Understand the mechanism and risks of Curve's native stablecoin crvUSD in one article

Is there a mechanism that allows users to simply deposit collateral to mint stablecoins without having to worry too much about liquidation risks?

Original title: "Understanding the DeFi Innovation Leader--Curve" (Everything You Need To Know About crvUSD)

Written by: Brown Bacon

compile: wesely

Curve is one of the leading DEXs in the DeFi track, with a daily trading volume of $100 million, it is probably one of the most reliable and stable exchanges for trading things like stablecoins, liquid collateralized derivatives, and more.

Curve is not only known for its huge transaction volume, behind the program interface similar to the Sega game style in 2000, it has the most prestigious elastic architecture and innovative token economics design in DeFi. The core point is that Curve has always been at the forefront of the DeFi innovation world, and today we will tell the story of its latest product, crvUSD.

TLDR

crvUSD relies on a soft liquidation mechanism, which is a proprietary AMM algorithm called the Loan Liquidation AMM Algorithm (LLAMA). It automatically swaps between collateral and the stablecoin (crvUSD) to avoid frequent occurrences of liquidations.

Another benefit of introducing the LLAMA mechanism is that Curve can provide more benefits for LP and veCRV holders, enhance the overall user experience, and reduce the impermanent loss risk of LP.

As of this writing, crvUSD only accepts sfrxETH as collateral, the protocol’s contracts have been tested publicly four times, and Curve has announced plans to integrate stETH among other assets.

One of the biggest risks associated with stablecoins is volatility, and any out-of-market fluctuations can lead to a loss in the value of the collateral, but Curve has found a solution to this problem.

The protocol provides a dynamic borrowing rate: when the interest rate decreases, users are encouraged to borrow crvUSD, and when the interest rate increases, users are encouraged to purchase crvUSD and repay the loan.

Current DeFi lending problems

If the price of the collateral you provide falls below a certain threshold, the collateral is liquidated, effectively closing out the borrow position. For highly volatile assets, liquidations are very common, and even the most common assets (such as ETH) are used as collateral, and liquidations can still easily occur in the face of brutal market shocks.

Perhaps the most impressive recent example is the unpegging of USDC in April 2023, which also had a domino effect on other decentralized stablecoins, such as DAI, which has 50% of its collateral in USDC. In addition, 3pool, as one of the largest pools in TVL, also experienced a crisis during the depeg period, which pushed the price ratio of USDC/DAI down to 0.96.

For centralized stablecoins, it is difficult to guess when it will be decoupled, because it is difficult to verify where the collateral of these stablecoins is on the chain, so it can also be said that the decoupling risk of USDC is more or less expected middle.

Magic Internet Money (MIM) is another well-known stablecoin emerging during the everything-to-the-moon period of 2021, which can be minted by depositing other assets. At the beginning of the bear market in 2022, the collapse of LUNA also put the stablecoin in crisis. At the time, it was discovered that the protocol had accumulated $12 million worth of bad debt, which had a devastating effect on the stablecoin, which was worth $300 million at the time, and naturally led to the decoupling of MIM.

Past stablecoin decouplings and resulting liquidations abound. While looking back at history is most rewarding for those curious, we need to consider another, more relevant issue - overcollateralization.

The reason why overcollateralization is necessary is to guard against the volatility risk of the collateral provided. If the value of the collateral falls below a certain threshold, the position must be liquidated, otherwise it will lead to bad debts, further creating systemic risks in DeFi. The volatility of collateral is affected by many macroeconomic factors, which may be the ambiguity of regulations, the impact of other financial markets, or the global macroeconomic slowdown; on the micro level, changes in demand for stablecoins will also affect decoupling Whether or not, there are smart contract risks, protocol failures, hacking and other issues.

Despite these risks, a stablecoin is of no use if it cannot remain stable. To ensure stability, some lending protocols utilize an arbitrage mechanism to secure the peg, where liquidators raise bad debts in the system and choose to liquidate borrowers' positions, earning a percentage of the profits. On the other hand, for users, some measures can also be taken to avoid liquidation risks, such as replenishing collateral in a timely manner.

Then why is there no mechanism that allows users to simply deposit collateral to mint stablecoins without having to worry too much about liquidation risks?

crvUSD

crvUSD is the native stablecoin of the Curve protocol. The underlying assets support various assets, such as ETH LSD. At present, it is mainly deposited into sfrxETH to mint stablecoins. The core of the stablecoin is LLAMA. As a unique algorithm, LLAMA converts the deposited collateral into crvUSD when the price falls, avoiding hard liquidation of the collateral, and retaining the depositor's mortgage while maintaining system stability. Taste. To understand this stablecoin and how it works, it is first necessary to understand the LLAMA mechanism.

The Lending Liquidation AMM Algorithm (LLAMA) is a fully functional AMM that uses a special AMM mechanism to constantly rebalance users' collateral. In this way, the execution of so-called "soft liquidation" helps to protect the user's asset principal to a certain extent. It does this by converting collateral into LP positions, reducing potential losses that borrowers may face in the event of price fluctuations. It follows the centralized liquidity model of Uniswap V3, in which the core liquidity is highly concentrated within the specified range.

"Soft liquidation" refers to the conversion of part of the collateral into crvUSD in the early stage of liquidation risk, so as to avoid the complete liquidation of assets. At this stage, it is not possible to re-deposit more collateral to secure your borrowed position, and the only way you can interact with the loan is to close out the position yourself. Alternatively, you can wait until full liquidation occurs to withdraw your crvUSD holdings.

The price of collateral is set within a range of concentrated liquidity, with an upper and lower limit on the price. If the price of the collateral falls within this range, then the collateral usually stays in a single asset such as ETH or crvUSD; if the price exceeds this upper limit, the asset stays in the collateral asset (such as ETH). When the lower limit is exceeded, a part of the mortgage assets start to be converted into crvUSD.

LLAMA obtains price data from external oracles, such as Uniswap TWAP oracles, Chainlink, Tricrypto. They use exponential moving averages (EMAs) to reduce price volatility, thereby reducing the risk of price oracle manipulation.

Now, let's see how LLAMA works with an example. Assuming users deposit their ETH as collateral to borrow crvUSD, if the price of ETH falls, the protocol will gradually start converting a portion of that collateral into crvUSD to ensure that the minimum percentage of collateral threshold is maintained. If the price recovers, it will convert crvUSD back to ETH. Also known as "liquidating" a user's collateralized position, this buyback effectively prevents said user's position from being fully liquidated when the market falls. If the price does not recover and continues to fall, the entire collateral position is converted to crvUSD, thereby ensuring the integrity of the entire borrowed position, which is liquidated without additional protocols.

Now, one might wonder, if the protocol converts the entire collateral amount to crvUSD, how does the stablecoin maintain its peg? This is where the arbitrage mechanism and Curve's PegKeeper contracts come into play.

How is crvUSD anchored?

PegKeepers are smart contracts with minting and burning functions. In the event that the price of crvUSD starts to rise above $1, they will mint unsecured crvUSD and deposit it in the stable exchange pool, helping bring the crvUSD price back to $1.

On the other hand, if the price falls below $1, crvUSD will be taken from the stable exchange pool and destroyed. In addition to this, the protocol also keeps the lending rate dynamic due to the inclusion of a monetary policy that determines the lending rate, with the exchange rate changing based on crvUSD's pegged variance. Therefore, when the collateral price falls and some positions are in a soft liquidation state, the lending rate will also decrease, thereby attracting more users to borrow stablecoins.

risk

While the LLAMA protocol does offer the ability to passively manage crvUSD borrow positions, it comes with its own risks.

1. One of the biggest risks of holding crvUSD is that if your position goes into soft liquidation mode, you cannot withdraw or add more funds.

2. If the price of the collateral asset falls sharply, your position will indeed be liquidated.

3. The parameters of issuing crvUSD are publicly controlled under the control of CurveDAO.

4. Although the team has conducted several rounds of "testing in the production environment", due to the relative newness of crvUSD, there are several scenarios that have not yet been explored.

Still, the high security standards that Curve adheres to are one of its notable points, and their past is a testament to that. In the case of crvUSD, they worked hard to ensure that all loopholes in the contract were found before they were made public, and even risked loans before final deployment. This rigorous testing helped to stress test the liquidation process.

crvUSD Lending Market

To start borrowing crvUSD, you need to go to crvUSD Beta. You can view the collateral that supports deposits on the Marketplace page. At the time of writing, only sfrxETH (Frax’s Ethereum LSD) is accepted as collateral. After clicking on the above asset, you will be directed to a new page where you can set the parameters for creating a loan, it is important to note that crvUSD does not have a testnet, so if you want to borrow stablecoins to try it out, you must be on the mainnet conduct.

They only support Frax LSD and have not started accepting any other LSD as collateral. It will also be interesting for the Curve community to see other LSDs (with larger market caps like stETH/or rETH) over sfrxETH and the community's reaction to choosing sfrxETH over other assets.

Stories that happen during deployment

What good is a protocol’s decentralization if the community cannot participate in its key decision-making processes? With Curve, the story behind the crvUSD deployment might make you want to question its decentralization.

The first contracts for crvUSD were deployed on mainnet on May 3, initially drawing down a $1 million loan, when the protocol was not available to the public. A second and third deployment followed in the following weeks, this time to combat-test the architecture, the most recent on May 14. In all of these deployments, the decision to use only sfrxETH as initial collateral was made by one person - Curve top principal Michael Egorov.

This didn't go well with Curve's community, some of whom even questioned whether Curve's long-term community thought about the entire asset selection was taken into account. Since then, the protocol has confirmed that it is only a matter of time before it will start accepting other LSD as collateral for crvUSD.

Summarize

While the community has questioned Curve's insistence on using sfrxETH as initial collateral, the protocol has been at the forefront of DeFi innovation and has been pushing boundaries. Their LLAMA protocol is an innovative mechanism that acts as a "first line of defense" against price drops on collateral for borrowing stablecoins. The protocol helps open up a whole new market for LSD holders while providing them with an easier experience of borrowing stablecoins.

Through this implementation, the protocol also incentivizes other lending protocols to implement better liquidation practices and promotes the development of stablecoins.