Opening a Trove and borrowing LUSD can be stressful, but it doesn’t have to be! In this guide, I’ll be going over the basics of Trove management including what to keep an eye on, the risks, and how to protect yourself from those risks.
Opening a Trove
Our community moderator, Derrick, has already written a step-by-step guide on opening a Liquity Trove (found here), so I’ll skip straight to the important stuff.
When you navigate to a frontend to open a Trove, you’ll eventually be presented with information like so:
Liquidation Reserve and the
Borrowing Fee are easy enough. The
Liquidation Reserve is a flat 200 LUSD that is “set aside” from your debt and awarded to liquidators in the event your Trove is liquidated. It’s not a “real” fee, and you get it back whenever you pay back your debt.
Borrowing Fee is a one-time fee ranging from 0.5% to 5% that is added to your debt. Remember: Liquity doesn’t charge interest on loans and there’s no time limit on your debt — pay once and keep your LUSD as long as you like. To get your ETH collateral back, you simply pay back all of your LUSD, which doesn’t incur an extra fee.
Next, you should check your collateral ratio and (depending on the frontend) your liquidation price:
Note: If your frontend doesn’t show a liquidation price, you can calculate it yourself using the following formula:
(110 * ETH price) / Collateral Ratio .
Your Trove’s collateral ratio is the ratio between the Dollar value of your ETH collateral (according to Chainlink ETH:USD price feed) in your Trove and its debt in LUSD. You can influence the ratio by adjusting your Trove’s collateral and/or debt up or down:
Note: As the price of ETH fluctuates, so does your collateral ratio. If ETH price goes up, your collateral ratio goes up and vice versa. LUSD’s price is not relevant for calculating your collateral ratio.
Under normal operation, a 110% collateral ratio is the minimum required by Liquity. This means that if your collateral ratio drops below 110%, your Trove will be liquidated — i.e. your ETH collateral will be forfeited and distributed to Stability Pool depositors. In the event you’re liquidated, you’ll still keep your borrowed LUSD, but your Trove will be closed.
Under Recovery Mode the rules are different. Recovery Mode is “activated” when the Total Collateral Ratio (i.e. the Dollar value of the entire system collateral at the current ETH:USD price, to the entire system debt) of the system goes below 150%. When the system is in Recovery Mode, the liquidation rules change, and Troves with a collateral ratio of 150% or lower are eligible for liquidation.
Note: Troves can be liquidated out of order, meaning high value Troves may be liquidated before riskier, lower value Troves.
With both of those collateral ratio requirements in mind, let’s go over some ways to try to avoid liquidation.
As a Trove owner, avoiding liquidation is likely going to be your number one priority. After all, no one wants to lose 10% of their position and getting liquidated can be stressful.
To avoid liquidations, be sure to pick a collateral ratio /liquidation price that you are comfortable with. For example, advanced DeFi users may be comfortable with a 165% collateral ratio, but less risky users should give themselves more room to work with. The price of ETH is volatile, which means your collateral ratio can rise and fall quickly. If you won’t be around to save your Trove during a big dip, make sure you have a large enough safety net.
In May ’21 alone ETH had multiple 20+% price drops — when opening a Trove, you should keep that in mind as you’re deciding on a collateral ratio / liquidation price that works for you. For example: if you’re a passive DeFi user, opening a Trove with a 130% collateral ratio is a risky move. If ETH drops 21% and you’re not around, you’re getting liquidated.
For risk averse users, or users who don’t plan on managing their Trove every day or so, it’s generally recommended to maintain a collateral ratio (CR) that is comfortably above both the 110% minimum CR and the 150% Recovery Mode CR. This protects you in both scenarios. An example ratio for risk averse users might be 200%-250% or higher. You may lose some capital efficiency, but you can keep your peace of mind — which of those is more important is up to you.
Note: Advanced DeFi users will always be able to get the most out of borrowing with Liquity, but please avoid taking on risk that you’re not comfortable with just because others are doing so.
The next type of “risk” you should keep in mind is redemption risk and how it may affect your Trove. Sometimes people confuse being redeemed against with liquidations or partial liquidations, but they are quite different.
I’ve written a separate blog post explaining redemptions in detail (found here), so I’ll skip to the important stuff as I did earlier.
How redemptions work is straightforward:
- Someone comes along to redeem LUSD
- All Troves are sorted from lowest collateral ratio to the highest collateral ratio (i.e. most risky to least risky)
- The redeemed LUSD is used to pay off the debt of the riskiest Trove(s) in return for their collateral
This means that it’s possible for someone to pay off your debt in return for your collateral if you’re among the riskiest Troves — regardless of your collateral ratio. While getting redeemed against has its cons, there’s two things to keep in mind:
- You aren’t “losing” money, the affect a redemption has on your Trove is net neutral. While you lose some ETH collateral, you also “lose” debt — i.e. you have less debt to pay back post-redemption.
- Since the impact on your position is net neutral, they’re not the same as a liquidation. In the event you’re liquidated, you lose 10% of your Trove’s value. That’s not the case with redemptions.
The biggest con of being affected by a redemption is that you lose some of your ETH exposure and will have to buy it back. But fear not, there is a simple strategy to avoid redemptions: avoid being among the riskiest Troves.
Almost every Liquity frontend provides a list of risky Troves as shown above. To get an idea of your redemption risk, you can see where you rank among the risky Troves and how much LUSD debt is front of your Trove.
For example, if you’re on the first page of the list, there’s a good chance you’ll be redeemed against. If you’re on the fifth page of the the list, and a few million LUSD debt is ahead of you, you’re likely safe from redemptions for the time being.
If redemptions are something that concern you, ensuring that you have a big enough buffer between your Trove and the riskiest Troves is the safest strategy to avoid them. You can also find a list of redeemed Troves here and use that to get an idea of what collateral ratios are frequently redeemed against.
The last thing I want to touch on is Ethereum’s gas prices, which are volatile — especially in times of market stress. This has nothing to do with Liquity itself and everything to do with demand for Ethereum block space. When the price of ETH is dropping quickly, every other user on Ethereum is trying to adjust their DeFi positions at the same time as you, making fees more expensive than normal.
Please keep this in mind throughout your Trove management process. If ETH drops quickly, will you have to panic to pay off your debt or add more collateral? If so, are you prepared to pay high gas prices? If that sounds stressful, then be sure to consider such scenarios when interfacing with Liquity or any other DeFi protocol. Giving yourself enough room to breathe in times of market stress is never a bad strategy when managing your Trove.
With all of the tips out of the way, you should be ready to start experimenting with Liquity. You can do so by navigating to the Liquity frontend registry here. We also expect more advanced Trove management tools like Instadapp and DeFi Saver to go live soon — making the above processes easier.
If you’d like to join the community, you can find us on Discord!