Liquity V2 part 3: Multi-Layered Stabilization: Redemption, Interest, and Liquidation

At the heart of BOLD’s resilience lies a multi-layered stabilization system that balances three forces: redemptions, liquidations, and interest rate dynamics. Together, they form a feedback loop that restores the peg, protects depositors, and maintains solvency even under stress.

In the next section, we’ll explore how these mechanics translate into real-world borrower and depositor strategies, including liquidation gains, batch-level interest optimization, and redemption dynamics.

Interest Rates and Redemption Dynamics

BOLD holders always have the ability to redeem 1 BOLD for $1 worth of collateral. This hard arbitrage floor ensures that if BOLD ever trades below peg, redemptions drive it back toward $1. Unlike Liquity V1, where redemptions targeted Troves with the weakest collateral ratios, Liquity V2 selects Troves with the lowest interest rates first (sortedTroves.getLast()).

Borrowers affected by redemptions don’t suffer an immediate financial loss, but they do lose exposure to their collateral — which can be significant. They are incentivized to choose higher interest rates to avoid being redeemed, especially when BOLD is trading below peg and redemption risk is high. These elevated rates, in turn, increase the demand for BOLD, as users seek to capture the higher yields offered by the Stability Pools. As in any market, increased demand puts upward pressure on price, helping BOLD restore its peg.

This design reshapes borrower incentives. Troves offering low rates risk being redeemed and losing exposure to their collateral, while higher-rate borrowers are shielded. In practice, this creates an interest-driven stabilization loop:

• Below $1: redemptions pressure low-rate Troves, forcing higher average rates, which in turn boosts yields for Stability Pool depositors and strengthens demand for BOLD.

• Above $1: redemption risk disappears, encouraging borrowers to lower rates. Yields compress, demand softens, and price drifts back down toward peg.

In effect, interest rates serve as an endogenous monetary policy lever, continuously adjusting to market conditions.

Redemption Routing Across Branches

Beyond peg restoration, redemptions also rebalance systemic risk. Through a mechanism called redemption routing, the protocol directs redemption volume toward the branches with the greatest “unbackedness” — the gap between a branch’s total debt and the BOLD sitting in its Stability Pool.

For example, if Branch A has 500 BOLD of unbacked debt and Branch B has 1,500, a 400 BOLD redemption would allocate 100 BOLD to Branch A and 300 BOLD to Branch B. This proportional routing ensures that collateral coverage improves where it is weakest, gradually rebalancing the system.

Liquidation Mechanics

While redemptions stabilize the peg, liquidations safeguard solvency. Any Trove that falls below its Minimum Collateral Ratio (110% for ETH) becomes liquidatable. The Stability Pool absorbs its debt, burning BOLD and redistributing collateral to depositors. To scale efficiently, the protocol uses two global accumulators (P and S) that track proportional deposits and collateral gains, ensuring O(1) accounting no matter how many depositors participate.

If the Stability Pool lacks sufficient BOLD, a Just-in-Time (JIT) liquidation or redistribution spreads the collateral across active borrowers in the same branch. This layered design guarantees solvency under stress, while rewarding participants for keeping the system healthy.

Shutdown and Urgent Redemptions

In extreme conditions — such as an oracle failure or a branch’s collateral ratio collapsing below the shutdown threshold — the protocol can trigger a branch shutdown. When this occurs, interest accrual halts, pending fees are settled, and normal redemptions are replaced with an urgent redemption mechanism.

Urgent redemptions bypass fees, offer a 1% collateral bonus, and allow direct targeting of Troves, enabling rapid unwinding of debt positions. This ensures that even under catastrophic market stress, users retain a predictable exit path and the system can recover in an orderly fashion.

The Feedback Loop of Stability

Together, these mechanisms form a self-reinforcing cycle:

• Interest rates adjust yields and borrowing incentives.

• Redemptions restore the peg and rebalance systemic risk.

• Liquidations maintain solvency and reward depositors.

• Shutdown safeguards ensure resilience in tail events.

By intertwining market-driven incentives with automated enforcement, Liquity V2 achieves a stabilization architecture that is both robust and self-adjusting — ensuring BOLD’s peg holds across a wide spectrum of conditions.

Conclusion: Stability by Design

Liquity v2’s architecture shows that stability is not the product of a single mechanism but the interaction of many. The trio of pools provides clear accounting and loss isolation; redemptions and liquidations enforce discipline; and adaptive interest rates align borrower and depositor incentives. Together, these forces create a system where BOLD can maintain its peg without governance intervention, even in volatile markets.

For builders, this means a predictable foundation to innovate on. For auditors and researchers, it offers a rich landscape of mechanisms whose subtle interplay deserves careful analysis. And for users, it reinforces the original Liquity promise: decentralized borrowing with stability that is earned, not assumed.