This post is in response to a discussion between Lucas and TnD on the discord, regarding staking and liquidations. Lucas said:
I wonder if the (Trustless) protocol could become the sole liquidator and that could be a source of profit sharing
My detailed response will follow below, but a quick summary of it is that I think there is significant potential value in Trustless pivoting to a system like this instead of the current liquidation plans, which can be seen in the docs here.
Let’s begin by evaluating Liquity’s approach and later connecting it to Trustless.
I was reading through a twitter thread about a project called PowerPool hoping to improve liquidity for LUSD on the open market, and was reminded about how Liquity does it. One of the cornerstones of Liquity’s value propositions is how they generate part of their revenue sharing in ETH by deploying a stability pool which is used in performing automated liquidations, with the aid of a backstop liquidity service called B.Protocol.
This has pros and cons.
Pros: Revenue sharing in ETH is seen is very attractive by users, who prefer to receive rewards in assets like ETH that are more liquid. And of course, the benefits of the liquidated ETH being passed directly to LUSD stakers (with a small cut sent to “initiators” of the liquidations as a reward) brings value accrual back to the protocol itself.
Cons: What we have seen happen with LUSD over the past few months, with the majority of LUSD held in the stability pool since the rewards there are attractive, leading to lower liquidity of LUSD on the market and a price depeg of LUSD to the upside. This leads to further downstream consequences, such as the LUSD-3CRV pool becoming imbalanced, causing downside impact and thus a lower expected yield over time as it returns to peg. For example, Gro Protocol recently pulled out of its LUSD-3CRV yield strategy because of LUSD’s liquidity and peg issue.
That said, Liquity is working on a few different solutions for this. If they could solve the LUSD depeg and liquidity problems, Liquity would continue growing even further. Possible solutions are explained in this twitter thread (along with their upcoming Chicken Bonds product, which was not mentioned).
What does this mean for Trustless?
As I understand it, Trustless plans to allow anyone to pay off the debt of liquidated positions. I can empathize with the thinking behind this approach, as it outsources the responsibilities to individual users rather than relying on a stability pool and a third-party service like B.Protocol, as Liquity does. However, I tend to believe that Trustless’ approach will ultimately benefit users who have the technical and financial means to program bots and obtain enough Hue (or perform flashloans) to do this. Furthermore, it will send the ETH collateral out of the Trustless protocol rather than utilizing it as a revenue sharing source which could lead to further value accrual for users of Trustless. For another example proving the value of ETH rewards for users, there are relevant discussions in the KyberDAO forum about why ETH rewards should be maintained for participants.
While Liquity’s current approach is imperfect, I tend to think that the pros of keeping ETH revenue sharing mostly within the system outweigh the cons and have contributed significantly to Liquity’s growth. The issues with unbalanced incentives already have multiple solutions being worked on that could provide helpful examples if Trustless ever considers implementing a similar protocol-managed liquidation approach.
What do others think? Is this feasible and achievable for Trustless? If so, how could it be implemented and involved with the Trustless DAO?