Detailed Explanation of Lybra Finance: New Opportunities Brought by V2 to Lybra

Introduction to Lybra Finance

After the “Shanghai upgrade,” Ethereum officially transitioned from POW to POS, and a large amount of ETH was staked. Some of the ETH was staked on decentralized staking platforms and, after staking, received liquidity staking tokens (LST) such as stETH (e.g., after depositing ETH into Lido, you receive stETH, which needs to be destroyed when redeeming ETH and rewards) as staking certificates. This led to the emergence of numerous DeFi projects designed based on LST. Lybra Finance (hereinafter referred to as Lybra) is one of them, and its V1 uses LST to design the interest-bearing stablecoin eUSD.

An anonymous team launched Lybra. After going live on the testnet on April 11, 2023, it announced a public sale, selling a total of 5 million $LBR during the IDO. Based on the price at the time, 0.0005 ETH/LBR, the IDO valuation was about $10 million, and the highest return calculated in coin terms was 47x. The product was officially launched on April 20, and to date, it owns half of the market share (measured in LSD value) of LSDFi projects.

The V2 version of Lybra will undergo significant updates in terms of multi-chain development, liquidation mechanism, bribery pool, and multi-LST collateral. Therefore, this article will start by introducing V1, followed by an introduction to the changes made in V2, and finally conclude with the impact of updating from V1 to V2 on Lybra, as well as the risks and potential opportunities for Lybra.

Exploration of V1 Mechanism

Since Lybra is expected to upgrade to V2 at the end of August 2023, the V1 mechanism described in this article refers to the mechanism of the current mainnet product. The core product of Lybra is the stablecoin eUSD, a decentralized over-collateralized stablecoin deployed on Ethereum. Compared to other decentralized stablecoins on the market, eUSD is an interest-bearing stablecoin, meaning holding eUSD can earn around 7.2% interest denominated in USD.

We will focus on the mechanism of eUSD, how to maintain the eUSD peg to $1, the use cases of eUSD, the factors affecting eUSD returns, and Lybra’s business data.

eUSD Mechanism

Collateral

1. Users first need to deposit ETH/stETH.
2. Lybra will convert the deposited ETH into stETH.
3. The ratio of deposited ETH/stETH to minted amount needs to be higher than 150% (the safety collateral rate is 160%, and the recommended collateral rate is 200%) to satisfy the over-collateralization requirement.

Minting

1. Users can mint eUSD by clicking “mint” on the UI interface.
2. In the future, the interest income generated by stETH will be converted into eUSD, after deducting a 1.5% service fee, and shared with eUSD holders.

eUSD Minting Mechanism (Source: Official Document)

Redemption

1. Users can withdraw all their collateral assets or exchange any amount of eUSD for equivalent stETH at any time, a process known as“hard redemption”in Lybra, and the protocol will charge a 0.5% redemption fee.
2. During the minting and redemption processes, there are two “invisible” supervisors: the Liquidators and the Keepers. These two roles drive the anchoring of eUSD to USD.

Liquidators

Liquidators are the first line of defense in maintaining the system’s viability. By becoming a liquidator, users can use their eUSD to settle the debts of borrowers (Minters) who do not have sufficient collateral. They maintain the stability and total supply of eUSD.

Keepers

Any third party can run Keepers to monitor the status of each liquidator and minter. When a borrower needs to be liquidated, Keepers can choose to use eUSD for immediate liquidation.

For specific liquidation and arbitrage mechanisms, see the next section.

How to Keep eUSD Always Pegged to 1 US Dollar

Over-collateralization

Every 1 eUSD is backed by at least 1.5 US dollars worth of stETH as collateral. The actual collateral rate is far beyond 150%. For example, as of August 10, the ratio of the value of pledged ETH/stETH to circulating eUSD is about 196.2%.

Pledged Data and eUSD Quantity Displayed on Lybra Official Website (Source: Official Website)

Liquidation Mechanism

The Lybra protocol has adopted a liquidation mechanism to protect the system from being affected by insufficient collateral. If a user’s collateral rate falls below the safety collateral rate, any user can voluntarily become a liquidator and use eUSD to purchase the liquidated portion of the collateral stETH. Liquidators can receive rewards after completing the liquidation.

Arbitrage Opportunities

When the price of eUSD deviates from its 1 US dollar peg, arbitrage opportunities arise. Users can use these price differences to profit and help restore the eUSD price to its expected value.

• If the price of eUSD exceeds 1 US dollar, users can deposit ETH as collateral to mint new eUSD, and then sell the newly minted eUSD on DEX. As more eUSD is sold, the market supply increases, pushing the price back to 1 US dollar. Users can buy back eUSD at a lower price or use it to repay loans, thus profiting from the price difference.
• If the price of eUSD is below 1 US dollar, users can buy eUSD at a discount on the market and then exchange it for 1 US dollar worth of ETH/stETH in the Lybra protocol. As users purchase the undervalued eUSD, demand increases, pushing the price back to 1 US dollar.

eUSD Price Change (Source: Coingecko)

According to Coingecko data, the value of eUSD is mostly higher than 1 US dollar, showing a positive premium phenomenon. The positive premium is partly due to the market expectations not being perfectly realized as in theory, and there are several other factors:

1. Demand for interest-bearing assets: A large number of users using USDC (currently only USDC-eUSD trading pair is available) to purchase eUSD has created considerable user demand.
2. During the minting process, stETH and ETH will be converted into eUSD, generating a large demand for eUSD.
3. The consumption of eUSD is mainly generated by asset redemption (eUSD→ETH/stETH), but since its issuance, eUSD has been mostly in a state of scale increase, and the volume of funds redeemed is too small to absorb market demand.
4. The token ratio in the Curve V2 USDC-eUSD pool is 1:1, which inherently has a positive premium. This is not only the result of factors 【1】and 【2】, but also the main reason for the positive premium price of the token. Unless a large amount of eUSD is exchanged for USDC, it may maintain a positive premium.

eUSD-USDC Pool on Curve (Source: Curve)

eUSD Use Cases

In addition to holding eUSD to enjoy interest income, eUSD can also be paired with USDC to form a liquidity pool (LP) for passive income. Moreover, one can purchase ETH by minting eUSD through staking ETH, and then continue staking. After several cycles of staking, this can serve as leverage for a long ETH position. Due to its short period since launch and participation in DeFi meaning forsaking around 8% yield, there are currently no other widely adopted use cases.

Lybra Earn (Source: Official Website)

Factors Affecting eUSD Returns

ETH Staking Yield

As seen from the minting mechanism, the underlying yield of eUSD is the ETH staking yield. If the yield from ETH staking decreases, the eUSD returns will also decrease. This part may also be related to the ETH staking ratio; the more you stake, the lower the staking returns.

Collateralization Ratio

When users stake, regardless of whether the collateralization ratio is 160% or 200%, the final return is the system’s average return. Therefore, for an individual user, a lower collateralization ratio theoretically means higher capital efficiency.

ETH Price

The most significant impact of the ETH price is liquidation. If the price drops sharply, it will trigger liquidation quickly. If the liquidation is not timely or the price fluctuation is too drastic, it might cause the on-chain liquidation to be incomplete, leading to a loss of the peg. Of course, if the price rises, the fiat-denominated value of the coin-based returns will increase, leading to a rise in eUSD interest income.

Impact of the Macro Bull Market

Another impact derived from the price factor is that if a macro bull market emerges, most users may adopt a low collateralization ratio or use leverage to go long on ETH, causing the overall return to decrease.

If it is expected that the ETH price will rise from $2,000 to $2,500, users do not need to exchange 1,000 eUSD at a 200% collateralization ratio of $2,000. Instead, they only need a 150% collateralization ratio to exchange for 2,000/150% = 1,333.3 eUSD and use the exchanged eUSD to convert to USDC to purchase ETH and repeat the previous operation. Under this operation, staking one ETH valued at $2,000 will yield more than 1,333.3 eUSD, meaning the actual collateralization ratio is far below 150% and the return rate is higher.

Decoupling of stETH and Other LST

Since the protocol exchanges staked ETH for LST, if LST decouples (i.e., trades at a discount), the LST staking rewards, which are a primary source of protocol income, will decrease, further reducing the eUSD yield and the value of the collateralized assets. Another more severe impact could be the panic selling caused by the decoupling, leading to a loss of the peg.

Lybra Business Data

Although Lybra started late compared to other established stablecoins, its growth can be described as “meteoric.” In less than four months, its scale reached $172 million, ranking 12th and being the only single-chain stablecoin in the top 12.

eUSD Ranking and Market Capitalization (Source: DeFiLlma)

Synchronized with the development of the stablecoin is its Total Value Locked (TVL), which increased a hundredfold from $3 million in April. However, the data also shows a slow growth of TVL, and even a downward trend.

Lybra TVL Change (Source: DeFiLlma)

From the perspective of the LST proportion, the value of stETH owned by the Lybra protocol accounts for half of the LSD TVL of the LSDFi project, highlighting its leading position.

LSD TVL Market Share Data (Source: Dune)

Tokenomics (Token Economics)

LBR is the native token of the Lybra protocol. Holders of LBR are also managers of the protocol and can share in the protocol’s income. LBR is an ERC-20 governance token with a maximum supply of 100M.

Token Utility:

• Sharing Income: Lybra protocol charges a service fee of 1.5% of the total circulating eUSD annually (the service fee is accumulated every second based on the current actual circulation of eUSD). The collected service fee is distributed to the LBR staking pool.
• Participating in Protocol Governance: The voting weight of LBR is directly proportional to the amount of LBR staked. Staking LBR earns esLBR, and esLBR holders can decide on the direction of the protocol, the treasury, and community activities. To exchange locked esLBR for LBR, a waiting period of approximately 30 days is required. The yield of esLBR increases with the length of the lock-up period.
• Ecological Incentives: LBR is used to incentivize various roles in the ecosystem, thereby promoting protocol development.

Token Distribution and Unlocking

60% of the tokens are allocated to the user minting pool, indicating that the team prioritizes the development of the stablecoin scale. The team and financing background have not been disclosed yet. Still, according to the documentation, 5% of the tokens are used for IDO, 40% of the funds are used to form LBR and eUSD-related LP, 20% for operating expenses, and the rest is minted into eUSD, laying the foundation for early protocol development. The team made rational use of early funds. Currently, the team has not unlocked any tokens, only advisors have started unlocking, and there is no sell-off pressure from the team and VC.

LBR Token Distribution (Source: Official Documentation)

However, according to the V2 document, Tokenomics took 1/12 of the mining pool share and distributed it to VCs and market makers. The new distribution is shown in the table below:

Updated Lybra Tokenomics (Source: V2 Document)

Changes brought by V2

From the explanation of V1 above, we can see some existing issues: eUSD is overvalued, its appreciation attribute is much stronger than its circulation attribute, and it relies too much on Lido and its LST stETH, etc. V2 not only improves the problems that appeared in V1 but also actively expands the boundaries of the Lybra protocol. The main updates of V2 are shown in the figure below:

Main Comparison between V1 and V2 (Source: Medium)

More than ten items were updated, and this section focuses on introducing peUSD and several key innovative mechanisms.

peUSD

peUSD is a homogenous token across all chains (OFT, using Layerzero’s cross-chain technology). peUSD can bridge eUSD from the Ethereum mainnet to Layer2. This will allow holders to use their interest-bearing stablecoins on any desired chain. Moreover, when exchanging, trading pairs, or participating in perpetual contracts, users will maintain the ability to accrue interest when bridging back. This will expand the market scenario for eUSD.

Multi-LST Collaterals

V2 will allow users to use various LSTs, including Rocket Pool’s rETH, Binance’s WBETH, Swell’s swETH, etc., to mint eUSD and peUSD. One of the benefits this brings is expanding the base of collaterals, further extending Lybra’s LST capture range, and expanding LBR’s utility through more partnerships, such as incentivizing different LSTs to stake in Lybra and creating more DeFi strategies, thereby bringing higher TVL (Total Value Locked).

dLP and LBR Destruction

If users want to receive esLBR rewards from the eUSD pool, they must lock at least 5% of dLP. For example, if a user wants to mint 1,000 eUSD, they need to provide at least $50 worth of LBR/ETH dLP tokens to be eligible for esLBR rewards. This will increase the amount of LBR staked and enhance LBR’s liquidity in the market. In addition, the mechanism of V2 will also intensify the destruction of LBR to reduce circulation. When users use LBR or eUSD to obtain dLP and esLBR, all LBR received by the protocol will be destroyed, reducing selling pressure. This will further reduce the circulation of LBR.

Stabilization Mechanism

V2 introduces a new flash loan feature to add an extra layer of financial security during the eUSD liquidation process. There are also separate pools of funds for different LSTs and a multi-level due diligence process for new LST assets. Moreover, V2 will introduce a series of stabilization mechanisms, including a new eUSD/3CRV pool, a premium suppression mechanism, and a dedicated stability fund. Through multiple stabilization measures, eUSD and peUSD in V2 are expected to break free from the trend of positive premiums and maintain stable and relatively small volatility.

DAO Governance Model

Holders of Lybra’s governance tokens LBR and esLBR will now have voting rights to manage the direction of the protocol. Users can also use esLBR to vote on matters related to any LST pool, including selecting specific LST assets, minting quotas of chosen LST vaults, and allocating rewards to each LST, among other topics.

Consequently, the incentives holders receive are consistent with the number of voting rights they commit to supporting. Each LST pool will be able to incentivize (bribe) esLBR holders to vote in support of that pool by providing token rewards. The LST sector, similar to the Curve protocol, involves users competing for esLBR, which represents voting rights, to increase rewards for their pool, leading to a potential “Lybra War.”

Lybra War Schematic (Source: Medium)

Currently, the Lybra testnet is still under testing, with an official launch expected at the end of August. To encourage testing, Lybra has introduced task rewards, where top performers in specific testnet tasks can receive LBR rewards.

Lybra V2 Testnet Status (Source: Lybra V2 Testnet)

Partnership Network and Ecosystem Expansion

In Lybra V1, users could only stake their ETH/stETH on the Ethereum mainnet to obtain eUSD. In V2, besides product upgrades, there is also a further expansion of the ecosystem boundary and a stronger partnership network.

Ecosystem Boundary Expansion

Although Ethereum is the most active public blockchain, its high gas fees and slow transaction speeds impose certain limitations on application scenarios and user base. Theoretically, the returns from using Lybra must be significantly higher than the gas fees and commissions required for withdrawals and redemptions, limiting small capital users and posing similar issues for applications deployed on Ethereum. In the V2 version, Lybra partnered with LayerZero, tokenized peUSD across all chains, and plans to deploy on Layer 2. This means that users with varying amounts of funds across different chains can leverage Lybra to generate returns, facilitating the expansion of eUSD application scenarios.

Partnership Network

The V2 version also addresses the earlier issue about reduced returns and depegging risks associated with using a single LST. The collateral has been expanded to include rETH and WBETH. The more LSTs that can participate, the larger the potential user base. According to DefiLlama data, these two new LSTs account for 11.82% of the market share of Ethereum’s liquidity staking. The diversification of LSTs as collateral also empowers LBR. Since esLBR can adjust the rewards for each LST pool, obtaining more rewards means holding more esLBR, representing voting rights. This increases the demand for LBR and could trigger the aforementioned Lybra War. As a stablecoin project, only by having more application scenarios and composability for eUSD/peUSD can Lybra attract more users to mint stablecoins and circulate them widely to gain market share. Both of these expansions contribute to its core business development. The expansion of partnerships primarily targets the user base, whether from the collateral layer or the DeFi collaboration layer, enabling Lybra to be used by more users in more ways. Ecosystem expansion, on the other hand, starts from the ground up, allowing Lybra’s stablecoins and products to reach more users.

Market Prospects and Challenges

Over-collateralized decentralized stablecoins have always been one of the cornerstones of the crypto economy. Still, due to limitations in use cases and user acceptance, even the market leader DAI only has a market capitalization of around $4 billion. Lybra, by generating interest from LST collateral, provides holders with returns far exceeding those of typical DeFi products, representing an innovative breakthrough and having a positive impact on the decentralized stablecoin space.

Other stablecoins like DAI have also introduced similar interest-bearing services. From the LSD track perspective, the average annual return of LSDFi is generally around 5% (according to a brief analysis by the author), while an APY of around 8% is quite attractive to Ethereum stakers. The emergence of peUSD and Lybra War could further increase capital efficiency and yield. However, as the ETH staking rate increases and staking rewards decrease, eUSD returns may decline. Theoretically, other fixed-income products, such as RWA, could also serve as collateral for Lybra, indicating strong protocol scalability. Currently, the main income shared by LBR holders comes from service fees; the larger the eUSD scale, the more LBR income.

The bribery mechanism introduced in V2 will also increase the yield of user LBR through third-party contests for governance rights. Additionally, most tokens will be unlocked two years later, and the introduction of a burning mechanism in V2 will have a positive impact on LBR. From a competitive perspective, there are many stablecoins based on LSD, and the TVL growth driven by 8% interest has been slowing down. The simple mechanism is extremely easy to replicate, and if Lybra cannot build its own protocol moat in time, there is a risk of being overtaken.

Conclusion

In less than four months since its launch, Lybra V1 has outperformed veteran stablecoin projects and led the development of the LSD track. The upcoming V2 not only addresses the issues in V1 but also further optimizes the product, tokenomics, UI/UX, and DAO governance, making it highly anticipated. However, like many decentralized stablecoins, it also carries risks of depegging and contract security, which should be noted. Please thoroughly assess the risks before investing in LBR.