LUSD is a stablecoin in the Liquity protocol that aims to maintain a stable value against the U.S. dollar. LUSD's price stability mechanism mainly relies on two core mechanisms: the hard peg mechanism and the soft peg mechanism. These mechanisms are implemented by user-led arbitrage, thereby ensuring the value stability of LUSD. How these mechanisms work is explained in detail below.
Hard hook mechanism
The hard hook mechanism consists of two important parts:
The ability to exchange LUSD for ETH
Minimum mortgage rate 110% guaranteed
The ability to exchange LUSD for ETH
One of LUSD’s hard peg mechanisms is that users can exchange 1 LUSD for $1 worth of ETH. This means that even if the market price of LUSD is below $1, users can receive $1 worth of ETH by exchanging it. This convertibility provides price support to LUSD, preventing its price from falling below $1 in the long term.
Guarantee of a minimum mortgage rate of 110%: In order to further ensure the stability of the value of LUSD, the Liquidity Protocol requires that all borrowings must maintain a mortgage rate of at least 110%. This means that for every $1 of LUSD issued, there must be at least $1.1 worth of ETH as collateral. This high collateralization ratio ensures that LUSD maintains a stable value even if the market fluctuates.
Soft hook mechanism
The soft hook mechanism consists of two parts:
Schelling point of LUSD parity with USD
Dynamically adjust stablecoin minting fees
Schelling point of LUSD parity with USD
The Liquidity Protocol treats LUSD as equivalent to the U.S. dollar, and this parity is the protocol’s implicit equilibrium state. When the price of LUSD falls below $1, users can engage in arbitrage by buying LUSD at a low price and exchanging it for $1 worth of ETH, thereby pushing the price of LUSD back up to $1.
Dynamically adjust stablecoin minting fees: When the price of LUSD falls below $1, Liquity will dynamically adjust the fees for minting stablecoins (new debt). This will increase the cost of borrowing and reduce the attractiveness of borrowing, thereby reducing the entry of new LUSD into the market and preventing LUSD from continuing to depreciate.
What is redemption? Redemption is the process by which users exchange LUSD for ETH at face value. For example, a user who pays x LUSD will receive x USD worth of ETH. Users are free to redeem LUSD for ETH at any time, but redemption fees may be charged during the redemption process.
Calculation of redemption fee: The redemption fee is determined by the basic rate and the amount of ETH redeemed. The base fee is a dynamic variable in the Liquidity protocol that increases with each redemption and decays with time since the last fee event (i.e., the last redemption or LUSD issuance). The redemption fee is calculated as follows:
markdown redemption fee = basic rate * redeemed ETH
Example: Assume the current redemption fee is 1%, the price of ETH is $500, and you redeem 100 LUSD, you will receive 0.198 ETH (0.2 ETH minus the redemption fee of 0.002 ETH).
The difference between redemption and debt repayment: Redemption is a completely separate mechanism and different from debt repayment. Repaying debt requires adjusting the debt and collateral of Trove (debt warehouse), while redemption involves exchanging LUSD for ETH.
How to avoid being redeemed? To avoid being redeemed, users should maintain a high collateralization ratio relative to the rest of the vaults in the system. When a redemption occurs, the riskiest vaults (i.e. the lowest collateralized vaults) will be redeemed first. Therefore, maintaining a higher mortgage rate reduces the risk of redemption.
in conclusion
As a stablecoin in the Liquity protocol, LUSD's price stability mechanism relies on hard peg and soft peg mechanisms. Through user-led arbitrage and dynamic adjustment of fees, LUSD is able to maintain a stable value against the US dollar. Users can exchange LUSD for ETH at any time and avoid redemptions by keeping collateralization ratios high. Together, these mechanisms ensure the value stability and market confidence of LUSD.