Interest-Free Loans

VeradiVerdict - Issue #134

In March, Pantera led the $6M Series A round of funding for Liquity, a novel decentralized borrowing protocol.

While the past year has seen the launch and adoption of many DeFi lending protocols, including giants like Maker and Compound, several characteristics set Liquity apart:

  • fixed 0% interest rate, unlike the floating rates of other protocols

  • 110% minimum collateral ratio, the lowest on the market

  • completely governance-free, algorithmic, and immutable monetary policy.

As you can imagine, these top-line numbers have been quite attractive for the open finance community. Since going live on the Ethereum mainnet earlier this month, Liquity has seen an extraordinary amount of engagement, amassing around $2.7B in total value locked (TVL) in just a few short weeks.

Source: Dune Analytics (full dashboard created by @dani)

Let’s unpack how Liquity can offer such low collateralization ratios and a 0% interest rate without sacrificing the protocol’s systemic resilience to shocks.

What happens when loans are under-collateralized?

On March 12th, 2020, following the COVID-19-induced fluctuations in the markets, cryptocurrency prices faced an unprecedented crash, with Bitcoin falling by nearly half. Decentralized lending platforms, most notably Maker, saw the mass liquidation of collateral pools as this sharp downward price movement pushed some borrowers beneath the minimum collateral ratio. This unanticipated event, now referred to as “Black Thursday,” stress-tested many nascent DeFi protocols and, in some cases, led to the irrecoverable loss of users’ funds.

When a price shock results in a loan being under-collateralized, many lending protocols liquidate the collateral through an automated auction. Similar to a “fire sale” of assets when a traditional bank is insolvent, the collateral (in Maker’s case, typically ETH) is sold in an auction to a group of purchasers, closing out the outstanding loan. These auctions, however, can sometimes take several hours, which, as in the case of “Black Thursday,” can make reacting to a crisis difficult.

Liquity’s solution to the liquidation problem is unique. Instead of having an auction after a loan (or “Trove”) is undercollateralized, Liquity creates a pool of users who have already agreed to buy the collateral (ETH) at a discount before a price shock even happens. This way, collateral can be distributed to the “Stability Pool'' instantly after an under-collateralized loan, not several hours later.

In practice, this means that users can deposit their LUSD—the protocol’s native stablecoin, to be discussed later—into the Stability Pool to receive their share of the liquidated ETH, proportional to their share of the pool. In addition to this ETH from “collateral surplus,” the protocol is also offering an estimated 40-60% APR on funds deposited to incentivize liquidity.

Source: Liquity (from Medium)

While participating in the Stability Pool is not risk-free—you’re implicitly agreeing to buy ETH during price drops, which carries the risk of the asset falling further—it is an excellent way to purchase collateral at a discount from market prices. This offers value for many users, as has been shown by the protocol’s strong adoption post-launch.

In short, the Stability Pool is the secret behind Liquity’s eye-catching 110% collateralization ratio without sacrificing systemic soundness. As the project’s whitepaper states:

Since the acquirers are known in advance, there is no need to find a buyer for a collateral buyout on the spot when a position becomes undercollateralized. This advantage allows for a considerable reduction in the collateral ratio, while keeping stability high.

Since the Stability Pool’s liquidation mechanism is simply a transfer of ETH, not an auction that requires the collateral to be purchased by some other asset, it also has the nice side effect of not increasing the demand for (and subsequent price of) LUSD, the protocol’s stablecoin.

How is a 0% interest rate possible?

In addition to the low collateralization ratio, Liquity is attractive for its interest-free borrowing. Not only does a 0% interest rate make borrowing much cheaper than other platforms, but the rate is also fixed, which is much more borrower-friendly and predictable than the variable rates that have become standard in DeFi.

Source: DeFi Rate

Since Stability Pool depositors are compensated with discounted ETH liquidations, not interest payments, the protocol enables truly zero-interest borrowing, a milestone for open finance.

However, it is worth noting that while there’s no interest, there is still a small cost: debtors face an upfront “borrowing fee” of at least 0.5%, in addition to a repayable deposit of 200 LUSD ($200 USD) to pay for gas fees in the event of liquidation.

How does the protocol’s stablecoin fit into this?

Many lending platforms have their own stablecoins that are “minted” when a loan is taken on the platform and “burned” when a loan is repaid. Typically, as is the case with Maker’s DAI, these are non-redeemable algorithmic stablecoins. In other words, they are tokens that approximate a fiat peg, typically $1 USD, without having any claim over the currency itself.

Liquity’s native stablecoin, LUSD, is unique: each unit of LUSD is redeemable for $1 of ETH at any time. This ensures that LUSD keeps its peg of $1 USD, since any variability in price could be simply arbitraged away. There are more complex dynamics at play here, but the fact that LUSD has remained remarkably stable despite recent turbulence in the crypto markets encourages confidence.

Source: Liquity (from Medium)

When LUSD is redeemed, where does the corresponding ETH come from?

Simply put, when someone wishes to redeem their LUSD, the “riskiest” Troves, or outstanding loan agreements, provide the corresponding amount of ETH. This process happens in a few steps, as described by Liquity:

  • Someone comes along to redeem their LUSD

  • All Troves (i.e. positions in Liquity) are sorted from lowest collateral ratio to the highest collateral ratio (most risky to least risky)

  • The redeemed LUSD is used to pay off the debt of the riskiest Trove(s) in return for their collateral

  • The Trove owner’s remaining collateral is left for them to claim (borrowers who are redeemed against do not incur a net loss)

Source: Liquity (whitepaper)

Redemptions stabilize LUSD by creating an easily exploitable arbitrage opportunity if the coin is trading below the peg. In addition, redemptions also raise the total collateral ratio of Liquity’s borrower pool, contributing to overall system stability. To limit the excessive use of redemptions, though, a default (but variable) fee of 0.5% is incurred.

While this serves as an incentive for borrowers to consistently remain well above the 110% collateralization ratio, contributing to the overall stability of the system, it is important to clarify that this is not a punishment. In fact, while a redemption may undesirably reduce the Trove owner’s ETH exposure, they do not experience a net loss, just a lower debt obligation. In addition, redemptions are only advantageous for the redeemer in the unusual circumstance of LUSD trading below $1 USD.

Source: Liquity.app

How can I use Liquity?

As has already been mentioned, there are a few ways for users to engage with the protocol:

  • Borrow LUSD interest-free against ETH. There is a 2000 LUSD borrowing minimum.

  • Provide LUSD to the Stability Pool to purchase ETH liquidations at a discount, in addition to nearly 50% in estimated APY from rewards.

  • Arbitrage LUSD by trading for ETH when the market price is below $1 USD.

  • Stake LQTY to earn a share of fee revenue.

Another interesting element of Liquity is their embracement of decentralization: there is no “governance” of the protocol, unlike some other lending platforms, and the underlying smart contract code cannot be changed by any party. While the code has been thoroughly vetted by auditors, in the event a bug is discovered or a “Liquity V2” is created, it will be launched separately.

As a result of this emphasis on decentralization, Liquity doesn’t operate a front-end. Instead, they allow third parties to create their own front-ends, allowing them to define a “kickback rate” for themselves. The most dominant front-end is liquity.app, capturing a nearly 80% share of the Stability Pool, but there are dozens of other options.

The bottom-line: While there are numerous decentralized lending platforms, Liquity bills itself as the most capital efficient protocol to date. By replacing collateral auctions with their Stability Pool and creating a fully-redeemable stablecoin, Liquity has made zero-interest and low-collateral borrowing possible, a true achievement for decentralized finance. 

- Paul V

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ALCHEMY SERIES B: $80m at $505m Valuation

Congrats to our portfolio company, Alchemy, for raising an $80m round at a $505m valuation. It is a pleasure to sit on the board of this high-growth startup!

Alchemy is the developer platform powering the blockchain industry. Alchemy gives developers the infrastructure and tooling they need to build great blockchain products. Similar to how AWS powers Uber and Netflix, Alchemy powers the infrastructure for the leading companies in the blockchain industry: the entire NFT space, the majority of decentralized finance, and multinational organizations such as UNICEF.

Some key stats:

  • Powering over $30B in transactions

  • Tens of millions of end users in 99% of countries worldwide

  • Grown 97x in last 8 months since public launch

  • Number of companies powered doubled in Q1 2021

  • Power all major NFT platforms

  • 13x growth in NFT transactions since beginning of year

You can read my previous blog post on Alchemy to understand the platform in more detail and our investment thesis

You can also check out the CEO’s vision in this video


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ABOUT ME

Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. I’ve been in the industry since 2014, and the firm invests in equity, early stage token projects, and liquid cryptocurrencies on exchanges. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.