Are CDP stablecoins toast? They have a rich history in DeFi, but have fallen out of fashion over the past few years. For better or worse, we have eased our staunch stance on decentralization in favor of more practical solutions. As onchain economies become more vibrant, it is increasingly difficult to justify the resource-intensive liquidity pools necessary for decentralized stablecoins with niche utility. CDPs have become confined to the closed-loop ecosystems they are born in, unable to compete with the versatility of money markets.

Liquity v2 appears to be a strong contender for CDP resurgence. It boasts fresh ideas from a well-respected team after a close-but-not-quite v1. This article will discuss the new dynamics at play in v2, its obstacles, and the potential impact on LQTY.

This is an abbreviated version of Delphi Digital’s Liquity v2 report published on Nov 27, 2024.

Liquity v2 Crash Course

Liquity v1 was unique in its ability to embrace the crypto ethos of decentralization and immutability while successfully bootstrapping liquidity for its stablecoin, LUSD, and maintaining its peg through several black swan events. The one-time borrow fee offered a unique value proposition for long-term oriented borrowers, and the token structure was effective for incentive alignment. Liquity’s immutability partially contributed to its status as one of the most forked protocols, and its usage began to taper off as LSTs gained traction and L2 activity picked up.

Liquity v2 will exist separately from v1 and have its own stablecoin, BOLD. Liquity v2 will accept ETH and ETH LSTs as collateral. The core design of Liquity v1 remains intact: the stability pool absorbs debt from liquidated loans, and users may redeem their BOLD for $1 of collateral at any time, which helps to support a strong peg. BOLD is redeemed against user loan positions, known as troves. Redemptions can be thought of as friendly liquidations: the redeemee’s loan position is partially or fully closed against their will, but they are not penalized.

Liquity v2’s biggest design differences are its interest rate and redemption methodology. In Liquity v1, borrowers pay a one-time borrow fee up front, and troves with the lowest collateralization ratio are the first to be redeemed against. In v2, borrowers set the interest rate they are willing to pay. If BOLD falls below peg, troves with the lowest borrow rate are redeemed against first.

Risk-tolerant borrowers may be willing to borrow at a low interest rate to save on costs, while users prioritizing trove safety may set an interest rate higher than the benchmark. Users can delegate interest rate management to third parties or use automated strategies to curate their borrow strategy.

75% of BOLD interest payments will go to the stability pool. The stability pool will feature the same dynamic exhibited by the Ethena model, where sUSDe yield is boosted by the share of the supply that is not staked and forgoing the yield. This will result in yet another source of sustainable, organic, impressive yield in DeFi.

The other 25% of BOLD interest funds Protocol Incentivized Liquidity (PIL) initiatives. PIL is controlled by LQTY stakers and could be monetized through bribes.

Voting power is calculated by a time-weighted boost based on stake amount. This idea is similar to the multiplier points concept introduced by GMX. LQTY stakers continue to receive LUSD and ETH rewards from v1 in addition to v2 PIL voting.

Liquity v1’s immutability resulted in the inability to tinker with protocol parameters or deploy on additional chains. Liquity v1 was forked 35 times, with forks achieving an aggregate total of $1B TVL at their peak. Liquity v2 is published under a Business Source License in hopes of fostering a more symbiotic relationship with alternative implementations of the v2 codebase. There are over 15+ friendly forks in the pipeline, including deployments on Arbitrum, Berachain, and Hyperliquid.

Exploring Risks

There are several potential vulnerabilities in Liquity’s model:

1. Is there meaningful differentiation on the user side compared to alternatives?
2. Can the flywheel work without incentives?
3. Is the friendly fork alignment sufficient?
4. Mainnet + immutability: a repeat of v1 shortcomings?

Differentiation

Mint-side demand

Liquity generates mint-side demand with borrow differentiation, while Maker generates mint-side demand due to its existing moat as leader and through governance-facilitated opportunities via the D3M.

Liquity offers a viable alternative to the utilization rate model for the first time. There will be numerous emergent dynamics due to this unlock. As discussed in our Contango report, money markets margin is often substantially cheaper than funding rates. In Liquity v2, redemption fees are paid to borrowers rather than LQTY stakers, significantly reducing the sting of redemption.

Together with its one-click leverage trading interface, Liquity v2 could become a popular venue for ‘stink-longs.’ If a user is somewhat long ETH, but not enough to pay overheated funding on exchanges or money markets, the user could set a 1% interest rate and long stETH, being paid the yield-borrow delta to keep the position open and a 0.5% redemption fee if BOLD de-pegs.

Buy-side demand

Liquity generates buy-side demand through the stability pool, while Maker generates buy-side demand with the DSR.

The positive yield spread between stability pool yield and borrow rates helps enable this reliable demand. If BOLD supply in the stability pool falls below 50%, it will be highly lucrative to buy BOLD and deposit to the stability pool, or even to mint BOLD at an aggressive rate and deposit.

Fat-Free Flywheel

Incentives are vital to bootstrapping early usage in any new protocol, but have been particularly vital to the success of past CDP stablecoins. The inflection point where incentives taper off and are surpassed by revenue is a major milestone and narrative boost for those that achieve it. Points programs, generic liquidity mining, and veTokens are all effective methods of generating usage despite various degrees of sustainability.

LQTY is attempting to recreate the veToken bribe economy, replacing emissions with protocol revenue. This method is far more sustainable than the veToken model. CDP protocols’ sector-leading margins make Liquity a strong candidate to effectively implement this idea, but the lack of token incentives creates a serious cold start issue. Demand for BOLD and willingness to LP need to scale in step to reach critical mass as fast as possible. Where is that first big surge to 400M BOLD supply coming from?

There will be 15+ friendly forks on L2s. These forks have committed to rewarding early BOLD users and incentivizing BOLD usage with 4% of their token supply on average. This offers major benefits to Liquity:

• Outsources incentive program to a variety of L2 friendly forks, each with their own fresh token supply and emission budget
• Creates demand vacuums for BOLD outside of the stability pool on a variety of blockchains, increasing the deposit surplus and setting off the organic, self-sustained mainnet flywheel

A 4% token allocation from 15+ friendly forks with a conservative valuation estimate of $100M would generate a $60M incentive budget for BOLD incentives. This is before considering alternative forms of alignment.

A liquid wrapper solution could offer yet another source of incentive stimulus. While LQTY is indeed a strong step towards sustainable tokenomics, the multiplier point dynamic leaves room for emergent inefficiencies. A liquid wrapper for permanently locked LQTY will likely emerge to undermine the multiplier points concept. If the solution comes from a new project rather than an established conglomerate like Convex, a significant portion of the token supply would likely be dedicated to growing BOLD supply.

Liquity v2’s design is differentiated enough that it likely sees eventual success, but a lack of native token incentives could prolong this timeline.

Friendly Fork Alignment

Liquity friendly forks may experiment with protocol parameters, governance, and collateral types and become the big winner in the end. To some degree, this would trickle down to Liquity mainnet via narrative and incentive alignment. However, if the relationship between Liquity and its forks is limited to a short term BOLD incentives, Liquity may fail to fully cash in on the ecosystem’s potential.

Ideally, forks will dedicate a portion of their supply to LQTY stakers, allowing LQTY to act as an index of Liquity and its family of friendly forks. At the very least, the friendly fork meta should go a long way in solving Liquity’s cold start issue and fostering a narrative. Establishing a ‘BOLD wars’ regime could widen the stability pool yield surplus, attract more capital, intensify bribing competition, and ultimately lead to higher earnings for LQTY stakers per dollar of PIL.

Mainnet + Immutability

One of the key issues with Liquity v1 was the lack of new collateral types once LSTs took over. Liquity v2 lacks support for LRTs, and will once again be immutable upon deployment and confined to Ethereum mainnet. Established protocols like Aave command impressive usage on mainnet, but experimentation and degeneracy has largely migrated to L2s. LRT farming has largely died down, but will likely gain market share as restaking research evolves and creative AVS solutions come to market.

LQTY Valuation Model

Several unknown inputs make forecasting LQTY difficult:

• How will the market value it?
• Value accrual to LQTY
• BOLD supply
• Market dynamics - appetite for leverage, interest rate, etc.

Let’s begin by analyzing other CDPs in their heyday.

2021 was the golden era for CDP stablecoins. The market placed a much greater emphasis on decentralization than it does today, and differentiation was far easier to achieve.

Modern MKR is treated harshly by the market, with a median P/E of 17 over the past year. The SKY rebrand has went poorly and there are few remaining growth catalysts for DAI.

Prime MKR was in a league of its own, offering desirable ETH beta and strong fundamentals. MKR traded at a median P/E of 28, which could be the ceiling for a mature CDP stablecoin, even in a bull market.

Prime LQTY had a median fully diluted P/S of 41 and a median circulating P/S of 4.5. Given the aggressive Pool2 incentive program and the extreme volatility of P/S throughout Liquity’s early days, this metric offers little insight for our forecast.

Prime SPELL felt like a narrative play despite strong fundamentals throughout its rally, as showcased by a median circulating P/S of 11. SPELL also utilized a Pool2 incentive program, and its fully diluted median P/S of 25 is relevant for our forecast. It incorporates SPELL’s consistent earnings throughout the period and controls for the emissions.

An adjusted modern MKR P/E multiple is the most reasonable base case for our analysis, balancing recency with likelihood and fit. Liquity shares Maker’s core business and token lifecycle, but likely warrants cashflow and growth premiums.

Value accrual to LQTY

During the height of the CRV wars, projects were directing $1.03-$1.05 in CRV emissions per dollar of bribes. This was impressive, as it suggests veCRV holders are leaking minimal value to emissions. Today, that number is closer to $1.50. BOLD incentives will likely come at a premium to CRV as they are cold hard cash pegged at $1, rather than a governance token with PvP emissions. If a flywheel takes shape, we could see this figure approach $1, meaning LQTY stakers nearly get nearly 1:1 value on their 25% PCI. The $1.50 per dollar from Curve is a good worst-case scenario, and would result in 67% return to LQTY on the PCI, or simply 17% of the entire interest bucket.

Cash flows are the silver lining of LQTY’s token economics, creating an indirect yet reliable link between BOLD supply and the intrinsic value of LQTY. Now almost fully diluted, LQTY is well-positioned to benefit from BOLD’s traction.

The above chart illustrates potential prices of LQTY at various BOLD supply levels, according to the valuation multiples described above. The chart uses base inputs of $1.10 incentives per dollar bribed and an interest rate of 7%. For example, if the market sees LQTY similarly to how they viewed SPELL in its heyday, LQTY’s price would be $2.26 at 500M BOLD supply, assuming a 7% interest rate and a moderate discount on PIL to bribers. The same scenario would suggest a price of $1.40 if the market treats LQTY like it has treated MKR so far this year.

This analysis ignores any potential upside from staking participation rate or multiplier points discrepancies. Using this framework, we can construct a scenario analysis for LQTY.

The rationale for each scenario is as follows:

Flop: CDP stablecoins do not work without incentives. The market rejects the BOLD bribe meta, and LQTY stakers are compensated for PIL similarly to current veCRV holders. BOLD supply is confined to 200M, and LQTY is valued like modern MKR at $0.29.

Bear: Liquity v2 is well received and offers benefits to users, but lack of incentives significantly slows growth as Liquity grinds for every dollar of TVL. The friendly fork meta never gains momentum, and incentives directed per dollar bribed remains high at $1.20. By the time Liquity reaches critical mass, LRTs become trendy over LSTs, resulting in similar immutability drawbacks of v1. BOLD supply growth stalls at 450M. The market values LQTY like modern MKR, placing no premium for growth, brand, or cash flows and pricing it at $0.99.

Base: Users enjoy cheaper borrowing and easy leverage, while DeFi integrations around sBOLD offer new synergies. LQTY stakers are fairly compensated based on historical precedence from CRV. BOLD reaches 800M supply. The market values LQTY’s cash flow, growth, and brand premium over modern MKR, pricing it at $3.02.

Bull: L2 friendly forks adequately subsidize early demand bootstrapping, establish a narrative for BOLD PIL similar to the CRV wars and expedite BOLD’s journey through the critical cold start phase. Bribes earn level of CRV during CRV wars ($1.03-$1.05). Users from Maker and Aave are lured to Liquity and BOLD eclipses LUSD’s all-time high at 1.5B supply. The market treats LQTY like it did SPELL, a promising new design with strong token fundamentals and a bone to pick with incumbents. SPELL’s fully diluted P/S of 25 prices LQTY at $7.75.

Mania: Same scenario as above, but market-wide bull run elevates valuation multiples and demand for leverage. BOLD flips DAI at 3B supply and the market values LQTY like prime MKR with a median P/E of 28, suggesting a price of $17.36.

The Bull and Mania scenarios may seem outlandish, but in a sustained bull market, the demand for leverage is insatiable. These scenarios are well within the range of outcomes. Last cycle, Abracadabra’s MIM quickly reached over 4B outstanding supply while DAI eclipsed 10B. This effect could be magnified on L2s, where leading money markets suffer from growing pains. Pooled designs like Aave must carefully manage risk parameters as they scale, and modular designs like Morpho must grow supply and demand in step across various markets.

Conclusion

Liquity v2 is the most serious attempt at breaking out of the utilization-based model that has become standard across DeFi. As discussed in the DeFi Year Ahead Report, utilization-based rates are highly inefficient and somewhat arbitrarily derived. Market-driven interest rates are one of the last remaining fundamental building blocks that DeFi is still lacking.

Liquity v2 has clear differentiation in borrowing experience and looks likely to succeed if Ethereum mainnet is not a dealbreaker. LQTY is a mature token that is well-positioned to flourish if the novel incentive mechanisms overcome the cold start problem. Reaching critical mass with market-driven interest rates would be one of the bigger unlocks in DeFi’s recent history, and the ramifications appear to be flying under the radar.

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