DeFi Leveraged Trading: Inequitable Costs of Decentralization

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 effectively disciplines leveraged traders with riskier positions, inducing them to take more conservative positions. These results highlight the limitations of blockchain/DeFi technologies in their current state and have interesting policy implications concerning the regulation of leveraged traders.

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

JEL Classification: G10, G20, G23