The CRITICAL Role of Redeemability in TradFi, Crypto and Liquid Loans

Whether you invest in stocks, bonds, or crypto, you should make sure that there is a possibility to redeem these assets for another asset at any time. In fact, redeemability is the key characteristic that can help you evaluate how liquid the asset of your choice is.

In this article, we are going to talk about redeemability in general, and how Liquid Loans addressess with this aspect, in particular.

What Does Redeemability Mean?

From a financial perspective, redeemability refers to the possibility to cash out your investment before it reaches maturity, i.e. the end of the investment timeline. Why is it so important to be able to sell your assets whenever you need?

The importance of redeemability for investors

For investors, there may be several scenarios when redeemability is really crucial. 

For example, the dollar value of the asset may significantly drop. In this case, it would be wise to cash it out for its face value, i.e. the dollar value of the instruments when they were issued, together with the interest accrued over time. With redeemable assets, it is possible.

Alternatively, investors may spot much better opportunities during the investment period. For this purpose, they will need cash which they may obtain by redeeming the assets they possess.

The importance of redeemability for companies

For issuers, redeemability is just as important as it is for investors.

Assume, there is a company that goes public by selling its shares on the stock market. It uses the raised money to accelerate its activities and to improve its performance.

Yet, the stock price may drop below a certain level at any moment due to the overall market volatility. In this case, exchanges may delist it which would be a severe blow to the company as it will lose access to external funding.

In this case, redeemability may come in quite handy. The company will be able to redeem its own stocks, grow back their prices, and thus avoid delisting.

However, redemption gets way harder if there is no collateral backing up the paper or a digital asset that you hold. Let’s take a closer look at what this process looks like in practice.

Redeemability in Finance

The examples of redemption in TradFi are aplenty. For instance, a callable bond or a redeemable bond enables its issuer to redeem its value before the maturity date and thus pay off its debt earlier.

Another example of a redeemable asset is a mutual fund. To perform the redemption of a mutual fund, an investor sends a request to the fund manager to process. The value that an investor gains usually corresponds with the current market price of the company shares minus all the related fees.

Gold Standard

Perhaps, the most popular historical case of a redeemable asset is the international Gold Standard that emerged in the 1870s and lasted until 1914. 

It implied linking a local currency of a given country to a fixed amount of gold and enabled its holders to cash out this asset at a fixed price at any time. 

The system proved to be quite efficient. The limited physical quantity of gold prevented countries from endlessly issuing banknotes and thus stood against inflation.

Gold Certificate

Another example is the Gold Certificate. Unlike the Gold Standard, Gold Certificates gave their owners higher flexibility when it came to regular payments. Investors stored some amount of golden coins in the state treasury while the government provided them with the paper equivalents of these assets.

The Gold Certificates emerged at approximately the same timeframe as the Gold Standard but lasted a bit longer until 1933. As the Great Depression hit the nations worldwide, trust in centralized financial institutions diminished.

Redeemability in Crypto

With cryptocurrencies stepping out into the light, a solution to the problem of mutual trust has finally been found. As smart contracts curate all the processes, the parties may now rely on the infallible code and forget all the problems related to redeemability. Right?

Well, not exactly.

The problem is that the majority of the top blockchain-based solutions ruling the market are highly centralized. Similarly to TradFi, redeemability remains a pretty acute problem in their case, too. What kind of solutions are those?

Fiat-backed stablecoins

First, there are stablecoins that are issued by centralized entities with their value linked to fiat currencies. Tether (USDT) and USD Coin (USDC) have long been dominating the market with no alternatives being available to the broad audiences.

Yet, even such good positions do not protect these stablecoins from depegging. Thus, USDT price dropped below $1 USD value many times throughout its existence with the most recent case taking place in August 2023.

USDT has been depegging all month. Why hasn't anyone noticed?

In this week's Deep Dive we propose a novel method of rating stablecoin depegs, check it out below ⬇️https://t.co/o8LuiTMSqW

— Kaiko (@KaikoData) August 31, 2023

USDC faced one of its worst depegs after the Silicon Valley Bank crash in March 2023. At that time, the coin price dropped as low as $0.91 per coin resulting in severe losses for many investors. Thus, redeemability is quite an acute question for such assets.

Voyager has been an unsuspecting casualty of the USDC depegging today:

Amidst their liquidation into stablecoins, the former crypto lender found themselves losing almost $45M of value overnight. pic.twitter.com/E8DQmApEgn

— Arkham (@ArkhamIntel) March 11, 2023

Wrapped assets

Wrapped tokens represent digital assets that derive their value from other cryptocurrencies. In the ideal scenario, a wrapped token must always be redeemable at a 1:1 ratio against an underlying cryptocurrency.

Such an approach helps to solve the interoperability problem inherent to many blockchains as it enables the use of the same coin (e.g. BTC) on different blockchains. Yet, it comes with some significant disadvantages as well. The high level of centralization is, perhaps, the most critical of them all.

In order to convert a token into its wrapped version, users have to rely on a custodian who holds an equivalent sum of this token in the wrapped form. 

The custodian may be a decentralized smart contract or a single merchant. In the last case, users have to blindly trust the honesty of this merchant who can cash out their reserves at any time and thus make the underlying asset unredeemable.

What Happens When Redeemability Breaks?

So what does actually happen to your investment when the asset redeemability stops working as it should?

In TradFi, this means that the certificate you hold no longer has the value that you expect it to have. You will still be able to redeem cash in exchange for this asset, but its price most likely will be lower in comparison with the face value.

In crypto, the situation is just the same. One of the most prominent examples of broken redeemability is Terra’s UST collapse which took place in May 2022. The lack of a redemption mechanism combined with a series of unlucky events resulted in a total depegging of the algorithmic stablecoin UST which hasn’t been able to revive ever since.

Redeemability in Liquid Loans

After learning from previous stablecoins failures, Liquid Loans has designed its protocol around redeemability.

Every USDL in existence is backed by a minimum of 1.1 USD worth PLS. In other words, USDL is an overcollateralization stablecoin.

In addition, USDL holders can redeem their coins for 1 USD worth of PLS at any time due to the redemption mechanims.

This function incentivizes users to buy USDL when it is under $1 and push the price back up.