Article: Liquity: A Chicken Bonds Primer by Rxndy444

Compiled by: TechFlow

If you’ve been paying attention to the DeFi world this year, you’ve probably noticed a couple of emerging trends. One narrative is the innovation in bootstrapping protocol owned liquidity (POL), and another is the expansion of NFT use cases beyond PFP.

The protocol we are about to discuss today is called "Chicken" - don't worry, vegetarians, this is not for eating. The Chicken Bonds we are talking about is an NFT-based liquidity bootstrapping engine provided by Liquity.

What is Chicken Bond?

As the name implies, CB is a type of bond. Through the Liquity frontend, users can deposit LUSD to create a bond position, which is then represented by a unique generated NFT.

These bonds have no maturity date, and they generate yield over time in the form of bLUSD. At any time, bondholders can choose to "opt in," in exchange for giving up their initial LUSD in exchange for receiving bLUSD, or they can "opt out," terminating the bond and receiving their initial LUSD deposit in exchange for giving up bLUSD.

The main purpose of CBs: to provide users with an amplified LUSD yield opportunity while obtaining additional liquidity for Liquity. On the surface, it is relatively simple, but there are many interesting aspects of the CB strategy, the mechanism of bLUSD, and NFTs themselves that are worth exploring in depth.

We’ll start by introducing the system and then some strategies on how to use CB.

NFT Integration

Obviously NFTs themselves aren’t the focus of CB, but they are certainly worth mentioning. They evolve based on the decisions of the bonder and can be traded on marketplaces like LooksRare and X2Y2.

Liquity's attention to detail is clearly on display in the unique design, with animations for each evolution and a huge number of trait combinations.

These evolutions correspond to bondholder activity. If bondholders join, the egg transforms into a mature chicken. If they exit, it transforms into a scared chick. Chickens also have the ability to earn badges, shown in the bottom corner above, which are earned through holder participation in the broader Liquity ecosystem.

Owning an open Liquity Trove, staking LQTY tokens, and voting for the LUSD pool on Curve will all earn your chicken a unique badge. The dynamic nature of these NFTs and the features that are influenced by on-chain activity are a novel design when it comes to the integration of NFTs in DeFi. This is a big step forward in the DeFi world and will surely be imitated by other projects in the future.

When selling your egg NFT, it’s important to remember that you’ll also be selling ownership of the underlying bond, so set your listing price accordingly.

Overall, this is one of the best examples of NFTs serving a legitimate financial purpose without sacrificing flexibility.

Enhanced LUSD (bLUSD)

Now that we’ve discussed NFTs, buckle up because we’re about to get technical. Here’s an explanation of bLUSD, the token that pays CB earnings.

bLUSD (Boosted LUSD) is an ERC-20 token that is independent of LUSD and is backed by the CB system's reserves. The reserves are made up of LUSD deposits from bonds, which are then deposited into Liquity's LUSD stable pool via B.Protocol or into Curve's LUSD/3CRV pool via Yearn Finance. Because bLUSD is backed in this way, it represents a proportion of the reserves. In other words, a holder who redeems 1% of the current bLUSD supply will receive 1% of the reserves.

When redeeming bLUSD, holders will receive a combination of LUSD and yTokens (Yearn Curve LP tokens). Anyone can redeem bLUSD only when the market price is below the redemption value. This is economically feasible and an arbitrage opportunity that is likely to be snatched up by bots. This arbitrage helps maintain the floor value of bLUSD, and due to the increased future yields earned on bLUSD, the market price should remain above this floor price.

Increase yield?

Yes, as the name implies, bLUSD generally offers higher yields than standard LUSD deposits in the stablecoin pool.

The LUSD stored in the CB system is in three buckets:

Pending Bucket: LUSD from open bonds (not entering or exiting) goes here, and the income earned from this LUSD goes to the reserve bucket. Reserve Bucket: A portion of the LUSD from bonds and the LUSD income from the other two buckets goes here, supporting the entire bLUSD supply. Perpetual Bucket: Another portion of the LUSD from bonds goes here, and the income generated from this bucket goes to the reserve. The LUSD in this bucket is owned by the protocol and is not used for redemption.

Since the yield from each bucket goes into the reserve bucket, this increases support for bLUSD beyond the yield from the normal LUSD+ Stability Pool - thereby enhancing yield. Yields earned from both sources (Yearn Curve vault and Stability Pool) are also automatically harvested and automatically compounded, maximizing yield potential.

What does this mean for bondholders?

The reserve bucket system is established to protect the principal of open bonds. Bondholders can exit at any time and obtain their LUSD principal, which is a good safety line. Exiting also means giving up the claim to the accrued bLUSD income, which is actually transferred to future entrants. Entry provides an opportunity to increase the yield, which will prompt bondholders to decide when it is best to enter the market.

The blue curve below shows the accrual schedule for bLUSD over the bond holding period, growing quickly initially and then slowing down as it approaches the cap.

At some point on this curve, bondholders break even, where the market value of their accrued bLUSD equals their initial principal.

After this point, it makes sense to enter the market, but given the diminishing returns, there is little value in continuing to wait.

bLUSD Strategy

Given the above properties of bLUSD, there are several different strategies that can be adopted, depending on the user’s goals and risk tolerance. Here are five ways to play bLUSD:

Continuous Stablecoin Yield: A relatively simple and passive strategy, the approach involves borrowing LUSD with ETH collateral through Liquity Trove, bonding it, and backing it out sometime after reaching the breakeven point. Then, when the market price of bLUSD is reasonably high compared to the redemption value, sell bLUSD in exchange for LUSD and bond it again to increase the principal to continue the yield cycle. The main risk here is the ETH exposure and the need to maintain the Trove collateralization ratio when the ETH price falls. Active Trading: A more speculative strategy, actively trading bLUSD would involve monitoring the market price, buying below fair value, preferably close to the redemption value, and selling when higher demand for bLUSD pushes the price higher. The risk here is timing these buys and sells to maximize profits, but the downside is limited by the minimum redemption value of bLUSD. Providing liquidity: Another passive strategy, doing LP for bLUSD, obtaining LUSD through Trove or exchange, bonding some LUSD and entering at a certain point in time to obtain bLUSD, and then depositing both tokens into the Curve pool to earn trading fees. LPs also hope to have some extra LUSD available to rebalance the pool during bLUSD sell-offs, earning some extra deposit bonuses from Curve. Impermanent loss risk is reduced by the CB mechanism, which allows POL to be transferred to the Curve pool to achieve price equilibrium. One-sided LP should also be considered as it can generally bring better returns. This would involve depositing LUSD into the Curve pool only when LUSD is unbalanced against bLUSD to ensure a premium. The current APR in the pool is 4.055%. Redemption robot: As mentioned earlier, the bLUSD redemption system creates an arbitrage opportunity when the bLUSD price is below the redemption value. Programmers can create a robot to monitor this opportunity and buy and redeem bLUSD when profitable. Focus on NFTs: Like most NFTs, CB Jpegs have different rarities depending on the features they come with, and presumably some collectors will be interested in purchasing rare CBs. The chances of obtaining rare combinations can be increased through events, and users can participate in these events and create multiple bonds to try to "hunt" rare properties.

 

Example

Chicken Bonds as a POL bootstrapping mechanism.

Every DeFi protocol at some point faces the problem of how to efficiently increase liquidity of its token.

Typically, this means offering temporary or diminishing rewards, usually in the form of native tokens, to attract liquidity providers. While this may work in the short term, it can lead to inflated token supply and attract so-called mercenary liquidity.

As Liquity itself has demonstrated with Chicken Bonds, boosting the "amplified yield opportunities provided by the token" can drive protocol-owned LUSD liquidity. As introduced earlier, LUSD deposits from CBs flow to buckets owned by the perpetual protocol. This system also allows Liquity to deepen the LUSD liquidity available on Curve as it is used as a source of yield on deposited LUSD.

The plan is to start rolling out CB to other protocols and DAOs starting around Q2 2023, allowing them to integrate this same system for their own native tokens and gain access to liquidity for free.

If desired, protocols can also deploy some liquidity to further incentivize their CB systems.

Creating a bond, not redeeming it to increase yields, providing liquidity for boost tokens, and purchasing boost tokens on the open market are all options that make CBs more attractive.

bLUSD as collateral

By design, bLUSD has a rising floor price due to the backing of the reserve bucket, making it relatively stable. This, coupled with the fact that it is a yield-yielding asset, gives it unique potential as collateral.

The idea here is: borrowing with bLUSD means there is no risk of liquidation if the threshold is below the redemption price of bLUSD. This will allow the borrower to obtain a highly capital-efficient loan with 100% LTV based on the redemption price and use the borrowed assets for another yield opportunity, such as staking stablecoins. Essentially, this will provide leverage without liquidation risk because the floor price of bLUSD is hard-backed from the redemption mechanism.

For example, a holder of LUSD will create a bond, and he will receive an egg NFT representing the bond, redeemable for bLUSD. They want to borrow another stablecoin for collateral, so they will take out a loan using the egg NFT as collateral based on the redemption (floor) price of bLUSD (currently 1.06LUSD). This loan can be a large portion of the value of the bLUSD claim underlying the bond, because if they default, the lender will be protected by the bLUSD floor price. The borrower will also be protected from liquidation because the value of their collateral is backed by the bLUSD floor price.

Indicators

Now let’s look at the numbers for CB and see how it has fared since its launch in October. All figures are in LUSD unless otherwise stated.

First, the trading volume and number of users are considerable, with over 1,700 bonds created in just 56 days since launch, totaling over 62 million LUSD.

Below, we can see the size of the bonds, and while there are a few large bonds > 500k LUSD, the majority of bonds are 100k LUSD and below.

This suggests that there are larger whales/funds/DAOs using CBs, but the majority is driven by smaller DeFi users, which is a good sign for adoption and sustainability.

As for the buckets, we see that most of the money is in the pending bucket, probably because bondholders figure out the best time to enter.

The Reserve bucket is being filled up by proceeds from the Pending bucket and currently stands at 3.2 million, while the Perpetual bucket has accumulated a respectable 550,000 POL through exits.

With nearly 53 million LUSD currently in the system, the treasury is generating a lot of revenue, which is driving market prices and the bLUSD floor price to grow.

At current yield levels, the $1.0606 floor price is expected to reach the current market price of $1.1603 within 60 days.

Enhanced yield is no joke - investors are hard-pressed to find an opportunity with a comparable yield that also offers a fully backed reserve.

Deepening Curve's liquidity is one of Liquity's main goals in implementing CBs, and so far, both the LUSD 3CRV and bLUSD/LUSD pools look strong. Some of the growth in bLUSD/LUSD can be attributed to the LP strategy described above, as well as the benefits of LUSD 3CRV liquidity.

in conclusion

Liquity’s work on Chicken bonds is one of the most useful DeFi innovations we’ve seen in recent months, and its multi-faceted design has broad appeal.

Whether it’s investors looking for quality yield, protocols/DAOs bootstrapping liquidity, LPs, NFT collectors, arbitrageurs, and more, Chicken Bonds and bLUSD have diverse use cases and strategies.