Analysis of Lybra Finance, the LSDfi leader: How stable is it? What are the risks of “layer 2 nesting”?

Lybra Finance Analysis: Stability and Risks of "Layer 2 Nesting"

Author | nobody (Twitter: @defioasis)

Editor | Colin Wu

Note: This article is for informational purposes only and is not endorsed in any way by the mentioned project or associated interests.

With the continuous rise in ETH staking rate and LSD track becoming the largest TVL asset category, doing more yield strategies around xETH is becoming a new trend of community attention in the LSD field, which has $18.52 billion in assets. According to Dune Analytics data, as of June 13, LSDfi TVL reached $420 million, accounting for only about 2.3% of LSD TVL, of which Lybra Finance accounts for 41.1%. It set a new single-day growth record of about $40 million in ETH/stETH inflows on May 29, but its market share is declining with the entry of competitors. Lybra Finance LBR achieved a more than 30-fold increase in May, but fell sharply from its high point in June, possibly due to profit-taking by previous investors, panic about contract issues in the market, and macro environment. Investors should be aware of the risks. In fact, building stablecoins on LSD is the core of Lybra, and this article will analyze Lybra Finance around eUSD stablecoin.

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Core Business

Lybra Finance allows users to deposit ETH or stETH on the platform as collateral to mint corresponding eUSD. The liquidation line is 150%, meaning that $1 eUSD is backed by at least $1.5 equivalent value of stETH as collateral. By holding the minted eUSD, users can earn interest income (holding is similar to bank deposits), which is supported by LSD income generated by the deposited ETH/stETH. This means that when users deposit ETH/stETH to mint eUSD through Lybra, the deposited ETH/stETH will be used to participate in LSD, and the rewards for participating in LSD to validate and maintain the security of the Ethereum network will be provided in the form of stETH. These rewards will be converted into eUSD as interest income and distributed to users through the Lybra Finance protocol. As of June 13, the interest income generated by holding eUSD is approximately 9.08% annually. (Note: Deposited ETH on Lybra will be converted to stETH.)

Protocol revenue

Lybra does not charge any fees for the minting and redemption of eUSD, its main protocol revenue comes from a service fee charged on the revenue earned from LSD, which is a 1.5% annualized service fee on the total circulating eUSD (the service fee is accumulated every second based on the current actual circulating eUSD), and the LSD revenue after deducting the service fee is distributed to eUSD holders. The collected annualized service fee will be allocated to the LBR Staking Pool, and users can convert LBR into esLBR through staking to obtain 100% of the service fee.

Stability

eUSD is actually an over-collateralized stablecoin.

(1) At least $1.5:$1 equivalent stETH as collateral and supports rigid redemption of eUSD to ETH (a redemption fee of 0.5% is required, priced in ETH).

(2) Liquidation mechanism for collateral ratio lower than 150%: any user can become a liquidator and purchase the liquidated stETH collateral at a discount price (1-liquidation reward rate) using eUSD as the payment currency.

(3) Based on the first two, arbitrage opportunities will arise when the eUSD price fluctuates. When eUSD$1, arbitrageurs can mint new eUSD by depositing ETH/stETH as collateral, then sell eUSD on the secondary market, wait for more arbitrageurs to execute this process, and gradually lower the price. After returning to the anchor, the arbitrageur buys eUSD back from the secondary market to repay the loan, and the price difference before and after eUSD is the arbitrageur’s profit.

(4) Curve provides eUSD exit liquidity. As of June 13, the circulating amount of eUSD was about $81.4 million, and through the LBR emission incentive of Lybra, 8.5 million eUSD has been operating in Curve’s eUSD/USD LP Pool, with a TVL of about $21.4 million, a daily trading volume of about $100,000, and a liquidity utilization rate of 0.43%. However, the proportion of Curve eUSD/USD LP Pool has been continuously imbalanced. Interestingly, the Curve v2 pool deployed by eUSD is used for trading volatile assets instead of pegged assets, which may cause malicious behavior, guide eUSD to decouple upwards and trigger liquidation, and extract liquidation assets from it.

Furthermore, the biggest significance of stablecoins is adoption. The utility of eUSD and whether it can be integrated and adopted by other on-chain protocols remains to be seen.

There are two points to note regarding rigid redemption:

First, rigid redemption requires payment of a 0.5% fee for the redeemed ETH, which may result in a 0.5% implicit tolerance range if eUSD deviates below $1, because for arbitrageurs, there is only profit when the degree of downward deviation exceeds 0.5%.

Second, rigid redemption does not mean repayment of eUSD debt. Users who have minted eUSD can choose to provide rigid redemption services and receive a 0.5% redemption payment fee, as well as higher LBR APY, transaction fee compensation, and other incentives. If redemption occurs, the user providing redemption services will lose some of their collateral, reduce their debt accordingly, and receive a 0.5% redemption fee paid by other users. This means that after the service is enabled, the user’s collateral will become the redemption liquidity of other users.

Risk response

eUSD, or the entire LSDfi track, is essentially the second layer of nesting. After depositing ETH/stETH into Lybra, they will all be converted into stETH, which has become a trusted asset in the DeFi field based on the original asset ETH and stETH’s credibility as the largest ETH2.0 platform Lido. Therefore, stETH can be seen as the nesting of ETH; eUSD is a stablecoin minted based on stETH collateral, which is the second layer of nesting. Users can obtain two sources of income by nesting twice, depositing ETH into Lido to obtain the first source of staking income and stETH certificates, and then using stETH as collateral to mint eUSD to obtain the second source of interest income. By nesting twice, users increase the return on holding ETH. High returns and high risks often go hand in hand, which is a major test for the platform. The liquidation mechanism is an important guarantee for the platform to prevent risks and prevent the spread of risks.

Generally speaking, since 1 eUSD is backed by at least $1.5 worth of ETH/stETH collateral, this means that under normal circumstances, the overall collateralization ratio of the Lybra Finance protocol must be above 150%.

For clearing that does not trigger platform risk control (i.e., protocol-wide collateralization rate > 150%), when a borrower (minting eUSD) is cleared, the user can become a clearing agent and use their own eUSD balance to clear up to 50% of the collateral of the borrower, and obtain collateral assets worth 109% of the repaid eUSD value, while the Keeper (a specific participant who plays the role of clearing) obtains collateral assets worth 1% of the repaid eUSD value. (Note: 10% is a clearing reward, 9% goes to the clearing agent and 1% goes to the Keeper, but it only applies to clearing behavior using the official clearing tool.)

For example: A deposited 1 stETH collateral and minted 1400 eUSD a week ago. During this week, the USD value of ETH fell from $2200 to $2000. At this time, A’s collateral ratio = 2000/1400=142% 150%

It can also be seen that there is a time difference between the initiation of clearing by the Keeper and the execution of clearing by the clearing agent, so it is not immediately cleared as long as the collateral ratio is lower than 150%, and there is a process similar to queuing, which is more similar to the clearing of DeFi on-chain lending protocols.

In another extreme case, when the overall collateralization rate of the Lybra Finance protocol is lower than 150%, borrowers with a collateral ratio lower than 125% will face complete collateral liquidation. In the case of complete liquidation, the clearing agent pays eUSD equivalent to the borrower’s (cleared party’s) debt to obtain collateral worth the borrower’s debt * (collateral ratio – 1%), and the 1% deducted is owned by the Keeper. The collateral and debt of the borrower, i.e., the cleared party, are both cleared to zero. In the more extreme case where the collateralization rate is lower than 101%, i.e., the collateralization rate < (100% + Keeper reward ratio), the Keeper does not receive any reward.

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