No topic makes crypto investors more nervous than stablecoins. While stablecoins have opened the world of DeFi lending and yield farming, they also threaten to bring it all down due to questionable asset reserves and opaque operations.
At least, that’s the narrative with the world’s largest stablecoin, Tether. But are all stablecoins in the same boat?
Most people, even seasoned DeFi investors, are unaware how stablecoins work under the surface. Fewer understand the unique mechanisms behind every stablecoin.
In this article, we’ll look at two mid-sized stablecoins to see how they go about the same goal—creating a stable, usable USD peg—in very different ways.
Launched in 2018, MakerDao created a stablecoin by locking up ETH to mint DAI. As a first-generation decentralised stablecoin, DAI still occupies the first seat among decentralized stablecoins due to its first-mover advantage, despite having suffered bad debts in March 2020.
A question on the centralization of stablecoins was widely raised that most stablecoins are centralized stablecoins formed with fiat collateral. This became the initial motivation for Liquity to create LUSD in 2021.
According to Footprint, MakerDao’s TVL is about 7.6 times that of Liquity, while DAI’s market cap is nearly 12 times that of LUSD.
But Liquity, as a latecomer to the over-collateralized stablecoin market, has had to learn from its predecessor. Its team engineered many of its mechanisms to address the pain points users of MarkerDao have.
Read Also: Silvergate To Become Exclusive Issuer Of Diem Stablecoin
This article will compare Liquity’s and MakerDao’s lending process, use cases, token patterns, and liquidation mechanisms.
Comparison 1：The Lending Process
Collateral
Before users can lend, they need to lock up their assets. Compared to Liquity, which can only lock up ETH, MakerDao allows multiple collaterals and supports centralized stablecoins such as USDC, USDT, TUSD, and tokens such as LINK, YFI, COMP, and Uniswap’s LP token.
Liquity regards LUSD as a decentralized stablecoin, with ETH as collateral, to be truly decentralized. On the other hand, USDT is a centralized institution, but the resulting stablecoin produced is still centralized.
MakerDao had also supported only ETH as collateral until March 2020, but the plunge in ETH token price in the same month accelerated MakerDao’s decision to support multiple collateral decisions online, opening up USDC to allow DAI to restore liquidity.
Multiple collaterals are a double-edged sword. On the one hand, it can diversify the protocol risk and adjust the supply and demand of DAI through stablecoins such as USDT. On the other hand, stablecoins with USDT as collateral also have numerous risks, such as being sued by the SEC for having inadequate reserve supervision. At the same time, the rise and fall of other tokens are also highly correlated with ETH.
It is impossible to say whether MakerDao or Liquity is more secure, but in terms of user choice, MakerDao has more diversified options.
Read Also: Groupe Casino to Launch Euro Stablecoin ‘Lugh’ on Tezos
Fee and Minimum Collateral Ratio
MakerDao receives a stability fee at the time of lending, which varies depending on the asset and different minimum collateral ratios (MCR).
For example, ETH has three pools with MCR from low to high of 130%, 145%, and 170%, corresponding to a stability fee of 5%, 2%, and 0.5%, respectively. Except for some stablecoins and LP Token, which have lower MCR, the pools of other tokens have MCR above 130%. The higher the collateral ratio (CR), will lower the capital utilization ratio.
For users at Liquity, the MCR is only 110%, with no increasing borrowing rate over time. While Liquity still has a borrowing fee between 0.5% and 5%, this one-time fee does not increase over time. This feature makes Liquity users more inclined to use their borrowings for the long term and not rush to pay them back, making Liquity’s TVL relatively stable. And as users with LUSD will also hold it for a long time, it induces a rise in the supply of the USD-pegged stablecoin.
MakerDao users looking into increasing daily repayable fees must find higher interest rate investment options to cover the stability fees or need to pay back DAI as soon as possible to put the constant interest accrual on the debt on a halt.
Comparison 2：The Use of Stablecoins
The stablecoins minted by MakerDao and Liquity through collateral are DAI and LUSD, respectively, and there is a clear difference between the two in terms of usage.
MakerDao supports allowing DAI holders to earn DAI Savings Rate (DSR) on their DAI holdings by depositing them into a savings account. When the DSR rises, it stimulates more holders to deposit DAI, which influences an increase in DAI demand.
MakerDao governs the supply and demand of DAI through stability fees and DSR. Still, these adjustments are based on the judgment of MakerDAO members, and it comes back to the question of whether MakerDao is decentralized enough.
Liquity provides a stability pool for LUSD holders, allowing users to deposit LUSD into the pool to earn collateral ETH and LQTY rewards for others being liquidated. The amount of revenue depends on how many people will be liquidated. The more unstable the market is, the more the price of ETH drops rapidly, increasing the revenue of the stability pool.
From an external use case perspective, numerous protocols currently support DAI. And over 60% of LUSD holders are always in Liquity’s stability pool and do not move outside of Liquity itself. While the percentage of LUSD in Curve, SushiSwap, and OlympusDao is growing, it is still lower in value than DAI.
Read Also: US Federal Regulator allows Banks to Use Stablecoins in Payments
Comparison 3：The Token Pattern
The tokens of MakerDao and Liquity are distributed as MKR and LQTY, with the main differences being their issuance and usage.
In terms of token issuance, there is no fixed amount of MKR supply, and it largely depends on the overall MarkerDao debt situation. In the event of a $5.3 million shortfall in MakerDao’s collateral ETH when the global cryptocurrency market crashed in March 2020, MakerDao replenished DAI by issuing and auctioning newly minted MKR, thereby covering the bad debt incurred by burning DAI. Conversely, when the surplus of the protocol exceeds a certain threshold, the MKR will be burnt.
LQTY is not involved in the liquidation, and its supply is only 100 million. It is mainly derived from rewards for depositing LUSD in its stability pool, and users can stake their LQTY to share other users’ borrowing and redemption fees. LQTY is mainly used to motivate users to deposit their lent LUSD in its stability pool to improve the liquidation mechanism, which explains why over 60% of LUSD is still in Liquity’s system.
In terms of token usage, MKR is a governance token that uses MKR to vote on protocol parameters (e.g., stability fees, debt caps, MCR) and other essential ecosystem elements (e.g., funding working groups, grantmaking, etc.) However, early and large investors hold most MKRs, which puts MakerDao in a centralized spiral.
LQTY is not a governance token, and its use case is only to help holders capture revenue, so the difference between the two token prices can be seen by as much as 400 times. The circulating supply of the token LQTY steadily increases until it is fully released, while the circulating supply of MKR will remain largely stable along with the market.
Read Also: BofA Says ‘Digital Assets Are Too Large to Ignore’, Initiates Research Coverage Of Crypto
Comparison 4：The Liquidation Mechanism
The liquidation mechanism is the core of the stability of any lending system, and there are clear differences between MakerDao’s and Liquity’s liquidation mechanisms.
MakerDao, which has undergone the ordeal caused by the plunge of ETH in March 2020, has refined its liquidation mechanism by switching from the original English auction model to a Dutch auction with initial asking prices ranging from high to low.
However, it is still an auction model with a six-hour time limit. MakerDao needs to have enough users holding DAI to participate in the event of liquidation. However, it has already strengthened the regulation of DAI circulation by introducing a stablecoin collateral and issuing MRK.
When a user falls below the MCR, anyone can initiate a liquidation operation on Liquity. The platform rewards the originator with a liquidation reserve of 200 LUSD deposited by the borrower at the time of borrowing plus 0.5% of the liquidated collateral to cover the gas fees. The LUSD used for liquidation comes from Liquity’s stability pool, and, in return, holders of the stability pool will receive a pro-rata share of the liquidated collateral ETH.
This model is profitable for both the liquidation originator and the liquidators holding LUSD in the stability pool, and liquidation occurs without waiting six hours, which will be executed as soon as the 110% collateral ratio is reached.
Even if significant assets need to be liquidated when the LUSD in the stability pool is depleted, a secondary liquidation mechanism called “reallocation” will occur. For a borrower who needs to be liquidated, the system will redistribute the debt and collateral from his Trove to other borrowers’ Troves. At which point, the higher the CR, the more debt and collateral the borrower will receive as additional net gain, even if his CR has been reduced.
In addition, Liquity has set up a Recovery Mode to ensure that it has sufficient collateral to cover its risks. When the system’s total collateral rate (TCR) falls below 150%, liquidation of all Troves with less than 150% CR will be liquidated. The Recovery Mode is a deterrent to users with low CR, keeping Liquity’s TCR currently at around 280%.
Conclusion
Footprint’s comparison of the differences between the two protocols is summarized in the table below:
Liquity can be said to be standing on the shoulders of giants, setting up mechanisms that target MakerDao’s pain points everywhere. But it is not conclusive that Liquity’s mechanism can beat MakerDao since both are the product of continuous optimization according to the market at different times. As the earliest stablecoin lending protocol, MakerDao has already established a firm foothold in the market through its first-mover advantage.
MakerDao and DAI still hold a massive advantage over Liquity in terms of size. Recently, MakerDao has also been expanding its use cases, proposing to make DAI a clean money and developing use cases to solve real problems in the real world.
As a front-runner in decentralized stablecoins, MakerDao has been criticized for its involvement in centralization, but its forward-looking and more ambitious strategic perspective is an advantage. However, Liquity will need to continue building a solid foundation in expanding the use cases for LUSD or develop more differentiation in the stablecoin segment, such as its strategy for long-term borrowing.
The above content is only a personal view for reference and information and does not constitute investment advice. If there are obvious errors in understanding or data, feedback is welcome.
Footprint Website：https://www.footprint.network/
Data Source: Footprint MakerDao Vs. Liquity Dashboard
Update: The Last image has been changed on November 16, 2021.