Liquity V2: A Comprehensive Guide to Its Architecture
In 2021, Liquity disrupted the DeFi landscape by introducing interest-free borrowing against ETH, reaching a peak of over $4.5 billion in TVL and over 30 Liquity V1 forks. Liquity’s immutability and use of Ethereum’s most liquid collateral established it as the leading Collateral Debt Position (CDP) provider on the market.
The protocol has proven resilient under various market conditions, successfully managing both liquidation cascades and overheated interest rate environments. However, over time, the rise of liquid (re)staking derivatives (LST/LRT) significantly increased the effective borrowing costs on the platform. Simultaneously, higher interest rates exerted pressure on Liquity’s capital efficiency by raising the average loan-to-value on to platform, so users can avoid redemptions.
In response, the team developed an innovative design that aligns the incentives of both borrowers and liquidators, allowing the system to self-adjust under varying market conditions while preserving the platform’s core ethos of decentralization and immutability. With the launch of the much-anticipated Liquity V2, the protocol is rewriting the playbook to enhance capital efficiency, improve collateral flexibility, and empower users with customizable borrowing terms.
Central to this upgrade is BOLD – a stablecoin that bridges the gap between stability and yield by supporting multiple collateral types and enabling users to set their own interest rates. With BOLD, Liquity V2 shifts control to the community, aligning incentives for both borrowers and liquidity providers.
In this article, we’ll explore how Liquity V2 is rebooting its structure and redefining the DeFi experience for the community.
Introducing BOLD
Stablecoins are a fundamental pillar of DeFi and a primary product-market fit for the crypto industry, but their reliability can vary significantly. To truly gain the trust of the users, the robustness of a stablecoin can be assessed based on three key areas:
Collateralization and Redeemability
A reliable stablecoin should always maintain sufficient liquid collateral and allow users to redeem it seamlessly, regardless of market conditions.Counterparty Risk
Reducing reliance on centralized entities ensures stability without introducing vulnerabilities to third-party failures.Decentralization
A stablecoin should embody the ethos of DeFi by being decentralized, avoiding privileged to control the key risk parameters, and promoting trustless usage.
In this image, Liquidity AG created BOLD. Designed as the DeFi treasury asset of choice, the stablecoin is setting a new benchmark with its unique features:
Novel Interest Rate Model
Rather than relying on utilization curves or a DAO-set fixed interest rate model, Liquity V2 enables users to select the borrowing rate for their credit lines based on their own risk tolerance and market outlook.Decentralized and Resilient
BOLD is built on a decentralized framework. The smart contracts are designed to be immutable – the collateral mix is fixed and the underlying logic cannot be twisted over time. Post-deployment, the core team has little control over the capital. Furthermore, 100% of the revenue goes entirely to BOLD holders and the ecosystem, eliminating the need for trusted third parties. The only "dynamic" element is the distribution of revenue, which is determined through voting by LQTY tokenholders.Stability Backed by Over-Collateralization
BOLD is supported by only 3 collateral assets, ETH, Lido’s wstETH and RocketPool’s rETH. Hence, BOLD borrowers are now able to capture the staking rewards on their collateral, effectively reducing the net interest rates on their credit lines.
Liquity V2 will behave similarly to money markets but with opposite spreads: depending on the utilization and integration of BOLD in the broader DeFi ecosystem, the Stability Pool will generally exceed the average borrow rates, something that isn't possible on traditional lending markets.
Key Features of Liquity V2
Redemption Mechanism
In Liquity V2, the redemption mechanism is designed to maintain the peg of BOLD by allowing users to exchange their BOLD for collateral assets at the market rate. This mechanism strangthens the system's peg stability and interest rate alignment, providing a safeguard against BOLD trading at a discount.
When BOLD trades below its peg, users can redeem collateral at a face value, effectively catering to risk-free arbitrage that stimulates BOLD demand and brings the price back to its intended value. A key difference from Liquity V1 is that the new design primarily targets the redemption of loans with lower interest rates set by users rather than focusing on redemptions based on the collateralization of debt positions. This market-driven approach incentivizes borrowers to actively manage their risk profiles while substantially improving protocol’s capital efficiency.
Furthermore, compared to the first version of the protocol, Liquity V2 enhances the sustainability and expected yield for the backstop liquidity providers (namely, the Stability Pool depositors). Instead of relying on $LQTY inflation and liquidation penalties, Stability Pool depositors capture the lion's share of user-paid interest rates (unless voted otherwise), while still acquiring bad debt at a 5% discount.
The peg mechanism is also controlled by the system’s maximum leverage. This, in turn, is kept at 110% of the deposited collateral, introducing an upper bound for BOLD at $1.10. If the price exceeds $1.10, users could theoretically maximize their borrow limits and instantly sell BOLD for a profit without bearing potential liquidations risk.
In summary, the redemption mechanism and maximum leverage levels of Liquity V2 serves as a dynamic tool to stabilize BOLD’s price, protect borrowers, and optimize collateral efficiency and rate setting within the ecosystem.
Multiple LSTs as Collateral
Liquity V2 introduces multi-collateral support, including the leading and most battle-tested liquid staking tokens (LRTs) on the market. Thus, the protocol expands beyond ETH as the sole collateral option. The multiple LSTs feature:
Attracts a broader user base by accommodating preferred assets.
Lowers the effective borrowing rate for the users.
Liquity V2 expands its collateral support beyond ETH to include Lido’s wrapped staked ETH (wstETH) and Rocket Pool’s rETH. With these, borrowers can benefit from the auto-compounding staking yields provided by LSTs.
Unlike other Liquity forks that pool LST collaterals together, Liquity V2 treats each asset as a distinct lending market, each with its own interest rates and risk parameters. This segmentation improves the protocol’s risk management, as the system dynamically adjusts the redemption process based on the debt collateralized by the LST and the size of the corresponding Stability Pool (SP). More importantly, a wstETH or rETH failure will not compromise the system, mitigating counterparty risk.
User-Set Interest Rates
One of the most significant changes in Liquity V2 is the introduction of customizable interest rates. This feature aims to create a more efficient and user-determined market between borrowers, backstop and onchain liquidity providers, and BOLD holders. Borrowers can:
Set competitive rates tailored to their risk appetite and interest rate outlook.
Benefit from a transparent and predictable rate-setting process that does not rely on third parties.
Participate in a system that incentivizes fair interest rate pricing through competition among borrowers.
Despite the flexibility Liquity V2 provides by allowing borrowers to set their own interest rates, each choice comes with its own set of trade-offs.
For example, if User A chooses a low interest rate like 1.5%, they will experience lower borrowing costs but face a higher risk of redemption. On the other hand, if User B chooses a higher interest rate such as 6.5%, their risk of redemption will be largely reduced but they’ll pay a hefty premium for it.
Hence, the architecture incentivizes participants to actively set and monitor their own interest rate, while penalizing the “set-and-forget” users. It also creates a yield-generating opportunity, where active borrowers might arbitrage their personal Trove’s interest rate with the Stability Pool yields.
Protocol Incentivized Liquidity (PIL)
Liquity V2’s Protocol Incentivized Liquidity (PIL) framework plays a pivotal role by allocating a portion of the protocol’s revenue to on-chain liquidity providers on decentralized exchanges. The system is governed by LQTY stakers, who gain voting power and, potentially, rewards.
The voting process allows stakers to either support or veto proposals that aim to optimize the protocol's growth, liquidity, and stability. Similarly to Curve’s (ve)nomics, the amount of staked LQTY directly impacts the voting weight, and the longer the tokens remain staked, the greater the voting power accrued.
The yield generated through the Protocol Incentivized Liquidity (PIL) mechanism comes primarily from the interest accrued on Trove debt positions in BOLD. Every second, borrowers pay interest on their open debt positions. 100% of the protocol’s revenue is distributed through two key streams: Stability Pool Rewards and Protocol Liquidity Incentives (PIL). Initially, 75% of the interest revenue is allocated to the Stability Pool to compensate liquidators, ensuring the system's resilience and maintaining BOLD’s peg stability. The remaining 25% is directed to the PIL framework, which is used to incentivize onchain liquidity provision and further enhance the protocol's ecosystem growth.
The distribution of PIL rewards follows a structured approach through a gauge weighting system, where LQTY stakers with voting power can influence the allocation of liquidity incentives. These stakeholders can propose and weigh various initiatives and direct funds to areas that best support the protocol's expansion. The selected initiatives then receive a proportionate share of the accumulated incentive budget on a weekly basis.
Security and Reliability
Liquity V2 emphasizes security and reliability as foundational pillars of its platform. To achieve these goals, the protocol has adopted a rigorous testing and auditing framework:
Deployment on the Sepolia Testnet Months Before the Mainnet Launch:
By launching Liquity V2 on the Sepolia testnet months before the official Ethereum Mainnet launch, the protocol engaged its user base and technical contributors to simulate real-world scenarios, test functionality, and gather critical feedback.
Extensive Auditing:
The protocol underwent in-depth audits by top-tier security firms, including Certora, ChainSecurity, Coinspect, Dedaub, and Recon. Additionally, a bug bounty program has been hosted on Hats Finance to uncover and address potential vulnerabilities in addition to these audits.
Licensing and Forkonomics: Innovation with Integrity
Liquity V1 was among the most forked protocols in DeFi. However, due to the lack of licensing in V1, Liquity and LQTY holders did not benefit from these numerous copycats. As a result, no value was captured for the original protocol, leading to missed opportunities for growth and synergies.
To address this, Liquity V2 will be launched under a multi-year Business Source License (BUSL), a strategic decision that balances innovation, intellectual property protection, and collaboration. The BUSL framework is designed to encourage responsible forking, allowing developers to collaborate rather than compete destructively. Over time, the license transitions Liquity V2 to a fully open-source model, aligning with the ethos of decentralization and a community-driven approach.
The commercial terms of the friendly fork model includes a portion of governance tokens or upside from new products being distributed to the original IP holders – Liquity and its users. The strategy ensures that value generated through forks contributes to the core product and supports its ecosystem's growth, while encoraging collaboration.
Liquity’s Multichain Approach: Over 15 friendly forks
Instead of pursuing a crosschain approach, where BOLD is bridged to multiple networks, liquidity is segmented, and marketing and integrations are carried by the core team, Liquity has decided to partner with multiple projects, granting them exclusivity for certain networks. Several protocols have adopted Liquity V2's architecture to build customized decentralized lending and borrowing solutions tailored to specific blockchains, with flexibility over their approach to risk management, governance mechanics and collateral types. The strategy ensures the necessary marketing and business development effort will be put towards the adoption of the novel design, while simultaneously aligning the incentives between forks and original codebase creators and users.
Felix – Hyperliquid Fork
Felix is a synthetic dollar protocol built on HyperEVM and the first incubated project by @hyperactive_cap, leveraging Liquity V2’s codebase to provide high-speed decentralized borrowing with enhanced security and risk management. HyperEVM is a general-purpose EVM secured by the same HyperBFT consensus as the rest of Hyperliquid’s L1. It enables seamless interaction with Hyperliquid’s native order books and liquidity pools.
Felix is issuing feUSD. Users can mint it by depositing various assets such as native HYPE, PURR, and bridged majors like BTC, ETH, and SOL.
At launch, Felix will introduce mint caps on feUSD to prevent excessive borrowing against illiquid assets, controlling the adequate liquidity for liquidations. Additionally, liquidation incentives will be implemented to encourage timely liquidations by factoring in collateral volatility and liquidity profiles, thereby preventing bad debt accumulation. These measures aim to enhance capital efficiency, promote long-term sustainability, and provide resilience across varying market conditions.
Once the HyperEVM mainnet goes live, Felix will implement an incentive program, allowing users to earn points for their participation in the ecosystem. Additionally, as part of the licensing agreement with Liquity, mainnet users of BOLD will also be eligible for separate incentive programs.
Nerite – Arbitrum Fork
Nerite brings Liquity V2 to Arbitrum to provide scalable and cost-efficient borrowing solutions. They introduce USDN, an over-collateralized stablecoin pegged to $1.00. Mirroring the collateral choice of the original codebase, Nerite supports three asset types including ETH, rETH, and wstETH, ensuring a decentralized and secure borrowing experience.
This protocol is set to launch its native governance token, $NERI. Similarly to LQTY, NERI’s tokenomics will grant holders governance rights, enabling them to participate in key decisions such as adjusting interest rates, modifying collateral requirements, and directing liquidity incentives within the ecosystem. The governance model is designed to empower the community by aligning their interests for long-term sustainability.
In preparation for the launch, Nerite announced the commercial terms with Liquity:
1% of the total supply will be allocated to Liquity AG for the licensing of the V2 code.
4% of $NERI will be dedicated to long-term liquidity incentives for a BOLD/USDN pool on Ramses, a decentralized exchange on Arbitrum.
2.5% of the $NERI supply will incentivize BOLD Stability Pool depositors, distributed linearly over the first six months following the protocol's launch.
Another 2.5% will be allocated as long-term incentives for using $BOLD across the Arbitrum DeFi ecosystem via Royco vaults and other usage-tracking tools. These incentives may include rewards for bridging $BOLD to Arbitrum, borrowing, depositing tokens in lending pools, and participating in crowdfunding initiatives.
Beraborrow – Berachain Fork
Beraborrow is the de-facto CDP market leader on Berachain. $NECT, protocol’s stablecoin, could be minted through various collaterals, including Berachain native tokens, liquid staking derivatives like $iBGT and $iBERA. Even liquidity provider positions from Bex (Berachain decentralize exchange) and Berps (Berachain perpetual) can serve as collateral options.
Collateral is then converted into "Dens" to mint $NECT without selling their assets.
What are Dens?
Dens serve as the foundation of Beraborrow's collateral management system, allowing users to deposit assets, earn yield, and mint the platform’s stablecoin, $NECT. This system provides liquidity without requiring users to sell their underlying holdings. By utilizing Dens, users can seamlessly access liquidity while maintaining exposure to their original collateral.
Beraborrow incorporates various stability mechanisms to ensure system resilience. A key component is the Brime Den, a protocol-managed reserve designed to absorb redemption impact and prevent sudden liquidity drains. The Brime Den acts as an intermediary layer, routing redemptions before they impact other users, ensuring a more resilient borrowing environment.
Quill Finance– Scroll Fork
Quill Finance is a decentralized over-collateralized stablecoin protocol built on the Scroll network, leveraging zk-Rollup technology for scalable and cost-efficient transactions. Users can mint $USDQ, a stablecoin pegged to the U.S. dollar, by collateralizing assets such as wrapped Ethereum (wETH), wrapped staked Ethereum (wstETH), EtherFi staked Ethereum (weETH), and Scroll's native token (SCR). The protocol's governance and liquidity incentives are managed through the $QUILL token, which allows users to participate in decision-making and protocol growth.
Virtue – IOTA Fork
Virtue is a stablecoin lending platform on the IOTA EVM, powered by Liquity V2. It allows users to borrow vUSD, a stablecoin pegged to USD, and earn yield through various DeFi mechanisms.
Conclusion
Liquity V2 is a significant step forward in decentralized borrowing and lending. The innovative protocol addresses the limitations of its predecessor while introducing key features such as multi-collateral support, customizable interest rates, and improved value distribution model through the Protocol Incentivized Liquidity (PIL) framework.
The implementation of the Business Source License (BUSL) ensures a sustainable and value-driven approach to forking, benefiting both Liquity V2 and its community. With the adoption of Liquity V2 by various projects across different ecosystems, the protocol’s influence is expected to grow, reinforcing its role as the most robust and future-ready CDP solution on the market.
As Liquity V2 continues to develop, we are excited to introduce sBOLD, a yield-bearing version of BOLD developed by K3 Capital. The product tokenizes Liquity’s stability pools in a delta-neutral manner, allowing sBOLD to be easily integrated with money markets, decentralized exchanges and yield trading platforms. It creates a set-and-forger solution for BOLD hodlers, who can take advantage of their liquidity without sacrificing the yield.
Stay tuned for our upcoming blog, where we will dive deeper into what sBOLD is and present the first integrations on our roadmap.