Price stability of $LYU

An Introduction to Lyve's Stablecoin Stability

This post aims to clarify the mechanisms in place for LYU's stability and address challenges other stablecoins face.

The Dual-Peg Mechanisms

At Lyve, we employ a dual approach to price stability, involving both "hard peg" and "soft peg" mechanisms. Let's dive into these methods one by one.

Hard Peg Mechanisms

One of the core innovations of Lyve is that its native stablecoin is redeemable against the underlying collateral held by the borrowers. That means, every LYU holder can exchange their coins for Ether at face value, i.e. for 100 LYU they would get USD 100 worth of Ether. When redeemed, the system uses the LYU to repay the riskiest Trove(s) with the currently lowest collateral ratio, and transfers the respective amount of Ether from the affected positions to the redeemer. In other words, the Ether is drawn from the Troves’ collateral, starting from the position with the lowest collateral ratio.

To enhance user experience for low-collateral borrowers whose loans (Troves) may be vulnerable to redemptions, the system charges a one-off fee on every redemption, called the redemption fee.

Since the redeemed LYU is burned by the protocol, the stablecoin supply (monetary base) will shrink upon every redemption, which usually has a positive effect on the price. As redemptions can be triggered automatically by bots whenever there is an arbitrage opportunity, we expect the exchange rate to quickly recover if it drops below the line.

It is important though to have the right formula for the redemption fee. If the fee is too high, redemptions may become prohibitively expensive even if the price of 1 LYU is significantly below USD 1. In other words, if the redemption fee spikes due to a large redemption without an equivalent immediate reaction of the LYU price, further redemptions may not be profitable until the fee comes down to a sufficiently low level again. On the other hand, if the fee is too low, there will be more or larger redemptions, increasing the risk for low-collateral borrowers of being hit by a redemption.

Of course, this classical monetary theory does not guarantee that the exchange rate will always immediately return to parity. However, given the soft peg mechanisms described below, it is unlikely that such a situation will persist for longer periods of time.

Lyve's design ensures that each LYU can be redeemed for its face value in Ether, thereby establishing a price floor. Additionally, a minimum collateral ratio of 110% sets a natural price ceiling at USD 1.10 for LYU. These hard peg mechanisms work in conjunction to ensure LYU's value remains close to USD 1.

Soft Peg Mechanisms

Similarly to other collateralized debt platforms like MakerDAO, Lyve treats its stablecoin as being equal to USD when determining the collateral ratio of its Troves. Even though the borrower’s debt is denominated in LYU, the current value of the Ether held as collateral is expressed in USD. Thus, the collateral ratio is defined as the collateral in USD divided by the debt in LYU.

With this enshrined formula, parity between LYU and the USD is fundamentally anchored in the system as its intended natural equilibrium state. Given the redemption mechanism, hard price floor and clear branding as a dollar-based stablecoin, we expect users to view the 1:1 dollar peg as a Schelling Point to which the system tends to return after temporary deviations.

As long as most people foster that belief, it will have a self-reinforcement effect: a LYU price above $1 makes borrowing more attractive (as you can expect to repay at a rate of $1 or lower), whereas a price below $1 incentivizes repaying existing debts (as this state is likely to be short-lived). When more LYU is borrowed than repaid over time, the total LYU supply will grow, which should make the tokens cheaper with regard to the USD and other currencies. Conversely, if the repaid amounts are higher than the new debts, the money supply will shrink, such that LYU will appreciate.

Generally, the long-term outlook of a 1:1 exchange rate between LYU and USD will stabilize the price in the short run too since users will factor in future price changes in their current decisions (buy/sell/borrow/repay etc.). Given that this mechanism crucially depends on assumptions about the future, it only acts a soft peg and does not provide hard guarantees for price stability.

Dampened speculation against the price ceiling

As shown above, the floating range of LYU is confined between USD 1 (minus fees) and USD 1.10. Speculating against those hard borders is difficult and hardly profitable. We posit that this will make LYU less prone to adversarial speculation in general. Let’s assume that LYU trades at USD 1.09 for example. It is clear that the upside for holders is realistically only 1 cent, while the downside is 9 cents. The closer the price gets to the price ceiling, the less interesting it becomes to speculate on further price increases.

Issuance Fee and Economic Modelling

Existing systems such as MakerDAO apply variable interest rates (stability fees) as an additional soft peg mechanism. Lyve replaces interest rates by an algorithmically determined one-off issuance fee on debt.

The issuance fee constitutes an upfront cost that borrowers need to pay for the LYU they draw. Similarly to the redemption fee, it is automatically increased upon every redemption (which signals that LYU is likely worth less than the USD) and decays in phases without redemptions. Higher fees immediately make new loans less attractive, and thus throttle the generation of LYU if there is not enough demand to keep up with the supply.

An increased issuance fee has a very direct effect on new debts compared to an interest rate increase which takes longer to impact supply. Existing loans are not directly affected by the issuance fee as such. However, if a loan gets closed due to a redemption, its owner might not be willing to reopen the position as long as the fee is high. This ensures that the LYU burned upon redemptions is not recreated through new loans right away. The issuance fee and the redemption mechanism thus work in tandem to slow down the growth of the monetary base or contract it if needed.

Intuitively, the issuance fee should be in the same range or even be identical to the current redemption fee. The reason is this: If the redemption mechanism succeeds to push a lower price back to parity, new loans will become more attractive (see above “Parity as a Schelling Point”). If the QTM holds, the resulting base rate will roughly correspond to the difference in percentage points between parity and the previous price level. By charging the same base rate as an issuance fee, we can basically cancel out the attractiveness gain for loans due to the restored peg.

Effects on Leverage and Liquidity

Lyve and other collateral debt platforms enable decentralized leverage by converting the borrowed amount and using it as collateral for further loans. The maximum achievable leverage ratio mainly depends on the minimum collateral ratio MCR and can be determined by the following formula:

maximum leverage ratio = MCR /(MCR-100%)

While MakerDAO with its 150% minimum collateral ratio allows for a 3x leverage, Lyve's

maximum leverage ratio is 11x. Of course, these are theoretic maxima since in practice you need to maintain some security margin as a borrower.

Also, this formula is based on a stablecoin price of exactly 1 Dollar. If LYU trades above parity, even higher leverage ratios become possible as the borrowed LYU can be converted into more collateral:

maximum leverage ratio = (MCR/price)/(MCR/price-100%)

For a LYU price of e.g. USD 1.05, the maximum leverage is 22x, or twice as high as during times with perfect price parity. In the case of MakerDAO, this is very different, since a Dai price of USD 1.05 will only slightly increase the maximum leverage from 3x to 3.333x, using the same formula.

People normally use leverage because they expect the collateral to appreciate by the time they close their position. However, an expectation of a depreciating debt can increase profitability as well. A higher LYU price makes leverage more attractive, assuming that the position can be closed at a lower price in the future. It is therefore not only the higher leverage ratio, but this extra profit opportunity that should act as an additional incentive for leverage seekers whenever LYU trades above parity.

But there is another effect that requires more explanation. At any given Ether price and even in sharp market downturns, we can expect that a certain (even if small) fraction of speculators will believe that LYU will return to parity, making the leverage profitable. Such speculators can draw a multiple of their invested funds as fresh LYU through leverage.

On the other hand, people who think LYU will remain above the peg or even appreciate can only use their own funds to invest in LYU. In other words, Lyve offers leverage solely for Ether but not for LYU. Therefore, it only amplifies the supply side, but not the demand side when LYU is overpriced. This process may help to push the price back to parity.

While the same mechanics are also present in MakerDAO, their effects are dwarfed by the 150% minimum collateral ratio. As we have seen, price appreciation has been a chronic issue for DAI. We think that Lyve has a much stronger soft peg mechanism that will pull the price down to parity when needed.

Stability Pool as a Liquidity reserve

A certain fraction of the entire LYU supply will be inside the Stability Pool and thus outside regular circulation. However, the pooled fraction of LYU may depend on the current LYU:USD exchange rate. The higher the price of LYU in USD, the lower will be the (expected) collateral surplus gains in case of liquidations, since the conversion is based on the nominal value of LYU being equal to USD.

As the price of LYU approaches USD 1.10, the risk of a potential loss for depositors increases accordingly, and stability deposits become less attractive. Eventually, owners may withdraw their stability deposits if the loss risk becomes too high. With more liquidity being injected into the money markets by former stability depositors, the LYU price should depreciate.

As a result, the Stability Pool will also act as a liquidity reserve and help to mitigate the liquidity crisis that might occur in case of black swan events affecting the Ether price. With that, the Stability Pool will serve both system stability (solvency) and price stability.

We think that this is a useful tradeoff despite the fact that it reduces the primary buffer for liquidations. Thankfully, the redistribution fallback mechanism and the Recovery Mode are designed to cope with mass liquidations even if the Stability Pool is emptied. While the redistribution of defaulted loans does not directly change the total collateral ratio of the system, it does reduce the individual collateral ratios of the borrowers who receive the debt and collateral shares, potentially below their respective comfort levels. Those borrowers may then either top up their collateral or reduce their debts in order to improve their collateral ratios, which in aggregate increases the total collateral ratio.

As an ultima ratio, the Recovery Mode changes the incentive structure for both borrowers and stability depositors. Only loans with a collateral ratio of 110% or higher at the time of liquidation are offset against the Stability Pool during Recovery Mode, while loans below 110% are directly redistributed to the other borrowers. This not only allows for higher collateral gains, but makes stability deposits practically risk free, assuming that the price of LYU never exceeds USD 1.10.