Comparison Series: Liquity Protocol and MakerDAO Pt. 1

In this post, I’ll be highlighting key differences between Liquity Protocol and MakerDAO.

Let’s start with the basics:

What is Liquity? Liquity is a decentralized borrowing protocol that allows you to draw interest-free loans against Ether used as collateral. Loans are paid out in LUSD (a USD pegged stablecoin) and need to maintain a minimum collateral ratio of 110%.

What is MakerDAO? MakerDAO is a decentralized borrowing protocol that allows you to draw loans with variable interest-rates against multiple collateral types. Loans are paid out in DAI (a USD pegged stablecoin) and the minimum collateral ratio needed to maintain varies across different Vault types.

https://defipulse.com/

Maker’s dominance in the Ethereum ecosystem is no secret. After launching in late 2017, Maker has held it’s moat over the years, and sits at #1 on every DeFi leaderboard with ~$9B TVL (total value locked) at time of writing.

As you can see above, Liquity is #10 on the DeFi leaderboard with >~$2B TVL since its launch on April 5th, 2021 (almost two months ago at the time of writing).

Liquity set out to create a more efficient borrowing protocol with a heavy focus on decentralization and capital-efficiency. As the numbers show above, users are quickly realizing that Liquity is one of the most innovative and useful borrowing protocols today.

Throughout this multi-part series I’ll be covering the major differences between these two protocols ranging from technical differences to philosophical differences.

Governance vs No governance

First and foremost, let’s take a look at the biggest philosophical difference between Maker and Liquity: governance.

MakerDAO

Governance plays a huge role in the Maker protocol and ecosystem. Using their governance token, MKR, users are allowed to vote on protocol parameters such as stability fees, debt ceilings, minimum collateral ratios, as well as important ecosystem things like funding working groups, giving grants, etc.

The governance process is quite lengthy, but has several core groups of participants who ensure everything runs “smoothly” and who host regular open meetings for all to attend and listen to. Most coordination takes place on the Maker governance forum and all votes are solidified via on-chain MKR votes. The Maker Improvement Proposal process is visualized below:

Liquity

Liquity takes a radically different approach to governance in that it chooses to have no human governance at all. System parameters are either set in stone or “algorithmically governed”. Within Liquity, system parameters like the allowed collateral type, minimum collateral ratio, and more cannot be changed. Additionally, Liquity’s borrowing fee and redemption fee are governed by math and math alone — i.e. there’s no opportunity for human intervention. Even Liquity’s ability to determine which oracle to use is handled this way. For example, if the ETH/USD Chainlink price feed goes down, it knows how to switch to Tellor automatically and vice versa.

While we can probably nitpick regarding the nuances of saying there’s no “human governance”, at least users can rest assured knowing that all they need to trust going forward is that the code works as promised and performs as promised, which is much easier to reason about than a human managed, constantly changing protocol.

Why is this important?

Participating in governance can be a headache and learning curve which results in a majority of users not participating — ultimately making the protocol more centralized than perceived. Here’s an interesting visual of the demands of Maker governance over time:

While the “idea” of governance is powerful, we’ve often seen the opposite. As governance overhead increases, so do the requirements per user participating in governance. As a result, governance turnout across various protocols is low including Maker’s turnout — and many have needed to pivot to Compound’s delegate (aka protocol politician) model of governance. It seems that in the current state of DeFi governance, your options are low voter turnout and 20 people (i.e. whales) making all the decisions or a delegate model where 20 people still make all the decisions. This is far from ideal.

By removing governance and trusting the math, Liquity’s ecosystem can instead focus on growing itself without the burden of governance and internal politics. Instead of spending all week preparing for a vote, community members can instead focus on what content they want to create, what tools they want to build, and what communities to collaborate with. If a Liquity V2 is ever required, community members and users can vote with their capital on which version they prefer without imposing that will on the users of the current version of the Liquity protocol. We’ve seen this work successfully in the Uniswap ecosystem, and I have no doubt we’ll see the same within the Liquity ecosystem.

Multi-collateral vs Single collateral

The next big difference between Maker and Liquity are the allowed collateral types — i.e. The types of collateral users can borrow against.

MakerDAO

The Maker system allows for many collateral types, which you can view here, that range from ETH, to arbitrary ERC20s, to LP tokens for Uniswap pairs. This diverse set of collateral types potentially allows for a wide range of borrowers, but introduces new risks to the system, which I cover later.

Liquity

Inline with its philosophy on decentralization, Liquity only allows Ether as collateral and adding new collateral types is not possible, meaning new asset risk cannot be introduced to the system.

Why would Liquity do this?

Liquity chose Ether as its sole collateral type for two reasons: 1. most borrowers in DeFi use ETH as collateral and 2. decentralization and risk minimization were heavily prioritized.

Many would agree that Ether is the most decentralized, liquid, and in-demand token in the Ethereum ecosystem; so it makes sense to prioritize ETH in any decentralized borrowing protocol. This idea, along with learning from MakerDAO’s history, resulted in Liquity aiming to create an efficient system built around a single-collateral backed stablecoin, instead of a multi-collateral backed stablecoin like DAI. Allowing other collateral types (e.g USDC, WBTC) could be a slippery slope and a potential point of failure — posing serious risks to not only the protocol, but its users.

To expand on what I mean, let’s zoom in on MakerDAO’s collateral breakdown:

DAI is backed by 41.9% PSM-USDC, 34% ETH, 5.6% WBTC, 5% USDC-A, 4.6% ETH-C, and 6.5% Others. Put differently, DAI is 52.5% backed by centralized assets: USDC and WBTC. The majority of the remaining borrow demand comes from ETH holders. If anything, DAI’s collateral breakdown highlights the very real centralization risks presented by allowing non-ETH collateral types. If a decentralized stablecoin is majority backed by centralized assets, well… maybe it’s not as decentralized as one would hope. Source.

To make matters worse, a governance proposal to raise the PSM-USDC-A Debt Ceiling by $1B was recently passed. In this case, they’re willing to increase DAI’s USDC exposure even further, at least for a short time to maintain DAI’s peg.

The Maker community realizes that their exposure to USDC is an existential threat and I hope to see them reduce their reliance on USDC in the near future. Fortunately, Liquity is immune from this type of centralization risk due to its focus on ETH as collateral and its immutability — making LUSD much more decentralized by default.

PSM vs Redemption Mechanism

I can’t bash Maker’s reliance on USDC without explaining why they’ve gone that direction. Remember, LUSD and DAI are stablecoins pegged to the U.S. Dollar. As such, they have economic mechanisms in place that encourage their price to stay around $1. I’ll briefly cover those mechanisms in this section.

MakerDAO

Maker’s primary mechanism for peg maintenance is the PSM (Peg Stability Module), which allows users to swap a given collateral type directly for DAI at a fixed rate, rather than borrowing DAI. The PSM contract was designed with stablecoin collateral in mind, allowing users to swap other stablecoins for DAI at a fixed rate to help keep a tighter peg.

While the technical details of the PSM are out of scope, what’s important to keep in mind is that the PSM allows for profitable arbitrage opportunities that keep the DAI peg in line when it diverges from $1.

Liquity

A similar, but unique mechanism called the redemption mechanism exists in Liquity. The redemption mechanism allows users to swap LUSD for ETH at face value, or such that 1 LUSD = $1 of ETH. Users can redeem their LUSD for ETH collateral of the riskiest Troves (loans) at any time. This mechanism is used to maintain LUSD’s peg and protect its price floor of ~$1. It works because when LUSD is less than $1, arbitrageurs can redeem LUSD as if it’s worth $1 and keep the difference as profit — burning LUSD and bringing the peg back to parity in the process. Again, the technical details are a bit out of scope, but you can read more about how it works here in an article written by Kolten, the Head of Growth at Liquity.

These two are somewhat different as they function inversely from each other. Maker’s PSM brings in collateral in exchange for DAI, while Liquity’s Redemption mechanism decreases global LUSD debt in exchange for ETH collateral.

Why compare the two?

They’re both key stability mechanisms and both introduce trade-offs, but the key differentiator is that one introduces a centralization trade-off and introduces a new type of risk to the system.

The PSM was introduced to maintain DAI’s peg by purposely increasing its backing by more centralized stablecoins (specifically USDC). The trade-off, as I mentioned above, is decentralization. Because of this mechanism, DAI is now backed >~40% by USDC as highlighted earlier. Maker is aware of this, although I’m not sure what they can do to fix the issue.

On the other hand, Liquity’s Redemption Mechanism doesn’t increase centralization, maintains LUSD’s peg very well, and increases system health (Total Collateral Ratio). Besides that, it means LUSD is directly redeemable for ETH, the underlying collateral, at any time, while DAI is not.

Stability Fee vs Interest-Free

The last difference I wanted to compare in part one of this series is Maker’s Stability Fee and Liquity’s one-time fee (i.e. interest-free) model.

MakerDAO

Maker’s Stability Fee is continuously charged onto your loan until you pay your back your debt (basically, it’s an interest-rate). Depending on governance, this rate can increase or decrease over the duration of your loan. Currently, Stability Fees for Maker ETH vaults range from 3% — 10%. You pay a premium depending on the minimum collateral ratio of the Vault. The lower the minimum collateral ratio, the higher your Stability Fee.

Liquity

When borrowing from Liquity, users pay a one-off borrowing fee to mint LUSD. This fee gets added to your debt once (unless more LUSD is borrowed afterwards), and that’s it. The Borrowing Fee can range from 0.5% to 5%, although the highest it has ever been is ~1% and it usually stays around 0.5%. You can view this statistic here. The borrowing fee fluctuates with redemption volumes, if a lot of LUSD is being redeemed, the borrow fee increases. If no LUSD is being redeemed, the borrowing fee decays back down to 0.5% — no governance needed.

Which model is more cost effective?

This is more of a perspective/preference type thing, but I’ll try my best to guide you:

  • Short Term Loans (1 month or less): Maker is more cost effective for short-term loans, as all of the interest is charged over time and there’s no up-front fee.
  • Long Term Loans (Over 1 month): Liquity is more cost effective for long-term loans, as there’s only a one-time borrowing fee and you know your cost to borrow upfront. There’s no variable interest rate to worry about.

As a quick comparison, let’s look at the cost difference between borrowing from Maker’s ETH-A Vault and borrowing from Liquity:

Maker: 10,000 DAI borrowed x 5.5% = ~$46 of interest per month

Liquity: 10,000 LUSD borrowed x 0.5% = $50 up-front borrowing fee

After around one month borrowing DAI becomes significantly more expensive than borrowing LUSD. Additionally, you get less capital efficiency as the ETH-A Vault requires a minimum collateral ratio of 150% while Liquity only requires 110%. If you’re yield farming, borrowing LUSD at 0.5% up front and knowing the cost of your loan will allow you to reason about your profits more effectively. Even better, you can borrow LUSD, swap to another stablecoin, then lend it out to keep the spread — making LUSD loans attractive for various use cases.

That’s all for part one of this series comparing Liquity to MakerDAO. Hopefully you’ve enjoyed exploring the key differences between these two protocols and we’ll dive even deeper in a future post. If you have any questions, feel free to reach out on Twitter.

And of course — many thanks to Kolten for collaborating with me on this series. All of the efforts are more than appreciated!

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