You choose your own borrow rate in DeFi? How Liquity Actually Works (2026)

Added: 2026-05-06

[00:00:00]In this video, we're going to be taking a look at the fully decentralized lending protocol, which is called Liquidity. Now, to start off with, we're going to cover what its core mechanisms are that actually let it function as fully decentralized, and I'm going to use most of the time and focus on Liquidity V2, but I will also go through Liquidity V1 just so we can set up the core concepts of the protocol since V2 is an optimization on the foundation set by V1.

[00:00:32]Okay, so first, how does Liquidity manage to be a fully decentralized lending protocol? What does that mean? Well, it means that the protocol itself functions solely based off of the math and cryptography used by its smart contracts. So, it's fully immutable. There are no changes that can be made to the parameters within the protocol itself, how it functions. If that were to happen, the entire protocol would need to be redeployed. The entire infrastructure and smart contracts would need to be redeployed.

[00:01:03]Now, we should also talk about what are the mechanisms that actually make it sort of self-functioning, self-sustaining, um and the other thing to mention is it functions based off of its own stablecoin. On V1, it's called LUSD. On V2, it's called BOLD. So, since they're stablecoins, they need to maintain their value to $1, and that means that they Liquidity needs to have this um self-sustaining mechanism that's going to keep its price pegged to $1. So, without further ado, let's dive into Liquidity V1 just to set things up. So, how does it work? It lets you deposit ETH, and you borrow LUSD. That's it. It takes ETH as collateral, and it mints the stablecoin LUSD when you borrow it.

[00:01:54]There's no additional collateral, there's no real-world asset exposure, track by exposure, it's purely ETH.

[00:02:01]Now, usually in lending protocols, you might be paying a recurring or compounding interest rate on your debt, but on Liquidity V1, you pay a one-time fee. So, there's zero interest over time. Just when you open a position, which is called a trove on Liquidity, you pay a one-time fee.

[00:02:21]Also, the minimum collateral ratio is 110%. If it falls below that, you get liquidated. Very simple concept. So, let's look at two very important mechanisms of Liquidity in general that actually help the stablecoin maintain its peg. So, first off, we have the stability pool. So, this is a pool where users can deposit their LUSD, and then when a liquidation happens, this pool absorbs the debt, and it also absorbs the collateral. So, if depositors' LUSD is used to pay off debt, they can also get ETH at a discount. So, this is sort of a passive income opportunity for LUSD borrowers to deposit here, and then they earn passive income through ETH and also Liquidity, which is the governance token of Liquidity.

[00:03:16]And then we have the redemptions, which are very much a key component to maintaining the dollar peg. So, how does it work? Well, when somebody comes to Liquidity, they can redeem one LUSD for $1 worth of ETH.

[00:03:36]So, again, one LUSD, not $1 of LUSD, but one LUSD for $1 worth of ETH. Think of it this way, if LUSD is trading at 99 cents, somebody can buy it at 99 cents, and then go and redeem for $1 worth of ETH.

[00:03:55]So, they get something worth $1 for something they bought for 99 cents.

[00:04:02]And what's the key idea of this mechanism? Well, it's to keep LUSD's peg to $1 cuz think of it this way, if for some reason through um market trading, LUSD's price falls, this mechanism instantly incentivizes it for people to keep buying it, redeeming it cuz they're essentially getting ETH at a discount.

[00:04:26]And if the price goes above $1 for LUSD, then people are going to just um sell it in the open market. If they're not going to really going to have incentive to redeem it for cuz they're they'll be losing money. They're going to get worse value if they redeem it when it's trading at a premium, and so that market action is going to also push its price down. So, now there's also a question, how do redemptions actually work? Where does that ETH come from? Well, it comes from existing troves, and the target troves are those with the lowest collateral ratio.

[00:05:02]So, what does that mean? Well, we said 110% is the lowest one. Let's say that the lowest um collateral ratio right now on Liquidity V1 is 120%. A trove that's at 120%, that means that when somebody comes, they want to redeem their LUSD for ETH, that trove's going to get targeted. That user is going to lose $1 worth of ETH. They're going to get one LUSD back. So, it's not a liquidation, it's rebalancing the position where the user loses exposure to ETH.

[00:05:33]Right? So, that incentivizes people to also um stay on top of their position, manage their collateral ratio to make sure that they're not next in line to get redeemed against.

[00:05:45]And finally, we're going to look at the system health, which is how does Liquidity avoid um black swan events, horrible situations where the protocol might get a lot of bad debt and become insolvent? Well, it uses this metric called total collateralization ratio. It's total collateral divided by total debt, and when it's below 150%, which means that's all of the troves in the protocol where their combined collateral ratio is below 150%, recovery mode is activated, and that pushes the liquidation threshold to 150% collateral ratio, and it restricts um risky actions within the protocol like generating new debt. So, it it creates this environment where positions that might have been less risky get liquidated to preserve the protocol's health.

[00:06:38]And that's the key components of Liquidity.

[00:06:41]I'm going to go ahead now focus on Liquidity V2. Just keep in mind all the mechanisms that we outlined here cuz there's a lot of parallels, of course, on V2. So, let's go over the main differences from the get-go. So, first, it doesn't just take ETH, it also takes wrapped staked ETH and rETH as collateral. The stablecoin is called BOLD, and the main difference is that there are user-set interest rates, which is how Liquidity V2 is actually able to offer some of the best borrow rates for ETH-based collateral in DeFi. And the way it works is that you set your own interest rate, but there's no one-time fee to open the position. Instead, the interest rate is used as the metric for redemptions. So, it's not what the collateral ratio is, it's what's the interest rate that users have for their BOLD debt.

[00:07:39]So, we can look at it here. Troves with the lowest interest rate, if it's low, there's higher redemption risk. If it's high, there's lower redemption risk. And this plays again into BOLD maintaining its peg to $1. As we mentioned, the main incentive if it goes below market price or below $1 is the redemptions, which are going to put the price back up. But then think of it this way, there's pressure for a lot of redemptions, which means users are going to rush to increase their interest rates, and that's going to be generating more interest, BOLD interest, in Liquidity.

[00:08:14]Um and then if the price does go up as well, as we mentioned, there's going to be market pressure to push it down to $1. Now, this mechanism benefits BOLD stability pool depositors a lot because again, when the interest rate goes up, that BOLD generated by the interest rate goes to the stability pool depositors.

[00:08:39]And that's again the same mechanism as on Liquidity V1. So, that's how BOLD also gives its users passive income from the interest fees being paid by users, um and also again from the liquidations, if they do happen. This entire mechanism keeps BOLD's price pegged.

[00:09:02]So, aside from just um depositing into the stability pool, what people also do with BOLD is they open up um LP positions, for example, on Uniswap or Curve, where they put up BOLD and the stablecoin or BOLD and ETH, so that they can mitigate and allow for swaps of of BOLD with another asset to happen. And there's also um sBOLD and ysyBOLD.

[00:09:33]One is a key three strategy, and both work with in the stability pool, but you can imagine them as sort of auto-rebalancing strategies within the stability pool.

[00:09:44]So, sBOLD um and ysyBOLD from Yearn, you can look at it like a strategy where BOLD is deposited into the stability pool. It earns certain yield, and that yield is then redeposited into the stability pool um according to the curator's strategy.

[00:10:03]So, there's a lot of passive income opportunities for BOLD holders. And as with V1, again, Liquity V2 is focused purely on ETH.

[00:10:15]That means that there's no real-world asset exposure, no TradFi exposure. It is tied solely to ETH.

[00:10:24]And one last thing to mention is recovery mode. There is no recovery mode in V2.

[00:10:30]The interest rate mechanism lets it function in and of itself and maintain the protocol health properly.

[00:10:39]One more thing I would mention that Liquity V2 has as a function is that users can set interest rate managers.

[00:10:47]So, of course, the interest rate isn't something you set once and that's it.

[00:10:50]You can change it at any time. That's how people combat um redemptions and avoiding getting redeemed against. So, you can actually delegate the management of your interest rate to a third party, and they're going to keep you safe from redemption, hopefully.

[00:11:07]Another thing to mention is that Liquity V2 troves are NFTs, which means that ownership of a trove can actually be changed at any point.

[00:11:18]So, with that, we've kind of covered the theoretical part of Liquity, how it functions. So, the thing to keep in mind is that V2 is focused on offering great borrow rates for people who want ETH exposure or perhaps to leverage ETH or wrapped staked ETH and rETH, and also passive income opportunities through the stability pool and through the LPs with BOLD and another asset pair.

[00:11:45]So, now let's go ahead and move on to a hands-on walk-through of Liquity V1 and V2.

[00:11:51]I'm on DeFi Saver right now, which lets me access both of those protocols from one dashboard.

[00:11:57]And why not kick us off with Liquity V1?

[00:12:01]Now, the purpose of this hands-on walk-through is to kind of quickly go over all the concepts we mentioned previously um just so you see what it looks like on the front end as well.

[00:12:12]So, when I access the Liquity V1 protocol, I'm first going to see the total collateralization ratio right now of the entire protocol. It's 600%.

[00:12:22]I'm going to see the option to stake Liquity or LUSD into the stability pool, which we also mentioned is uh the option that users can earn some passive income, and also we have the option to create a trove, which I'm going to go ahead and do.

[00:12:38]So, we can input the amount of ETH we want to supply. I'm going to put 20 here. And also, just to mention, I'm doing this on DeFi Saver's simulation mode, which essentially lets you create any position you want on any of the supported protocols in a test environment.

[00:12:56]So, um let's go ahead and all right, let's borrow 15,000 LUSD for this example.

[00:13:04]So, before I actually open up the position, I'm going to be able to see some important metrics like my collateral ratio.

[00:13:10]Um I'm also going to see what the borrowing fee is going to be, the total amount of debt, as well as the liquidation price, and the amount of debt in front. Now, this debt in front metric, it represents how much LUSD is there in other troves that have a worse collateral ratio than me, and that are going to get redeemed before mine does.

[00:13:31]Cool. So, let me go ahead and open up the position.

[00:13:36]It's going to ask me to create a smart wallet, prove that, and then sign to create the actual trove. Cool.

[00:13:44]So, now we're on the Liquity V1 dashboard. I can see pretty much all the metrics I previously mentioned, all the ones that are relevant to my position. I now also have the option to close the position if I decide to in one transaction. I also have the boost and repay tools, and then the basic supply, withdraw, borrow, and payback.

[00:14:10]Here, I can also access automation options from DeFi Saver, and there's also the notify and history tab, which don't work in our simulation environment. So, um we're we don't need to go through the hands-on uh example of them right now.

[00:14:27]So, moving back here, that covers what the front end of Liquity V1 looks like, and we can move to Liquity V2. And we're going to see some parallels here, because as we also talked about previously, it's not a drastic change in how the protocol works.

[00:14:45]So, again, we're going to see that we don't have a trove.

[00:14:48]We can choose which ETH market we want to be in. I'll just stick with regular ETH.

[00:14:53]Create a trove.

[00:14:55]And on DeFi Saver, I can also create a leveraged position in one transaction.

[00:15:00]So, how about I say that 20 ETH is my collateral, and I'm going to leverage it four times.

[00:15:09]That's going to generate BOLD debt.

[00:15:12]And down here, we can see the first difference, which is the interest rate.

[00:15:15]So, as we previously mentioned, on Liquity V2, I can set my own interest rate. And here, I can see what are some of the more popular interest rates that are available, or what's the main range of interest rates set by users.

[00:15:30]So, I'm not going to go uh way above this range. In fact, let me set one that's about 1.7%.

[00:15:41]And I'll actually be able to see, as with Liquity V1, what's the amount of debt in front of my trove um before it gets redeemed against. I'll see my net API, the collateral ratio, and of course, the liquidation price.

[00:15:59]So, I'm just going to go ahead and open this leveraged position.

[00:16:06]Sign this transaction.

[00:16:12]And there we go.

[00:16:13]So, we opened up a leveraged position Liquity V2 in one transaction here, and now we can look at the dashboard. Looks a bit different than V1, but the main difference here is that you'll see the interest rate, which you can also change at any point. It's not something that's fixed.

[00:16:31]And you'll also see the batch manager, which as we mentioned, you can delegate the interest rate management for your Liquity V2 trove, and we'll see the address that's doing the management right here.

[00:16:44]Debt in front, liquidation price, all the basics that you would see with any protocol actually on DeFi Saver.

[00:16:53]Then we move on to the tools. We still have boost, repay, the basic actions like supply, withdraw, borrow, and payback. And then also shift, which lets you change your position to a different protocol.

[00:17:06]We also have the option to transfer the position um to a different account, which means that since Liquity V2 troves are NFTs, they can be transferred from one account to another. They can change ownership that way.

[00:17:20]So, we can also create another trove if we want, or we can close it.

[00:17:25]Up here, we have the automation options from DeFi Saver, and then the stake option. Just like with V1, you can stake your LUSD. Here, you can stake your BOLD, whether it's the stability pool or in different vaults.

[00:17:38]And that includes Liquity staking here as well.

[00:17:41]Last two options are notify and history, but as we mentioned, those are not something we'll be going through in our simulation mode.

[00:17:49]Now, if I go back to the portfolio page, I'll be able to see both my Liquity V1 and my Liquity V2 positions, and I can then click on them, access them, manage them whenever I'd like.

[00:18:03]And that wraps up our guide through the front end of Liquity V1 and V2.

[00:18:10]Hopefully, this gave you the full picture of how the protocol works, since now we have the theory part of it done, but also the hands-on aspect of it as well.