Efficiency and Security in DeFi Lending

Abstract

We investigate the design of efficient DeFi lending interest rate functions in a tractable general equilibrium model. The security of the underlying (Proof-of-Stake) blockchain is endogenous. We show, for known parameters, that there exists a unique efficient DeFi rate, which maximizes security and DeFi users utility. The associated utilization rate properly defines an “optimal utilization” and can be below one. Using this state-contingent efficient DeFi rate, we construct explicitly efficient interest rate functions under parameter uncertainty. We provide a condition under which efficiency can be attained with a function of the utilization rate only. When this condition is not met, we show how allowing the interest rate rule to depend on more inputs enables to restore efficiency. 

Keywords: blockchain, Proof-of-Stake, decentralized finance, protocol design, welfare, lending, security, interest rate mechanism, efficiency

JEL Classification: O3, D47, G29