The Bank of Canada has released a working paper that analyzes decentralized finance (DeFi) lending protocols for sources of volatility and how they relate to crypto asset prices. His findings point to potential ways to optimize DeFi lending platforms, or possibly to the practical limits of decentralization.
The authors of the article entitled “On the Fragility of DeFi Lending” and published on February 22 confirmed the inclusiveness of DeFi offers and the advantages of smart contract protocols over the use of human discretion. They then identified systemic DeFi weaknesses. Information asymmetry is highlighted here, a key issue for regulators, except that in DeFi, asymmetry favors the borrower:
“The collateral composition of a pool of loans is not easily observable, meaning that borrowers are better informed about the quality of collateral than lenders.”
This is because borrowers are at least aware of the quality of the assets they used as collateral for the loan. Furthermore, “only tokenized assets can provide collateral, and such assets typically exhibit very high price volatility.” The article argued that price and liquidity form a feedback loop: the price of an asset affects the size of the loan, and this in turn affects the price of the asset.
In addition, the lack of human input into smart contracts can have undesirable effects. Traditional loan agreements may be modified by loan officers in response to updated information. Smart contracts are inflexible because the terms are pre-programmed and “may depend only on a small set of real-time quantifiable data”, and even minor changes to the contract can require a lengthy discussion process.
“As a result, DeFi loans typically involve linear non-recourse debt contracts that include overcollateral as the only risk control.”
Efficiency, complexity, and flexibility are thus reduced compared to traditional finance, and “self-fulfilling sentiment-driven price cycles” are created. The authors used advanced mathematics to explore a number of proposals to achieve market equilibrium under these circumstances.
Related: Bank of Canada stresses need to regulate stablecoins as legislation is filed
It was found that a flexible optimal debt limit provides balance. However, the “simple linear clipping rules” usually designed in smart contracts cannot introduce a flexible limit. It would be difficult to create protocols with this feature and would be highly dependent on oracle choice. As an alternative to this challenge, “DeFi lending could abandon complete decentralization and reintroduce human intervention to provide real-time risk management.”
The authors therefore conclude that the DeFi trilemma of decentralization, simplicity, and stability remains invincible.
Interesting new study by Bank of Canada on “fragility of DeFi loans” https://t.co/BqnjIxnelB
— Ryan Clements (@ryanjclements) February 22, 2023