Liquity V2 Launches with Multi-LST Support and Dynamic Interest Rates, Enhancing DeFi Capital Efficiency

Executive Summary

Liquity has officially launched its V2 protocol on Ethereum, introducing multi-liquid staked token collateral, user-set interest rates, and a significantly reduced collateralization ratio, aiming to boost capital efficiency and reshape decentralized lending.

The Event in Detail

Liquity V2, launched on the Ethereum Mainnet on May 19th, introduces significant upgrades to its decentralized stablecoin lending protocol. Key among these is the expansion of collateral options to include multiple Liquid Staking Tokens (LSTs), such as Wrapped Ether (WETH), Wrapped Staked ETH (wstETH), and Rocket Pool ETH (rETH). Each LST now operates within its own independent lending market, complete with distinct risk parameters and Stability Pools, accommodating multiple collateral types and ETH.

The protocol implements a novel user-driven dynamic interest rate mechanism. Borrowers are empowered to set their own interest rates, ranging from 0.5% to 1000%. This mechanism aims to foster market competition and directly compensates stable pool depositors with a sustainable yield derived from these interest payments. For instance, 75% of the interest revenue from each borrow market is funneled to its respective Stability Pool depositors.

Capital efficiency is substantially enhanced by reducing the minimum collateralization ratio for ETH to 110%, which corresponds to a loan-to-value (LTV) ratio of 90.91%. This allows for leverage up to 11x on investments. Concurrently, Liquity V2 has removed the 'Recovery Mode' feature that was present in V1. This removal, effective as of July 23, 2025, ensures consistently high LTVs for borrowers, independent of the system's overall state. The V2 architecture addresses the previous need for Recovery Mode by ensuring a sustainable yield for the Stability Pool through real yield payments and adaptive redemption logic, which aims to maintain sufficiently large Stability Pools.

Furthermore, Liquity V2 introduces Protocol Incentivized Liquidity (PIL). This mechanism directs a portion of V2's revenue to encourage sufficient BOLD stablecoin liquidity, with the goal of stimulating ecosystem growth under the direction of LQTY stakers. A fixed split of 75% of interest proceeds goes to Stability Pool Rewards and 25% to Protocol Liquidity Incentives, providing a continuous budget for PIL.

Market Implications

The introduction of Liquity V2 positions the protocol as a more competitive entity within the decentralized finance (DeFi) lending landscape. By supporting a wider array of LSTs, Liquity V2 directly competes with established platforms like Aave and Compound, which already list wstETH and rETH as collateral options. While Aave v3 'e-Mode' and Compound's Comet architecture offer similar LST collateralization, Liquity V2's 110% minimum collateral ratio is notably lower than many other DeFi borrowing protocols, signifying a significant increase in capital efficiency.

The user-set interest rate model represents a departure from traditional algorithm-managed rates common in DeFi. This market-driven approach aims to establish an equilibrium between borrowers and BOLD holders, potentially leading to more stable and predictable yield mechanisms, in contrast to protocols that rely heavily on inflationary token incentives for yield. The absence of protocol-level governance for key mechanisms, beyond DEX liquidity incentives, aligns with a trend towards immutable, market-driven financial systems, which may appeal to users seeking higher decentralization and reduced upgrade risks.

The removal of 'Recovery Mode' and the emphasis on a permanently high LTV ratio provide borrowers with greater certainty and flexibility, which could attract more users seeking to maximize their capital utilization. This design choice highlights a maturation in DeFi protocol development, moving towards robust systems capable of sustaining high leverage without relying on reactive risk parameters.

Broader Context

Liquity V2's design choices contribute to the ongoing evolution of sustainable yield generation and risk management within DeFi. The protocol's reliance on user-set interest rates and real yield from borrowing fees, rather than inflationary token emissions, addresses a critical challenge in DeFi: the transition towards more predictable and sustainable yield models. Many DeFi platforms have historically struggled with the sustainability of yields, often relying on short-term liquidity incentives that lead to volatility.

The minimal governance structure, with non-upgradable smart contracts for core functionality, reflects a commitment to immutability and decentralization. While some in DeFi advocate for upgradeability to fix bugs or adapt to regulations, Liquity V2 prioritizes a "set-it-and-forget-it" architecture, aiming to enhance long-term trust and security through a fixed operational framework. This approach provides a counter-narrative to protocols that frequently adjust risk parameters through governance proposals, offering a different model for protocol longevity.

The expansion into multi-LST collateral also underscores the growing importance of liquid staking derivatives in the DeFi ecosystem. These tokens allow users to maintain staking rewards while deploying their assets in other financial activities, unlocking liquidity without forfeiting yield. Liquity V2 capitalizes on this trend, providing a high-efficiency borrowing avenue for LST holders and further integrating staked Ethereum into the broader DeFi lending infrastructure.