<p dir="ltr">Many protocols confront the difficulty of bootstrapping liquidity at some phase of their lives. To attract money, protocols often distribute their "valuable" governance tokens via liquidity mining schemes. However, these incentive schemes are often costly and unproductive in terms of long-term liquidity retention. When the rewards begin to dwindle, mercenary capital migrates to a more profitable yield farm, leaving the liquidity pool in the same condition as before.</p><p>To address this problem, Olympus DAO and Tokemak both devised methods for accumulating protocol-owned liquidity (POL) — that is, liquidity managed and held by the protocol as opposed to the unpredictable and transitory liquidity owned by users. Another market option is "chicken bonds," a bonding mechanism invented by Liquity Protocol and now used by Liquity's LUSD currency. In this article, we will look at how chicken bonds function and their current popularity.</p><h2>What are Liquity Chicken Bonds?</h2><p dir="ltr">Chicken bonds are a bonding technique that may be used on yield-bearing tokens to accelerate protocol-earned liquidity while increasing bonders' yields. The increased return on boosted tokens is obtained from the protocol's liquidity as well as liquidity from users linking underlying assets to freshly minted boosted tokens.</p><p>Let's use Liquity as an example to demonstrate the chicken bond mechanism. By putting LUSD into the chicken bond system, a user may construct a LUSD chicken bond. Following this, the bond position gradually accumulates a virtual balance of boosted LUSD tokens (bLUSD). bLUSD has a higher yield than LUSD put in the stability pool. According to a smooth plateauing curve up to a cap, the longer they bond, the more bLUSD accumulates. A user may cancel their bond at any time and get their original LUSD principle returned, a process known as "chicken out." Alternatively, the user may opt to claim their bLUSD in return for their LUSD, which they would permanently give up – a process known as "chicken in."</p><p class="prosemirror-p-center"><em><img src="https://lh6.googleusercontent.com/UsWpWD2bzBUjzUcGKXfr80bal7jU_QQd_mkqyrLemQaGUz9pqzgyb3Z-ZKcRtxwDLepcVrP0Y6xSPvIws2gMN1X3W63DfhuRNknuCZ7vdnsR-Uk8wwGnitrMA6IM_pn_u7pO5DA3XsvK7crxdilUhUWTeiO0kVnqmkbqgOtUlZfcrmMsjG_kbyMGKVZc4A" width="624" height="320"></em></p><p class="prosemirror-p-center"><em>Source: Liquity</em></p><p>Where Does the bLUSD Yield Come From?</p><p dir="ltr">For bLUSD, there are two primary yield sources:</p><ul><li><p dir="ltr">Liquity's stability pool is accessible through the B.Protocol, and yield is received via reduced ETH during liquidations as well as LQTY awards.</p></li><li><p dir="ltr">Yearn Curve vault Curve LUSD/3CRV pool, whose yield is produced from trading fees and CRV incentives.</p></li></ul><p dir="ltr">The Yearn Curve vault and B.Protocol are in charge of converting and auto-compounding yield farming profits back into LUSD. To understand how this return is obtained, we must first understand how the LUSD invested in chicken bonds is divided into three distinct buckets. The LUSD chicken bond treasury is made up of three buckets:</p><ul><li><p dir="ltr"><strong>Pending bucket:</strong> The pending bucket comprises LUSD contributions from bondholders that the protocol has yet to obtain. It is worth noting that the holders of the LUSD deposits have not yet chosen whether to go all in or all out. Pending bonds may be claimed (chicken in) by users at any time, transferring LUSD from this bucket into the reserve and permanent buckets, or withdrawn (chicken out), returning principle LUSD from this bucket to users.</p></li><li><p dir="ltr"><strong>Reserve bucket:</strong> Holds a part of the LUSD surrendered by bondholders who have elected to chicken in, as well as the yield received on the full treasury. The whole bLUSD supply is backed by LUSD in the reserve bucket. This bucket's bLUSD may be redeemed for a corresponding share of LUSD.</p></li><li><p dir="ltr"><strong>Permanent bucket:</strong> Contains the remainder of the LUSD collected from bondholders who have chickened jn. The LUSD, in this case, is protocol-owned and cannot be redeemed by bLUSD holders.</p></li></ul><p>Through the B.Protocol, LUSD deposits in the pending bucket are placed into the stability pool. After that, the yield is auto-compounded and put into the reserve bucket. LUSD given up by users who have opted to chicken in goes into the reserve and permanent buckets. The funds are then transferred to the stability pool and the LUSD/3CRV Curve pool. Again, the yield farming gains go into the reserve bucket.</p><p dir="ltr">If you were wondering, the quantity of LUSD that goes to the reserve and permanent buckets when a user chooses to chicken in is determined by how far down the accrual curve each bond is when they close their bond. The farther down the curve a user deposits LUSD, the more of it is transferred to the reserve and less to the permanent bucket.</p><p class="prosemirror-p-center"><em><img src="https://lh3.googleusercontent.com/jaNQ_6E8Fgq1lwbofQRKxTslVXJvEmBIAgwr4QCZqSvjfFdz9R_Me9vwhFv8uoIt7ye1eC78hn41BOxxPPzxCNN-vEizllTLdWM-ns9XE5SXy4S-qecL4ZTpAaArOlbDH31-G4mkl88ro8uLhqn7LfFlV7QYgM4-LMLSjqZtmhfG8vqStnf0yqazWyd5iA" width="624" height="273"></em></p><p class="prosemirror-p-center"><em>Source: Liquity</em></p><p dir="ltr">As can be seen, all of the yields from these three buckets went to the reserve bucket, which is the pool of assets that backs the bLUSD. This implies that, barring any black swan occurrences, the floor price of bLUSD should theoretically always be growing (or, at the very least, remain constant if no yield is harvested).</p><p dir="ltr">The graph below shows the amount of money in each bucket, giving us an idea of how much capital is being put to work to increase the return on bLUSD.</p><p class="prosemirror-p-center"><em><img src="https://lh4.googleusercontent.com/BOSDnc_2qMk_wEkbHOGWxdGEbgH_0mPTf80XeTFXx6i902wzM3BJHF9k3eCF25jAqHgdMM1AdvjjxHj2qreBuNMrE-9GeuU4Ecor7BOfRpq9h7abfXoNSZUpvKxht9f-nXBokR1i-mKpDlX23MceSvcashtVzTdZde68SYvZVbqR6zPtBjbPuVqzmF7Bgw" width="624" height="391"></em></p><p class="prosemirror-p-center"><em>Source: Dune Analytics</em></p><p dir="ltr">Because of this yield amplification, the price floor of bLUSD has been climbing since its introduction.</p><h2>Since Its Inception</h2><p dir="ltr">Since their debut in early October, chicken bonds have received approximately $71.5 million in LUSD deposits, albeit only a portion of that capital has been utilized to chicken in. More than 90% of the capital in these bonds is still pending.</p><p dir="ltr">Given the project's infancy, activity has been healthy and dominated by bond creations. The sheer amount of chicken outs on November 9th is an intriguing statistical point. There's a good likelihood this is due to the ETH price decrease that day ($1.6k to as low as $1.1k), which may have prompted users to unbond LUSD in order to re-collateralize their debt holdings on Liquity.</p><h2>The Advantages of Chicken Bonds</h2><p dir="ltr">Chicken bonds are principal-protected and flexible, enabling consumers to unwind at any moment while still reaping the benefits of a greater return. Chicken bonds, on the protocol front, are a low-cost approach to bootstrapping protocol-owned liquidity.</p><h3>Principal-Protected</h3><p dir="ltr">When a user starts a chicken bond and starts earning bLUSD, they may cancel at any moment and retrieve their principal. The user has not lost any money; they have just lost the opportunity cost of keeping capital in the chicken bond up to that time.</p><h3>Increased Yields</h3><p dir="ltr">As previously stated, chicken bondholders who opt to chicken in may profit from greater yields if they swap LUSD for bLUSD. However, users must wait at least until the value of accumulated bLUSD exceeds the original LUSD capital placed before taking the plunge.</p><p dir="ltr">Furthermore, the bLUSD acquired is a yield-bearing token with a rising redemption price as the yield gained on the whole treasury flows into the reserve bucket that supports the bLUSD token.</p><p dir="ltr">The APR of bLUSD over time is the total earned yield from the pending, reserve, and permanent buckets divided by the amount in the reserve bucket. The yield amplification multiple determines how much higher the bLUSD APR is in comparison to the stability pool APR. It is computed as follows: (bLUSD APR/stability pool APR). Currently, the results indicate that the bLUSD APR is 15.95x greater than the stability pool APR.</p><h3>Stability of the Peg</h3><p dir="ltr">Increasing liquidity for LUSD Curve pools to enhance peg stability is one of the potential benefits of chicken bonds. We previously discussed how LUSD in the permanent bucket might be placed into the stability pool and/or the LUSD/3CRV pool to generate yield for bLUSD. Using a shifting function, these funds may be shifted dynamically between the two sources to maximize yield and enhance the LUSD peg.</p><p>LUSD has infamously traded at a premium to $1, and chicken bonds might be the answer. The ramifications of this, however, have yet to be apparent since all money is put in the stability pool for the first 45 days (the initial bootstrap period). The bootstrap period will end later, so we'll see whether liquidity migrates to the Curve pool and affects the market price of LUSD.</p><p>Protocol-owned liquidity is basically generated by borrowing user money and holding a portion of the return on it for the protocol. The permanent bucket, which holds the protocol-owned liquidity, is now valued at $930,000. The expense of constantly bootstrapping additional POL is minimal. At the present, the protocol is just providing bLUSD holders with the yield gained on POL that goes to the reserve. This is a far more cost-effective technique for obtaining POL than the normal expensive liquidity mining operations and costly governance token emissions.</p><p>Principal protection with the potential for great yields It sounds like something out of a storybook. Chicken bonds, like other DeFi products, come with significant hazards.</p><h2>&nbsp;The Risks</h2><h3>Chicken Bond Liquidation Losses</h3><p dir="ltr">Liquity's stability pool, which liquidates troves (loans) that have dropped below the required collateral ratio of 110%, is the primary source of increased yield. The stability pool yield is derived by liquidations purchasing ETH at a 9% discount. However, during times of market volatility, liquidations may fail to sell troves successfully, resulting in a loss to the stability pool rather than a gain. These losses would be shared by the reserve, lowering the bLUSD redemption price.</p><h3>Smart Contract Risk</h3><p dir="ltr">The chicken bond system as a whole is vulnerable to the smart contract risk of multiple protocols, including Liquity, B.Protocol, and Yearn. Due to the integrations involved with auto-compounding and other components of the bonding process, it is also vulnerable to the smart contract risk of its own smart contracts.</p><h3>Chicken Outs on Suspended Ground</h3><p dir="ltr">Users may not always be able to avoid taking risks, especially during times of strong ETH price volatility. Because the deposits of LUSD into chicken bonds are put into the stability pool, the capital may be locked up if Liquity sees severe liquidations. In this circumstance, customers may be temporarily barred from chickening out until the ETH from the liquidations is converted back to LUSD.</p><h2>Final Thoughts</h2><p dir="ltr">The chicken bond mechanism is now doing well because customers are drawn to the high yield of bLUSD as well as the promises of flexibility and principle protection. At the moment, the yield is adequate to support and attract LUSD holders to invest in chicken bonds. However, this return is contingent on two factors: the balance of treasury assets and the availability of healthy yield sources. For starters, the modest bLUSD supply in comparison to a big pending bucket maintains bLUSD yields high and appealing. If there is a high number of bLUSD supply and a little amount of capital in the pending and permanent buckets, for instance, there will be little to no "yield amplification," and the bLUSD's APR will be unappealing in comparison to the underlying yield.</p><p dir="ltr">Second, if demand for chicken bonds increases at an exponential rate without a rise in stability pool yield, the underlying yield source may be diluted since interest revenue is now distributed over more deposits. As a result, demand for chicken bonds may be discouraged or limited. However, one of the more pleasant concerns for DeFi protocols today is rapid growth. Nonetheless, Liquity must maintain a solid balance of treasury assets in order to sustain yield amplification. This might be accomplished by increasing the size of the permanent bucket to a specified threshold. It is also critical to avoid over-diluting the underlying yield source in order to maintain an appealing bLUSD APR. If deposits become too enormous, this might be accomplished by diversifying into other sources of income.</p><p dir="ltr">Overall, the chicken bond mechanism is a novel approach to bootstrapping liquidity. In theory, the chicken bond incentive system is similar to veToken economics, in which users who commit to locking up their tokens for a longer amount of time — in this example, those who chicken out and permanently lock their LUSD — are rewarded at the cost of others who don't. So far, the concept seems to be functioning well on Liquity's LUSD. The project, although promising, is still in its early stages, and it has to be seen how nimble they are in dealing with the issues and hurdles that come with expanding too large. If the chicken bond concept is successful, it might be used for Liquity's governance token, LQTY, along with other yield-bearing tokens.</p><div class="pr-block-special"><strong>Disclaimer:</strong><br>This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.</div><p><br></p>

A bonding method called chicken bonds may be applied to yield-bearing tokens to speed up protocol-earned liquidity while raising bonders' yields.

Liquity's Chicken Bond: An innovative approach to bootstrapping liquidity