DeFi Leveraged Trading: Inequitable Costs of Decentralization

Abstract

Decentralized Financial lending applications mimic the functionality of margin trading accounts without centralized brokers. This decentralization comes at a cost; leveraged traders must pay blockchain transaction fees to validators and, absent an intermediary, third parties must be incentivized to perform liquidation transactions on positions with insufficient collateral. I show that volatile blockchain transaction fees force smaller traders to temporarily abandon their leveraged positions. Meanwhile, 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 traditional centralized market to a decentralized blockchain market.

Keywords: Blockchain, DeFi, FinTech, Decentralized Lending, Compound

JEL Classification: G10, G20, G23