On the Fragility of DeFi Lending

Abstract

We model DeFi lending where cryptocurrencies serve as collateral to secure financial transactions, with their values derived from their role as a medium of exchange for consumption, yet subject to information frictions. Overcollateralization mitigates these frictions, enabling greater gains from trades between borrowers and lenders in DeFi lending. Lending backed by volatile or bubbly cryptocurrencies can be stable and does not inherently lead to fragility. Instead, specific DeFi institutional arrangements, such as the rigidity of DeFi contracts, can result in multiple self-fulfilling equilibria where lending and prices vary significantly. Introducing flexible contract updates can restore equilibrium uniqueness, highlighting an efficiency-stability-decentralization tradeoff.

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

JEL Classification: G10, G01