If you’ve been following DeFi for the past few months, you may have started to see more news about the fully decentralized lending protocol Liquity.
It offers a host of novel features that make it one of the most promising projects in the DeFi space to date, and has brought forward a variety of innovative improvements to crypo-lending.
If you want to learn more about the protocol and the technical details behind how it works, the team has put together a comprehensive explanation on the Liquity Docs and actively answers questions in the Liquity Discord.
In this guide, I’m going to provide an in-depth and thorough explanation of all of the ways that you can start making money with the Liquity protocol today (spoiler: there’s a lot).
Along with that, I’ll also point out all of the potential risks for you to be aware of along the way and explain how you can minimize your risk profile to keep your funds safe.
This guide is meant for beginners and crypto-veterans alike and I’ve tried to explain everything in the most understandable way possible, so I hope that everyone’s able to get some value out of it. If you find this guide helpful, make sure to share it with anyone else that you think would be interested!
What makes Liquity so innovative?
Before we discuss the methods that you can make money with Liquity, its probably a good idea to briefly go over the innovations that the Liquity protocol has brought about and why you might want to get involved.
For starters, Liquity is a lending protocol, meaning that it enables users to borrow money against an underlying collateral payment (in this case ETH), similar to how real-life banks allow people to borrow money against tangible collateral (often money or real-estate).
There are a few key improvements that set Liquity apart from the numerous other DeFi lending protocols today like AAVE, Compound, and Maker, etc.
For the sake of saving time, I’ll go over the most important of these improvements that directly affect you, but if you’re interested to read more about it in depth, there’s a great description about these innovations on the Liquity Features Page.
Many of the benefits of Liquity stem from the fact that the protocol allows for an incredibly capital efficient system because of the way that it handles the process of liquidating under-collateralized assets (when someone has borrowed more than they are allowed to given the collateral payment that they have deposited, their collateral is taken by the system, similar to how banks in real life work).
Unlike lending protocols like Maker, which use lengthy auctions to liquidate assets (which can often take 6+ hours), Liquity utilizes an instantaneous liquidation mechanism that safely pays off the debt of people with under-collateralized loans and claims their collateral.
This makes sense, but now you may be wondering how this affects you.
In short, because of the genius liquidation mechanism provided by Liquity, the protocol is able to charge 0% interest rate on your loans.
Yes, you read that right. You can take out loans against your collateral for no interest rate. This is an almost unheard of concept. Instead, all you have to do to take out a loan is pay a small 0.5% fee one time.
On top of that, there’s no term on your loans with Liquity. In other words, you can take out a loan indefinitely, and as long as you don’t get liquidated, you never have to pay back any part of your loan.
Finally, because of the stability of the protocol, you can take out loans at a minimum 110% collateral ratio (whereas other lending platforms allow loans with a minimum of 150%, 200%, and even up to 750% collateral ratios).
What this means is that the collateral you deposit into the protocol only needs to be worth at least 110% of the loan that you take out, allowing for the most bang for your buck as far as getting leverage against your collateral.
There are a number of other innovations that Liquity has made including the implementation of one of the first truly decentralized lending protocol’s through the lack of governance, the usage of decentralized frontends, and several other improvements that I’ve chosen to gloss over for the sake of time, but I encourage you to read more about them if you’re curious.
Now that we’ve discussed the benefits of using Liquity, let’s get into the juicy topic that we all want to know about…
How can you make money with Liquity today?
Currently, there are a number of different ways to make money using the Liquity protocol (many of which have very good returns). I’ll describe each strategy along with the risks you should be aware of when getting involved.
When discussing these strategies, there are a few coins and simple concepts that you should be aware of: in the Liquity protocol, you deposit ETH as collateral for your loans.
In return, you get a stable coin called LUSD which remains roughly pegged to the US Dollar (1 LUSD = 1 USD).
Additionally, the Liquity protocol issues its own token called LQTY to people who support the system (I’ll talk more about this soon).
Now that we know the basics of the system, we can discuss the main ways that you can start making money with Liquity today.
Method 1: Borrow LUSD against ETH
This is the most straightforward of the use cases of the protocol and is equivalent to taking out a loan in real life. In short, you can deposit your ETH into the Liquity protocol and can take out any amount of LUSD that would leave your collateral ratio greater than or equal to 110%.
From here, you can use your LUSD as you could any other stable coin. Because you get your loan in cryptocurrency, you can use this leverage to capitalize on any insights you have about the crypto markets without spending your precious ETH.
In other words, once you have taken out your LUSD loan, you can spend your LUSD on any assets that you predict will appreciate, and make a profit on these purchases. This is equivalent to buying on leverage (fun fact, you can actually buy up to 11x of your deposited collateral if you keep purchasing ETH with your LUSD).
Risks #1: Getting liquidated — If the value of your ETH collateral drops to below 110% (or below 150% during recovery mode) of the value of the LUSD that you borrowed against, your collateral will get liquidated. What this means for you is that you will lose all of the ETH you posted for the loan, but you will keep all of the LUSD that you borrowed against it. This means that you will effectively take a 10% loss. In order to avoid this, it’s important that you maintain a high collateral ratio.
Risk #2: Getting redeemed against — Even if you’re collateral ratio is above 150%, you can still lose your underlying ETH collateral. If someone wants to redeem their LUSD for the corresponding value in ETH, the ETH is taken from the collateral of the person in the protocol with the lowest collateral ratio, and the LUSD is used to pay off your debt. In this scenario you technically don’t lose anything (your debt is paid off and you lose a corresponding amount of ETH). Again, you can avoid this risk by maintaining a high collateral ratio.
Risk #3: Not being able to pay off debt — This is the same as risk #1 but with a bit more nuance: if you spend your LUSD, it might be difficult to pay off your debt in the future if you ever needed to. Because you can only pay off your debt with LUSD (not with ETH or anything else), by spending your LUSD, you are losing your only means to paying off your debt. When you do need to pay off your debt (if this ever happens because ETH price drops for example), you will have to buy it back in a DEX and pay gas + transaction fees which could be costly, so this is something to keep in mind.
Method 2: Stake your LUSD in the stability pool
Instead of spending your LUSD on some other cryptocurrency, you also have the option of depositing it in Liquity’s stability pool (the mechanism that allows for the incredibly stable and liquid liquidation process of the protocol).
What this means is that you temporarily deposit your LUSD in the protocol, and in return, you get LQTY (the reward token for the protocol) as well as small amounts of ETH when people’s positions get liquidated. At the time of writing this article, the APR on this method is around 25% (way higher than returns you’ll see in traditional banking methods).
Keep in mind that you can take out your LUSD at almost any time (with one exception that I’ll mention below), so this is a relatively safe way to use your LUSD.
Alert #1: You slowly lose your LUSD —This is less of a risk and more something to be aware of. When you deposit your LUSD in the stability it slowly gets used up over time. This could be a risk for the same reason I mentioned above about using up your LUSD — you may lose your way to pay off your debt. However, to put things into perspective, the LUSD used up by the system is distributed across all LUSD stakers, so you end up losing fractions of an LUSD every few days/weeks. Also, when you lose LUSD, you almost always gain back more than the amount you lost in ETH (great for all the ETH bulls out there!). In practice, this isn’t actually worth worrying about, but I wan’t to mention it just for completeness.
Alert #2: Not being able to withdraw LUSD — You can almost always withdraw your LUSD, but in the event where someone else can be liquidated, you are not allowed to withdraw your LUSD from the stability pool. This isn’t really a concern at all though because liquidating someone else (which I’ll talk about later) earns you money, so this feature basically forces you to make more money 😂. Again, this is less of a risk, and more just something to be aware of.
Method 3: Stake LQTY
There are two ways to get LQTY. The first, which I mentioned above, is through staking your LUSD in the stability pool. For doing this, the system rewards you with LQTY. Additionally, you have the option of buying LQTY in many DEXs like Uniswap if you really want to bet on the protocol.
Once you have this LQTY, you can stake it in the protocol to earn rewards in LUSD and ETH. These rewards come from the revenue generated by the protocol from people taking out loans and redeeming there LUSD. Because of this, buying and staking LQTY is arguably the best way to bet on the Liquity protocol (if you are a big believer).
On top of this, staking LQTY currently offers the biggest rewards of anything in the protocol. At the time of writing this article, the reward on staking LQTY is around 51% APR!
The craziest thing about this method is that there’s virtually no risk to it. Once you have LQTY, there’s currently no reason why you wouldn’t want to stake it. When you stake LQTY, you can unstake it at any time, and you don’t lose anything at all for staking it. The only cost is paying the transaction fee to stake/unstake your LQTY.
Method 4: Become a Uniswap ETH-LUSD LP
This method probably won’t remain viable for much longer, but at the beginning of launch, the Liquity team incentivized people to become ETH-LUSD liquidity providers to ensure the liquidity of LUSD.
In return, they issued a fixed LQTY reward for participants, which is currently at around 1.5% yield.
I won’t go too in depth on this method for the sake of simplicity and given that it’s starting to slow down (considering the decreasing yield and decreasing available LQTY reward pool), but it’s important to note that the risks that come with this method are common with any crypto LPing.
Method 5: Liquidate Positions
We’ve already discussed how the system liquidates under-collateralized debtors positions. This process actually occurs when someone clicks the button to liquidate someones position.
The person that clicks the button to complete the liquidation is rewarded with 200 LUSD (the intention of this is to cover gas costs) along with 0.5% of the ETH that was liquidated. This may not sound like a lot, but if you consider the fact that there are many whales with thousands of ETH in collateral, it starts to add up if you are able to liquidate the right people.
That being said, at the time of this article, we’ve seen an ETH bull market for the past several months, meaning that few people have fallen below the 110% collateral ratio and been liquidated, so it’s not as easy to earn money from this method right now. That being said, if ETH were to see some price correction or crash, we would see a lot of liquidations happening which could be incredibly profitable for liquidators.
Alert #1: The main thing to be aware of when liquidating is the gas cost of completing the transaction. With ETH gas costs rising, you want to make sure that you’ll be making more than you pay in gas when liquidating someone’s position. That being said, the Liquity team has done a considerable amount of analysis to come to the conclusion that the 200 LUSD reward will almost always outweigh the gas-cost of liquidation.
Method 6: Redemption Arbitrage
Now we come to the last major method of making money with the Liquity protocol: arbitraging with the redemption mechanism. As previously mentioned, the Liquity protocol allows you to redeem your LUSD for ETH at any time. It’s important to note that when you redeem ETH for your LUSD, the system always gives you ETH as if your LUSD was worth exactly 1$.
What this means is if the value of LUSD falls enough below 1$, you can arbitrage the difference between the actual price of LUSD and the value that LUSD is given by the redemption mechanism by taking out LUSD against ETH and then redeeming ETH for your LUSD, getting more in ETH then your LUSD is actually worth.
However, it’s also important to consider that the protocol charges an 0.5% network fee for redemption, meaning that the LUSD price has to fall sufficiently below the 1$ mark in order for redemption arbitraging to be profitable.
Like any arbitraging, there are certainly risks to this strategy. However, as they aren’t specific to the Liquity protocol and are just general to the practice of arbitraging, I’ll leave out an in depth discussion of the risks (the main risk is just your order going through at a price you didn’t expect and then losing your profit margin on the arbitrage, which becomes very risky considering the volume necessary to make arbitrages profitable).
As you can see, there are a number of ways that you can make big returns with the Liquity protocol.
If you decide that you wan’t to get involved with any of the above methods yourself, I would recommend reading this article on How to Earn Rewards with Liquity as it details the step by step process of using the protocol.
Risk mitigation with Liquity
There are a few risks I mentioned above that are important to be aware of when using the Liquity protocol. However, there are ways to largely mitigate these risks to the point where you can have a very low risk profile and still reap the rewards of the system.
In short, risk mitigation with Liquity just comes down to maintaining a good collateral ratio. If you’re able to maintain a collateral ratio higher than the majority of the system, you stand very little risk considering that billions of dollars of ETH would need to get liquidated before your position was, meaning that you would get part of this reward back if you have deposited LUSD in the stability pool.
In general maintaining a collateral ratio above 150% ensures that you can’t be liquidated, although you can still be redeemed against as long as you have the lowest collateral ratio of the system. In general, Liquity recommends maintaining above a 250% or even 300% collateral ratio.
What it really comes down to is thinking about the lowest price that you think ETH may drop to, and then calculating the collateral ratio you would need right now to ensure that if ETH fell to that price, you still could not get liquidated.
There are a few ways to ensure that you maintain a good collateral ratio:
- First, you can just take out a loan initially at a high collateral ratio. This is very straightforward and works very well, especially during the ETH bull market as collateral ratios continually increase with the price of ETH.
- Additionally, you can deposit more ETH into your position to raise your collateral ratio. Keep in mind that you will have to pay gas costs to do this, which may get high during an ETH crash.
- Finally, you can also pay off part of your debt in LUSD. Again, it’s important to keep in mind that you will have to pay gas costs to do this. Additionally, you aren’t allowed to have a portfolio with a debt under 2000 LUSD, so you wont be able to fractionally pay off your debt below this number. However, as long as your debt is above 2000 LUSD, you can pay off whatever amount you want to down to 2000 LUSD. Once you hit 2000 LUSD, you must pay off the entire debt at once if you want to pay off your debt.
If you are able to maintain a good collateral ratio and maintain your position responsibly, there’s a lot of money to be made with the Liquity protocol!
Some closing thoughts
I hope this article has been helpful to you, and hopefully you’ve learned about the Liquity protocol and are considering getting involved yourself. If you found this guide valuable, make sure to share it with anyone else that you think may benefit from it!
If you like this type of content and want to learn more about Liquity, or are interested in blockchain in general, make sure to reach out to me and connect with me on Twitter and Linkedin, I love meeting/talking to new people!
That’s all for now, thanks for reading!