DeFi Leveraged Trading: Inequitable Costs of Decentralization
43 Pages Posted: 18 Oct 2022 Last revised: 9 Oct 2023
Date Written: October 06, 2023
Abstract
Decentralized Financial (DeFi) lending applications allow users to take leveraged positions in risky cryptoassets without the use of a financial intermediary, mimicking the functionality of a margin trading account without a centralized broker. This decentralization comes at a cost; leveraged traders must pay blockchain transaction fees to miners/validators and, absent an intermediary, third parties must be incentivized to perform liquidation transactions on positions with insufficient collateral. I provide evidence suggesting that volatile blockchain transaction fees can effectively “price out” a significant portion of market participants engaged in DeFi leveraged trading, forcing these traders to temporarily abandon their leveraged positions. Meanwhile, I show that the market liquidation incentive disciplines leveraged traders with riskier positions, inducing them to take more conservative positions. These results highlight the costs of moving from a paradigm of centralized intermediation to a blockchain-based decentralized model.
Keywords: Blockchain, DeFi, FinTech, Decentralized Lending, Compound
JEL Classification: G10, G20, G23
Suggested Citation: Suggested Citation