Liquity Protocol: The Appeal Of Interest-Free Resilience

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Money is the one thing competition would not make cheap, because its attractiveness rests on it preserving its dearness.

– F.A. Hayek, “Denationalisation of Money,” Third Edition, 1990, p. 94

As 2022 winds down, the crypto market as a whole faces a sobering reality check.

A number of DeFi projects that were touted as decentralized and robust during the 2021 bull market have, in fact, proven to be the complete opposite as the bear market has taken its toll. Among other reasons, many DeFi protocols have been crippled by faulty economic designs, unthorough smart contract development, and the shortcomings of DAOs.

All of this has been especially true in the competitive stablecoin space, where the collapse of projects like Terra, once valued in the tens of billions of dollars, has reinforced the need for more resilient stablecoin projects that are truly committed to first principles. In this blog post, I will focus on Liquity Protocol (LQTY-USD), and explain why I personally believe its foundational ethos of enabling interest-free loans uniquely positions it to cater to a far-reaching market that extends well beyond the existing DeFi userbase.

Rise and Shine

When it comes to stablecoin design innovations, Liquity Protocol is a gem in a sea of imitations. Built on Ethereum (ETH-USD), it has been battle-tested since its debut in early 2021, and continues to chug along, having withstood multiple periods of market volatility since its launch. Being immutable and governance-free, there is no human interference possible with the protocol, and it was designed this way by the Liquity team from its inception.

In the flight to safety that many DeFi users have embarked upon during 2022s crypto bear market, by shifting away from both pseudo-decentralized stablecoins and questionable centralized stablecoins, LUSD-USD has understandably upheld a resilience premium above its $1 peg as a result. The outsized demand for LUSD versus other stablecoins it trades against reflects the growing confidence users have in Liquity Protocol as reliable DeFi infrastructure, as well as LUSDs value proposition as a censorship-resistant and transparent stablecoin entirely backed by ETH on-chain.

Liquitys smart contracts will be code for ever engrained in the consensus-approved global status of the Ethereum machine… Liquity, in other words, has created (good) infrastructure…

– Luca Prosperi, Liquity + a Glimpse of (My) Future, Dirt Roads Blog, 10/13/22

Amidst the uncertainty plaguing the crypto market at large, LUSD is experiencing a noteworthy resurgence of growth, as the number of troves representing active and distinct LUSD borrowers marches forward to perhaps soon reclaim its prior highs:

Number of troves representing active and distinct LUSD borrowers

Dune Analytics

This rise and shine of Liquity Protocols usage is a well-deserved accomplishment for its founding team, who continue to innovate and have had incredible success with their recent launch of Chicken Bonds, a novel approach to advancing Protocol-Owned Liquidityacross DeFi – beginning with LUSD.

Broad Appeal of Zero-Interest Loans

When users borrow LUSD against their ETH, its interest-free. Although there is a one-time borrowing fee upon drawing LUSD from a trove thats typically around 0.5%, there are no ongoing interest charges being paid by LUSD borrowers to Liquity Protocol itself.

This begs the question: is there an opportunity for LUSD to be more widely adopted in parts of the world where interest on loans is generally frowned upon for cultural and/or religious reasons, such as is the case in predominantly Muslim regions across the Middle East and North Africa (MENA), as well as parts of Asia, for example? Lets delve deeper.

The field of Islamic finance largely operates on Profit and Loss Sharing (PLS) arrangements, since interest on loans is generally forbidden based on prevailing interpretations of the Shariah, which refers to the overarching values of the Muslim tradition. As is to be expected, opinions on this subject do vary, and contemporary Islamic thinkers, such as the late Dr. Muhammad Shahrur, have considered it more holistically from the standpoint of the burden on the borrower and other factors referenced in The Quran. For the purposes of this blog post though, Ill consider this topic from the normative position.

Hence, fiscal transactions in a given society move, by responding to the economic and social needs, between the two extremes of a) payments of taxes and charity money to b) giving loans with interest, while a middle position is reached if c) interest-free loans are provided.

– Dr. Muhammad Shahrur, “The Qur’an, Morality and Critical Reason,” pg. 209

For example, let us consider the case of someone looking to take out a loan to purchase a home. When taking out an Islamic mortgage, under a PLS arrangement the borrower would not pay interest on the loan, and the bank would instead buy the property upfront on their behalf. The bank may then mark up the value of the home to a defined level and the borrower would then pay the bank back in installments, such that their ownership share rises over time until the home is fully theirs.

Connecting the Dots

Although I am not in any sense an expert on Islamic finance, one can generally recognize from reading various writings on the topic that there is no prohibition on capital providers to earn a profit, as long as they are assuming risks in their attempts to do so.

On the question of risks, smart contract risk is an immanent feature of DeFi. Even with Liquity Protocol, despite its demonstrated resilience thus far, this reality nevertheless exists in the backdrop, and users should be mindful of it. Also, Liquity Protocol and its borrowers collectively assume a risk from under collateralized troves, because if the Total Collateral Ratio in the system falls below 150%, Recovery Mode kicks in.

Islamic financing is generally also asset-backed, and the assets are recognized as having intrinsic value. In the case of Liquity Protocol, LUSD can only be borrowed against ETH as collateral, which is the base asset and utility token of the Ethereum network.

An opinion paper published in 2019 by Amanie Global Islamic Finance Advisors offers commentary on ETH and Ethereum from the standpoint of their compliance with the Shariah, following exploratory research on the subject spearheaded by Virgil Griffith of The Ethereum Foundation at the time.

The right to make and carry out contracts is fundamental to liberty and is protected by the Shariah… With the advent of blockchain technology nowadays, the potential of [the] Ethereum network to develop smart contract[s] and applications is endless…It is important to analyse each smart contract or application on a case to case basis because different permutations may exist and the prospect of real-case applications using smart contract[s] is enormous.

– Amanie Advisors and The Ethereum Foundation, Shariah White Paper on Ether, April 2019, pg. 30 – 31

With LUSD, users are utilizing their ETH to borrow the stablecoin for their own usage; thus, there is no counterparty as a capital provider involved in the transaction. Liquity Protocol itself issues the LUSD to borrowers in accordance with its unalterable smart contracts terms. Institutions may also help facilitate this process for their clients; this is already being done by asset managers like Wave Financial, for example, whereby they have helped their users borrow LUSD against their ETH to purchase homes.

While a borrowing fee is applied by Liquity Protocol, this fee appears to be no different than, for example, the upfront fees vis-a-vis closing costs that are applied in the case of a borrower taking out a Shariah-compliant mortgage. And because Liquity Protocol offers an in-built use case for LUSD via its Stability Pool, LUSDs inherent utility in this regard enables it to be used by borrowers to uphold the protocols ability to cover liquidations of under-collateralized troves in the event that ETHs price drops.

In a sense, all of this may be viewed as a mutually beneficial system akin to the PLS dynamic underlying Islamic finance, since redistribution of collateral and debt from liquidated troves to open and remaining troves may be triggered if there is not enough LUSD in the Stability Pool to cover liquidations. Furthermore, for troves that are liquidated, while the respective borrowers will lose the ETH that they put up as collateral, their LUSD debt is nevertheless forgiven by Liquity Protocol, so there is no additional burden of payment expected of them thereafter. The onus is thus on the borrower to ensure their trove is sufficiently collateralized per their individual risk tolerance and Liquitys terms, and the protocols documentation emphasizes this in advance.

Conclusion

While the value proposition of crypto may increasingly be in question as the bear market persists and 2023 approaches, there still remains an ongoing curiosity among global audiences for this technology and its long-term potential. In the Muslim world, crypto-related startups have seen an uptick, and the debate around what is and isnt permissible in the context of cultural and religious norms will likely persist as this nascent asset class evolves over time and the adoption of regulations offers more clarity.

In the midst of this debate, I personally view Liquity Protocol to be worthwhile for Islamic financial institutions across MENA, Asia, and beyond to consider more closely as a decentralized and interest-free stablecoin application, particularly as they explore how they may be able to participate in DeFi on Ethereum and enable users to more actively engage and innovate in the space.

Platforms like DeFi Llama have recently created Halal dashboards consisting of DeFi yield opportunities which they have assessed to be compliant with the Shariah. This reflects the growing need for specialists in Islamic finance to apply their understanding of the subject to DeFi, such that Muslim users can better navigate the space in accordance to their individual beliefs. Followers of other religious traditions who may share similar beliefs could also find such guidance as helpful.

Considering their commendable and established track record, I look forward to seeing what the team behind Liquity Protocol has to offer toward advancing the development of stablecoins and other ideas in the years to come, and I hope that their products will ultimately cater to a wider audience of new users worldwide who are seeking to participate in the future of DeFi on Ethereum.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.