IOSG: What did Liquity experience during the test of the "519" market crash?
How does Liquidity maintain relatively stable operations amidst the market turbulence as Ethereum rapidly drops to $1800?This article was published by IOSG Ventures.
On May 19, 2021, the price of ETH plummeted from $3,400 to $1,800 in a short period, causing other cryptocurrencies to also experience significant drops, and the entire market quickly entered a downward trend. Meanwhile, Liquity faced its first major test, including the near liquidation of 606,000 ETH staked by Tron founder Justin Sun. In this article, we will review the entire process.
Liquity allows users to borrow ETH at a 0% interest rate with a collateralization ratio below 110%. Liquity is entirely controlled by algorithms, based on game theory logic, with no human intervention. However, even though Liquity is theoretically well-designed to handle extreme market fluctuations, nothing proves the strength of its protocol design better than an actual market shock. Especially during extreme downturns like on May 19, it proves that Liquidity is indeed very robust!
When the price of ETH crashed, 300 addresses were liquidated, some due to normal liquidation and others due to the [Recovery Mode]. During this turbulence, Liquity experienced two liquidation modes.
For readers who are not very familiar with Liquity: Under normal circumstances, positions with a collateralization ratio below 110% will be liquidated. In [Recovery Mode], when the Total Collateral Ratio (TCR) falls below 150%, all positions with a collateralization ratio below 150% will be liquidated.
Data source: https://duneanalytics.com/dani/Liquity
In the above image, we can see the system's rapid liquidation process under extreme pressure, from 1,054 addresses at the start to only 677 remaining at the end of the liquidation. According to statistics, the system liquidated 121 addresses in normal mode, while 189 were liquidated in Recovery Mode. This liquidation mechanism allows Liquity to operate healthily and quickly exit Recovery Mode. In fact, the transition between these two modes happened so quickly that Dune was unable to capture the relevant data:
Despite the large number of liquidations, the stability pool effectively handled all bad debts. Approximately 93.5 million LUSD debts were liquidated, and the 48,668 ETH that were liquidated were distributed to stability pool depositors.
So, does liquidation increase price pressure on ETH?
The ETH that is liquidated is not sold on the market but is proportionally distributed to all stability pool stakers, each of whom can choose to sell or hold their share.
Top 5 largest liquidations
How is the price of LUSD?
LUSD experienced its largest volatility since its launch; however, importantly, its price fluctuated around $1 at that time.
This validates the hard peg mechanism in Liquity's design. In other words, as long as the trading price of LUSD is below $1, arbitrageurs can buy LUSD on the market; then, based on the face value of LUSD ($1) and the ETH:USD trading pair price provided by Chainlink's oracle, they can redeem ETH, thus locking in risk-free profits. The LUSD redeemed comes from the riskiest positions, while improving the overall health of the system.
On the other hand, the minimum collateralization ratio of 110% creates a natural price ceiling at $1.1, because as long as LUSD is above this threshold, borrowers can borrow the maximum amount using their collateral and sell LUSD on the market for more than $1.10, thus obtaining instant profits.
Returning to the performance on May 19, initially, we saw the price surge, pushing LUSD to nearly $1.10. This was expected behavior, as the drop in ETH price led many borrowers to realize the risk of liquidation, thus eager to repay their debts, driving demand for LUSD.
At the lowest point, the price of LUSD reached $0.91; however, due to the aforementioned arbitrage forces, it quickly recovered its peg.
Largest redemption amount
Follow-up
The storm has gradually calmed, and the Liquity system continues to operate stably, with all defaulted debts compensated, and stability depositors in the green. At the time of writing, Liquity's total collateralization ratio is 281%. Here are some summary statistics:
After users repaid debts, redeemed LUSD, or burned approximately 880 million LUSD through liquidation, about 880 million LUSD remains in circulation.
Approximately 909,000 ETH (worth $2.47 billion) is retained in the system, distributed across 677 addresses.
Overall, we are very satisfied with Liquity's performance in this test. Although liquidation is not an enjoyable process, especially with high gas fees, it has proven that using Liquity can indeed maintain a relatively safe collateralization ratio.
What did we learn from this crash?
Nothing validates the effectiveness of a protocol better than its performance in extreme market downturns (like on May 19);
The May 19 incident was a real stress test for the Liquity protocol;
Liquidity performed quite robustly, ensuring sufficient ETH collateral, and LUSD maintained its peg to the dollar;
In a short period, the Liquity system's collateralization ratio fell below 150%, automatically triggering "Recovery Mode";
A total of about 400 addresses with 50,000 ETH were liquidated and allocated to the stability pool;
The largest single liquidation amount exceeded 17,000 ETH!
Liquidation does not create selling pressure on ETH, as the collateral is proportionally distributed to the liquidity pool.
Most ETH was liquidated at prices below $2,000, bringing significant profits to stability pool stakers.
