1. The Stablecoin Trilemma is a Holy Grail

Stablecoins are an important area of the crypto world and have become an indispensable part of it for many years.

However, it is difficult for the current stablecoins to achieve good results in all three attributes of decentralization, stability, and scalability at the same time. I first heard this view mentioned by Liquity CEO Robert Lao in a public speech at ETHcc[6].

1.1  The three attributes of stablecoins

Stability: This refers to the price stability of the stablecoin, or its ability to maintain a stable peg to $1 (in the case of USD-pegged stablecoins). If the price fluctuates excessively, the stablecoin is considered unstable.

Scalability: This refers to the ability of the stablecoin's supply to not be limited by any single factor, such as a particular digital asset.

Decentralization: This refers to the lack of connection to off-chain assets, making the stablecoin relatively independent and unaffected by off-chain assets and the off-chain world.

1.2  Performance of common stablecoins in these three attributes

Currently, the three common types of stablecoins in the crypto world fall short in at least one of these three attributes:

l Fiat-collateralized stablecoins

Examples include the well-known USDT and USDC, which are backed by credit from centralized platforms. While they excel in stability and scalability, they lack decentralization entirely. Consequently, they are constantly exposed to platform credit risks and stablecoin risks stemming from the credit risks of platform-related entities (e.g., the USDC credit risk triggered by Silicon Valley Bank in 2023).

[Note: Stability does not equal security. Relying solely on credit entails bearing the potential risks associated with credit. The notion of "too big to fail" has been shattered by numerous examples, from Lehman Brothers in the distant past to Silicon Valley Bank more recently.]

l Algorithmic stablecoins

Most algorithmic stablecoins struggle to achieve stability, often exhibiting short-term upward spirals and eventual downward spirals. This is particularly true after the LUNA incident, which has further shaped public perception and impressions of such projects.

l CDP digital currency over-collateralized stablecoins

Examples include Lusd and the former DAI. These stablecoins boast high decentralization and excellent stability. However, their scalability is relatively poor, as the supply of Lusd, for instance, is tied to the amount of ETH collateralized on its decentralized platform.

1.3  The critical importance of a stablecoin is effective supply

A stablecoin's total supply, or rather its effective supply (excluding the amount collateralized outside its own ecosystem), is a crucial indicator of its usability. If the total supply is small:

1) Market liquidity is poor, trading depth is shallow, trading slippage is significant, and traders incur substantial losses.

2) Due to the presence of large slippage, the stablecoin itself may also exhibit instability. While CDPs have mechanisms in place to ensure that they can re-peg to $1, there may still be some degree of soft de-pegging.

3) For the above two reasons, people are reluctant to hold these small-supply stablecoins. This also reduces the willingness to mint such stablecoins, further limiting the total supply.

4) To incentivize people to use and hold these stablecoins, project developers often launch lending pools where stablecoins can be deposited to earn interest. However, if the majority of minted stablecoins are always locked up in the project's lending pools, two major problems arise:

a. The three problems mentioned above remain unresolved. This approach merely incentivizes holding without encouraging usage, offering limited benefits for stablecoin development only.

b. Incentives that exceed conventional return levels are typically unsustainable. Once the incentives cease, holding these stablecoins becomes less meaningful, leading to a chain reaction of supply decline. Therefore, such incentives can only serve as temporary marketing tactics but not as a genuine method to ensure the success of a stablecoin or achieve a usable supply level.

The logical relationships are illustrated in the following diagram:

2. Liquity V2's original vision

Liquity V1's Challenges and V2 original Plans for Improvement

Even in its early stages, Liquity likely anticipated the limitations of its initial design. Community members from the project team indicated that their focus would be on expanding Lusd usage rather than LQTY operations. Over the past few years, Liquity's efforts have led to some recognition of Lusd, particularly for its security and extreme decentralization. However, Lusd's overall adoption has not seen significant growth. Additionally, as LQTY incentives have gradually decreased, the original model has faced increasing challenges.

Addressing scalability is one of Liquity's key priorities. Liquity V2 initially envisioned introducing "delta neutral hedging" to enable equal-value collateralization. The project team actively promoted and explained this concept in forums and the community. However, after about half a year, Liquity adjusted the scope of its V2 plan, shifting to a next-generation CDP design that still employs over-collateralization to enhance and refine V1's functionalities.

The potential challenges the initial version of V2 may face

I deeply admire Liquity's commitment to extreme decentralization and its unwavering spirit of innovation. In the meme-driven crypto world, there are only a few projects dedicated to such ideals. However, achieving a powerful perpetual option (delta neutral hedging) mechanism in a decentralized manner presents significant challenges:

Trading Depth: Derivatives are typically traded on CEX due to their superior liquidity and low slippage.

Efficiency: Is an AMM-like mechanism necessary to ensure fast and one-time trade execution?"

Security of funds: Simultaneous long and short positions are not without risks:

a) Futures: Even with a 1:1 hedge in half-margin futures, a 100% price increase can lead to margin call on the short position. If the price immediately retraces 40% (e.g., a wick), the short position may be liquidated before the spot asset can be sold, resulting in an overall loss of 20%.

b) Options: While the potential profit-to-investment ratio is higher, options premiums are often significant, and losses are more likely.

I believe Liquity has carefully considered these challenges. Therefore, I understand and support their decision to modify V2 (despite some fans' disappointment). One of my motivations for writing this article is to present a method for resolving the stablecoin Trilemma  within the framework of Liquity V2's current plans.

3. Liquity V2's Current Plans

Overview

Liquity V2's primary change is introducing user-set interest rates, which also determine redemption priority. This aims to address unintentional redemptions by collateralized users and enhance the sustainability of income for stablecoin collateralized yield earners.

Detailed Explanation

In V1, when Lusd's price falls below $1, users can purchase Lusd and redeem the Trove with the lowest collateralization ratio at a Lusd price of $1. This allows redeemers to profit from the Lusd-$1 price difference. As more users engage in this strategy, Lusd's price tends to return to or near $1.

However, V1 presents two challenges:

(1)Unintended Losses for Redeemed Trove Holders: If Trove holders do not repurchase their assets promptly after redemption, they may incur unexpected losses due to sudden price surges.

(2)Decreasing SP Income: V1 Stable Pool (SP) contributors earn newly minted LQTY tokens and automated liquidation proceeds. However, liquidations are infrequent, resulting in minimal liquidation revenue. Additionally, as LQTY minting gradually declines, SP income also decreases if LQTY prices remain stable.

V2's ingenious feature of user-defined interest rates and interest-based redemption priority effectively addresses the two aforementioned issues (1) and (2).

From another perspective:V1 uses a single parameter, the collateralization ratio, to control two things: the liquidation order and the redemption order; while V2 keeps the liquidation order unchanged based on the collateralization ratio, but uses the interest rate to control the redemption order—the lower the interest rate, the easier it is to be redeemed.

Due to the immutable of Liquity contracts, V2 will introduce a new stablecoin, BOLD.

Problems not addressed in V2's planning

However, V2 did not solve the scalability issue mentioned earlier, and the total supply and utility of the stablecoin still failed to be effectively stimulated.

Even with the implementation of user-defined interest rates, the inherent challenges of the stablecoin remain unresolved. These include high slippage, susceptibility to soft de-pegging, and a reluctance among users to hold or mint the stablecoin. While the stablecoin yield pool may potentially offer higher returns (not guaranteed, see my subsequent article), it operates in isolation and fails to break this cycle or dispel the underlying concerns.

4. Challenges Facing Liquity V2

This article aims to primarily address the core issue 1: the problem of a low effective total supply of the stablecoin. As for core issue 2, I do have a solution, but it involves extensive reasoning and design, so I won't go into detail in this article.

So, how can we increase the effective total supply of the stablecoin? Let me start by discussing a few issues that arose with V2.

4.1  The enthusiasm of one type of user from V1 was dampened

V1 was widely recognized as the epitome of decentralization and extreme security. Not only was the contract immutable , but it also withstood an abnormal 40% single-day drop in ETH prices without flinching.

V2 was an upgrade over V1 in multiple aspects, with most types leaning towards CDP, while still pursuing the ultimate decentralization and immutable .

However, V2 dampened the enthusiasm of one type of stablecoin contributor from V1—those who did not want to pay high interest rates but preferred small leverage borrowing, or in other words, users with high collateralization ratios (CR) and low interest rates (IR). Because they increased the supply of the stablecoin, they contributed to it, and therefore should have been supported.

But this type of user saw their enthusiasm diminished after the launch of V2 for two reasons:

1)If they joined V2 as-is, their Troves would be the first to be redeemed unintentionally.

2)If they remained in V1, as V2 impacted the total supply of LUSD and reduced the income of the V1 stablecoin pool, LUSD holders would face increasing trading slippage, which would also dampen the enthusiasm of this type of user.

4.2  Will there be a Liquity V3 in a few years, and a new stablecoin LUSD3? And will the current V2 be affected?

Liquity's immutable demonstrates the project team's confidence in their economic model design and their pursuit of ultimate credibility. This is highly admirable and commendable. If there were more builders like this in the crypto world, it would not receive such negative evaluations from many people.

However, this immutable feature seems to have one and only one problem: when upgrading, they have to create a new stablecoin. The launch of V2's LUSD2 (currently named BOLD by Liquity) has actually raised some users' concerns and controversies about the potential LUSD_V3 and LQTY_V3 in a potential V3, leading them to adopt a cautious wait-and-see attitude towards V2 instead of fully accepting it. How can we alleviate these concerns and encourage V1 users to become seed users and advocates for V2, cultivating an open mindset towards V2 and potential future V3/V4? This is also a key issue that needs to be addressed.

4.3  Increasing the total supply of the stablecoin is a fundamental challenge.

Currently, V2's main strategy for reducing unintended redemptions is to separate IR and CR. However, the root cause of redemptions is the decline in the LUSD price, which in turn stems from insufficient DEX liquidity or limited LUSD supply. Therefore, expanding the LUSD supply is a fundamental challenge and the most important one.

5. My proposal - Combining Cornerstones to Solve the Holy Grail.

5.1  V2+V1

In simple terms: Combining multiple LUSDs into a single aggregated stablecoin, thereby stimulating the total supply and usage of this aggregated stablecoin.

As shown in the following image:

LUSD is very reliable and has already achieved a considerable scale.

Assuming the future LUSD2 (BOLD) is also highly reliable, if they remain independent, issues like high slippage would still persist. What if we combine the two?

The simple steps are:

1. Users can voluntarily stake them into a smart contract, and the contract will mint a new stablecoin called LQSD1 (Liquity Aggregated Stablecoin) at a 1:1 ratio.

2. The V2 stablecoin pool will allow both LQSD1 and LUSD2 (BOLD) as collateral to earn partial interest for users.

3. Users' interest will also incentivize providing liquidity for LQSD1 on DEXs.

4. If one day a user feels LUSD2 is not so reliable, they can burn their LQSD1 to redeem LUSD.

5. The contract requirements are:

(1) Only LUSD or BOLD can be used to mint Liquity-USD, not to mint LUSD/BOLD

(2) When the contract has sufficient LUSD and BOLD balances, Liquity-USD can be burned to redeem an equal amount of either LUSD or BOLD.

(3) If the contract's LUSD balance is 0, people can only redeem BOLD

(4) In summary: one-way minting, redemption until depleted

5.2  V1+V2+V3

With this design, if one day Liquity V2's originally planned delta-sd solution comes to fruition, and a new stablecoin needs to be created, it won't be a problem, right? We can mint a new aggregated stablecoin. And each solution will incentivize some users, and the combined force of these users will stimulate the total supply of this stablecoin, achieving scalability.

5.3  Divergent Risks, Only the Fittest Survives

As shown in the image above, we may see multiple Liquity Aggregated Stablecoins like LQSD1, LQSD2, LQSD3 emerge. We may have the following questions:

1)  What if an unforeseen issue arises with Lusd4, causing severe de-pegging of Liquity-usd4?

1. Won't these three aggregated stablecoins still divert attention and liquidity?

My answer is:

1) If an unforeseen issue arises with Lusd4, causing severe de-pegging of LQSD3, people will frantically redeem LQSD3 for Lusd1/Lusd2/Lusd3 until the Lusd3 contract's balances of Lusd1/Lusd2/Lusd3 are depleted, leaving only Lusd4. At this point, those still holding LQSD3 and failing to redeem for Lusd1/Lusd2/Lusd3 in time will bear the risk of Lusd4. However, this will not affect the original systems of Lusd1/Lusd2/Lusd3 in the slightest.

2) Assuming all the stablecoins in the image above already exist, and Lusd4 has no issues, but people generally consider Lusd1/Lusd2/Lusd3 safer and Lusd3 and LQSD2 more profitable, how will the overall situation evolve?

Even though all the aforementioned stablecoins have corresponding profit models, people will still tend to invest in or swap their stablecoins to mint Lusd3 and LQSD2, because they appear safer and more profitable overall. Moreover, since Lusd3 and LQSD2 are interchangeable at a 1:1 ratio, in this scenario, LQSD2 will become the mainstream stablecoin with the highest total supply, far exceeding the scale of Lusd2 or Lusd3 without this model, because it will almost equal the combined total supply of Lusd1/Lusd2/Lusd3 at that point.

5.4  Layer1+layer2

Liquity's official blog once said that Liquity is "the most forked stablecoin protocol." These forked projects often issue their tokens on Layer 2, an area that Liquity has not deeply explored.

As is well known, transactions on Layer 2 are currently more active than Layer 1 due to the low gas fees. Then, using the above method, why can't Liquity itself capture the long-tail users on Layer 2?

Perhaps someone would argue that although the number of transaction  on Layer 2 is higher, the transaction usd-amounts are still highest on Layer 1, and for both lending and stablecoins, the focus is on the amounts. As shown in the image below:

This is the data on transaction counts and amounts across all transactions on DEXs on various chains that I compiled from Dune Analytics on 2024-5-3. As we can see, if we combine the data from non-Ethereum chains, the total transaction count is 10 times that of the Ethereum chain, and the total transaction amount is about 2/3 of the Ethereum chain. It may not seem like a big issue if we exclude these chains, but it is still a bit regrettable.

However, please take a look at the following table, which shows the transaction data for this year so far:

As we can see, the transaction count on these chains this year has already reached 11 times that of Ethereum, and the total transaction amount has clearly surpassed the Ethereum chain. This change is something we cannot ignore.

So, if we incorporate stablecoins like polygon-lusd, arbitrum-lusd generated using the Liquity model, and then synthesize them into the aforementioned Liquity-usd, the total supply would increase significantly. Moreover, with the above method, we don't need to repeatedly deliberate whether to join a chain that appears less stable or secure but also has very few issues. Because, in the end, the fittest will survive.

(Of course, at that time, we can also consider: on these chains, can the assets that can be collateralized not only be wETH but also the native tokens of these chains? For example, on Polygon, collateralizing Matic or wEth to obtain liquity-polygon-usd.)

6. Advantages of This Proposal

The advantages of this proposal are as follows:

6.1 Improved scalability: Each building block, similar to addition. If one day wbtc+cross-chain becomes secure, we can also do an over-collateralized lending like Liquity, which would be another major building block for this type of stablecoin, as shown in Mode C in the image below.

1）If it's still a divide-and-conquer approach at that time, the stablecoins issued from ETH and BTC collateralization would still be in competition, as shown in Mode A in the image below.

2）For projects that continuously upgrade their contracts, although they can conveniently incorporate new assets, once an asset encounters an issue, the entire credit foundation will be challenged, as shown in Mode B in the image below.

6.2 For Liquity:

1）This method alleviates some fans' resistance to V2 creating a new coin, and their concerns that a potential future V3 could again create a new coin that would impact V2.

2）This approach is very suitable for Liquity, which has been successful, immutable, and advocates for extreme decentralization.

6.3 The value of the Holy Grail

Holy GrailEven if solving the Holy Grail is only a possibility, its significance and commercial value are extraordinary:

1) The Holy Grail is not only a monument in the minds of builders but also the expectation of followers.

1. Not many teams are believed to be able to solve the Holy Grail , and innovators who can solve such problems are highly anticipated and will be extensively covered by major KOLs.

2. On the contrary, if it is only a partial improvement, people's interest will be limited, and they will not be excited or inspired; some may even be disappointed.

3. Solving the Holy Grail can also generate a higher level of marketing, just like Apple's continuous pursuit for phones has won some loyal fans. As Simon Sinek's book "Start With Why" says: It is the cause that is represented by the company, the brand, or their products that inspires loyalty.

6.4 It isolates factors that may cause issues.

6.5 Expands audience:

Embracing the "long tail of users with small amounts but large numbers" not only increases the project's overall scale but also expands its audience, which is highly beneficial for promoting a stablecoin project.

6.6 A more stable performance helps improve user confidence

Furthermore, embracing long-tail customers ensures that the project's revenue and other related indicators will not be drastically impacted by the inflow or outflow of large amounts of assets, avoiding frequent disturbances and noticeable lack of smoothness, which would undermine user confidence.

6.7 Avoiding the dilemma of repeated deliberation, time delays and the loss of some customers

It forms an ecosystem and atmosphere where the fittest survives, avoiding the dilemma of repeated deliberation, time delays, and selective abandonment of certain customers, whether for various LSDs or Layer 2 chains.

(I had previously worked on a central bank credit system for billions of people, and for a time, we were deliberating whether to include some valuable but not 100% accurate credit evaluation algorithms, as the algorithms could not achieve 100% accuracy. Because even if the accuracy was 99.99%, it could still potentially affect thousands or even tens of thousands of people with inaccurate data. As a result, the entire team became somewhat stagnant due to repeated deliberations. Later, I proposed that since this algorithm was valuable for commercial banks, why not offer multiple product lines? The main product would be nearly 100% accurate, but there would also be some products with partial inaccuracies for commercial banks to use cautiously, combined with manual due diligence.

Just like many drugs have side effects, it should be up to doctors and patients to choose how to proceed, rather than simply not producing them at all.)

7. Extreme Case Simulation and Response

Previously, we simulated an extreme scenario of what would happen if lusd4 encountered issues or a trust crisis.

Now let's simulate another extreme scenario: In the situation depicted in the image above, assume that after around 3 years, both lusd2 and lusd4 are abandoned by users. What would happen next? At that time, LQSD1/LQSD2/LQSD3 would all face a trust crisis, but lusd and lusd3 would still be developing steadily. In this case, if we create an LQSD4 by combining lusd1 and lusd3, the result would be better than their individual development.

8. Is this proposal only suitable for Liquity to implement?

No, but it's better if Liquity does it.

8.1  If another project adopts it

Suppose Liquity does not adopt this proposal, but another project X does. Project team X could base it on Liquity V1, Liquity V2, and other successful CDP products, and then combine them with a few Layer 2 chains that people generally trust, forming the aforementioned aggregated stablecoin XSD1 or XSD1 and XSD2. These aggregated stablecoins may have a larger total supply and better scalability and sustainability than lusd2, or at the very least, they possess the potential to compete effectively with LUSD2.

8.2   If Liquity implements it

Given Liquity's rigorous approach to smart contract economic models and dedication to decentralization, once launched, most users would directly and unconditionally trust the security of LQSD1 and LQSD2, as well as Liquity's evaluation of LQSD1 and LQSD2, which would greatly benefit promotion.

9. Other Suggestions for Liquity V2

The above is my plan and suggestion for addressing the first of the two most important challenges currently facing CDP projects:

(1. The low effective total supply of the stablecoin 2. The small proportion of assets willing to be held and provide liquidity)

However, if both challenges could be addressed simultaneously, the situation would be different.

As for the second challenge, the "small proportion of assets willing to be held and provide liquidity" is actually a surface phenomenon. The root problem lies in whether the new type of stablecoin can have some relatively large application scenarios, rather than just being stored in yield pools for yield farming. For this challenge, I also have a solution that seems to have not been proposed by anyone else, but due to length constraints, I won't go into details here.

There are also some other analyses, such as: "The yield pool of the V2 stablecoin may increase the yield, but it is not absolute," etc., which may be mentioned in future articles.

------------------------

Finally, a digression: I have always been full of respect and admiration for the builders and innovators in the crypto world, especially in this stage where all kinds of chaos, scams, and plagiarism are rampant. This spirit of craftsmanship and innovation is all the more precious. Uniswap embodies this spirit, and so does Liquity. Perhaps many people who are eager to make quick money will scoff at my view, but it is my nature and my previous work experience that make me this way.

I am willing to invent and create. My work experience has instilled in me the rigor of technicians, the prudence and ingenuity of financial products, and a longing for the Web3 spirit, making me more inclined to be an innovator and builder in this world.

My contact information is as follows. If you think my proposal has shortcomings or are interested in further discussion, please feel free to contact me.

Twitter:@64perspective

YouToube:@user-zg6lv5xn4p