's do one more uh is there a situation there is a market failure where your your subsidies are not enough to compensate yeah I mean that that's the risk that we are currently modeling like how would this protection fund behave I mean in in let's say in in bare markets and fles crashes so would it still be sufficient to cover all the subsidies I mean the first results look promising but it's still an ongoing research so we want to make sure that we yeah optimize this subsidy mechanism uh to the extent possible um so what's the plan for bootstrapping the system um good question I mean probably we need to start with um some excess collateral like before people can even start minting the stable coin you need to kind of prepare it or pre fund it with some leverage positions so that you have this buffer to start with and then a bit later the stable coin can start and people can me the stable coin but the idea is that people would kind of line up a bit in advance because they know when the stable coin is activated uh they would get this free leverage and maybe because you said uh the idea is uh I mean we're planning to launch this in about a year from now and we're actively working with all kinds of Market participants to uh make sure there's enough liquidity from the GetGo liquidity game awesome uh so great thank you very much uh Robert and Cedric uh it was a [Applause] pleasure