On the Fragility of DeFi Lending

Abstract

Abstract We model DeFi lending where cryptocurrencies are used as collaterals based on their value as payment instruments for consumption, and this value is privately known by its owners creating an adverse selection problem. DeFi lending is overcollateralized by crypto prices with rigid contract terms. We identify a price-liquidity feedback: higher crypto prices lower adverse selection in consumption market. Lower adverse selection makes the crypto better collateral and allows borrowers to raise more funding and raises its price. Constrained by contract rigidity this feedback gives rise to multiple self-fulfilling equilibria. Flexible updating of contracts restores equilibrium uniqueness, indicating a efficiency-stability-decentralization tradeoff.

Keywords: Decentralized Finance; DeFi, Smart Contracts; Dynamic Price Feedback; Financial Fragility; Adverse Selection; DeFi trilemma, Stability, Efficiency, and Decentralization Tradeoff

JEL Classification: G10, G01