Analyzing the LSDfi project by Lybra Finance

Author: @0xMavWisdom

Note: This text is for informational purposes only and is not associated with any financial interests or endorsements of the mentioned project.

With the continuous increase in ETH staking rate and LSD emerging as the leading asset category in terms of Total Value Locked (TVL), there is a growing trend in the community to explore more profit strategies around xETH. Integrating DeFi into the LSD space, which boasts $19.62 billion in assets, is becoming a focus of attention. According to data from Dune Analytics, as of May 30th, the TVL of LSDfi reached $315 million, which is only equivalent to 1.6% of the LSD TVL. Among them, Lybra Finance accounted for 56.9%, and it set a new record for single-day growth with over $43 million worth of ETH/stETH inflows on May 29th. The LBR Token has also achieved over 30x growth in just over a month. This article will analyze Lybra Finance with a focus on the eUSD stablecoin.

Core Business:

Lybra Finance allows users to deposit ETH or stETH as collateral on the platform to mint corresponding eUSD stablecoins. The liquidation threshold is set at 150%, meaning that each $1 eUSD must be backed by at least $1.5 worth of stETH collateral. By holding the minted eUSD, users can earn interest income passively (similar to a savings account), which is supported by the LSD income generated from the deposited ETH/stETH. This means that when users deposit ETH/stETH into Lybra to mint eUSD, the deposited ETH/stETH is used to participate in LSD. Participating in LSD rewards users for validating and securing the Ethereum network, generating rewards in the form of stETH. These rewards are then converted into eUSD as interest income through the Lybra Finance protocol and distributed to users. As of May 30th, the annualized interest income generated by holding eUSD is approximately 8.4%. (Note: Depositing ETH on Lybra will be converted to stETH.)

Protocol Revenue:

Lybra does not charge fees for minting and repaying eUSD. Its main source of protocol revenue comes from the service fee charged on the income generated from LSD. This service fee amounts to 1.5% of the total eUSD in circulation on an annual basis (the fee accrues every second based on the current actual eUSD circulation). After deducting the service fee, the income from LSD is distributed among eUSD holders. The collected annual service fee is allocated to the LBR Staking Pool, and users can stake LBR to convert it into esLBR and receive 100% of the service fee.

Stability:

eUSD is actually an overcollateralized stablecoin.

(1) At least $1.5 worth of stETH is required as collateral for every $1 eUSD minted, and it supports a rigid redemption of eUSD to ETH (subject to a 0.5% redemption fee, denominated in ETH).

(2) Liquidation mechanism for collateralization below 150%: Any user can become a liquidator and purchase the liquidated stETH collateral using eUSD as the payment currency at a discounted price (1 minus the liquidation reward rate).

(3) Based on the previous points, arbitrage opportunities arise when the price of eUSD fluctuates. When eUSD < $1, arbitrageurs can purchase undervalued eUSD on the secondary market and then rigidly redeem it for ETH worth $1. As more arbitrageurs engage in these repetitive operations, the price gradually equalizes. When eUSD > $1, arbitrageurs can deposit ETH/stETH as collateral to mint new eUSD and sell it on the secondary market. By waiting for more arbitrageurs to execute the same operation, the price is gradually pushed down. Once the peg is restored, arbitrageurs can repay the loan by repurchasing eUSD from the secondary market, and the price difference between the initial and final eUSD prices becomes their profit.

(4) Curve provides liquidity for exiting eUSD. As of May 30th, the circulating supply of eUSD is approximately $90 million. Through Lybra’s LBR emission incentives, over $19 million worth of eUSD is operating in Curve’s eUSD/USD LP Pool, with a TVL of approximately $32 million. The daily trading volume is around $1.62 million, and the liquidity utilization rate is 5.05%. However, the true significance of a stablecoin lies in its adoption and utility. Whether eUSD can be integrated and adopted by other on-chain protocols remains to be seen.

There are two points to note regarding rigid redemption:

First, rigid redemption requires a 0.5% fee to be paid on the redeemed ETH. This may result in a 0.5% implicit deviation tolerance if eUSD deviates below $1. This means that for arbitrageurs to profit, the downward deviation must exceed 0.5%.

Second, rigid redemption does not necessarily mean the repayment of eUSD debt. Users who have minted eUSD can choose to provide rigid redemption services and receive a 0.5% redemption payment fee, as well as higher LBR APY, fee compensation, and other incentives. If a redemption occurs, the user providing the redemption service will lose a portion of their collateral, reduce their corresponding debt, and receive the 0.5% redemption fee paid by other users. This means that by offering the redemption service, a user’s collateral becomes the redemption liquidity for other users.

Risk Management:

eUSD, or the entire LSDfi sector, essentially operates as a second-layer nested system. After depositing ETH or stETH into Lybra, they are uniformly converted into stETH. With stETH relying on the native asset ETH and enjoying a strong reputation as the main staking token on the Ethereum 2.0 platform through Lido, it has become a trusted asset in the DeFi space. Hence, stETH can be seen as a nested asset within ETH. eUSD, on the other hand, is a stablecoin minted on the basis of stETH collateral, representing the second layer of nesting. Users can earn two forms of income by depositing ETH into Lido and obtaining stETH tokens, which represent the first yield from staking. Subsequently, they can use stETH as collateral to mint eUSD and earn a second income stream in the form of interest. By employing this dual-layer nesting strategy, users can enhance the returns from holding ETH. However, it is important to note that high returns often come with high risks, posing a significant test for the platform. The liquidation mechanism serves as a vital safeguard for risk prevention and curtailing the spread of risk.

In general, since each eUSD is backed by at least $1.5 worth of ETH/stETH collateral, the Lybra Finance protocol maintains an overall collateralization ratio above 150% under normal circumstances.

For the liquidation that does not touch the risk control of the platform (i.e., when the overall collateral ratio of the protocol is greater than 150%)), when the borrower (minted eUSD) is liquidated, the user can become the liquidator. With the help of Keeper (a specific participant playing the role of liquidation), the user can use his eUSD balance to liquidate up to 50% of the borrower’s collateral and receive collateral assets worth 109% of the repaid eUSD value. Keeper receives collateral assets worth 1 of the repaid eUSD value. (Note: The liquidation reward is 10%, with 9% going to the liquidator and 1% going to the Keeper, but it applies only to liquidation actions performed using the official liquidation tool.)

Here’s the translation of the example you provided:

For example, A deposited 1 stETH as collateral and minted 1400 eUSD a week ago. Within that week, the USD value of ETH dropped from $2200 to $2000. At this point, A’s collateral ratio is calculated as 2000/1400=142%, which is less than 150%. B, as a Keeper, initiates liquidation against A, with a maximum liquidatable collateral of 1 stETH * 0.5 = 0.5 stETH.

Liquidator C has a balance of 500 eUSD, which is fully used to repay A. C will receive 500/2000 * 109% = 0.2725 stETH, equivalent to 545 eUSD. B, as the Keeper, will receive 500/2000 * 1% = 0.0025 stETH, equivalent to 5 eUSD.

After C repays A’s debt, A’s remaining debt will be 1400–500 = 900 eUSD, and the collateral value will be 1–0.2725–0.0025 = 0.725 stETH. At this point, the collateral ratio is calculated as 0.725 * 2000 / 900 = 161%, which is greater than 150%.

This also indicates that there is a time delay between the liquidation initiated by the Keeper and the execution of the liquidation by the liquidator. Therefore, it is not an immediate liquidation as soon as the collateral ratio falls below 150%. There is a process similar to a queue, resembling the liquidation process in on-chain DeFi lending protocols.

Another extreme scenario is when the overall collateral ratio of the Lybra Finance protocol falls below 150%. In this case, borrowers with a collateral ratio below 125% will face complete collateral liquidation. In the event of full liquidation, the liquidator can acquire collateral assets equivalent to the borrower’s debt by paying an equivalent amount of eUSD. The value of the collateral assets obtained is calculated as the borrower’s debt multiplied by (collateral ratio — 1%), with the deducted 1% owned by the Keeper. The borrower, i.e., the party being liquidated, will have both their collateral and debt reset to zero. In an even more extreme situation, if the collateral ratio is below 101%, i.e., collateral ratio < (100% + Keeper reward ratio), the Keeper does not receive any reward.