Equilibrium in a DeFi Lending Market

Abstract

We study lending in decentralized finance facilitated by a programmable interest rate rule set by a Protocol for Loanable Funds (PLF). PLFs suffer a disadvantage when compared to traditional lending platforms, given their inability to incorporate off-chain information into the borrowing and lending rates that they set. For this reason, for a pre-determined PLF interest rate function, the DeFi equilibrium is sub-optimal when compared to a competitive lending market equilibrium. We nonetheless show that an optimally designed PLF interest rate function is able to generate equilibrium interest rates, and therefore welfare, that is arbitrarily close to a competitive lending market equilibrium.

Keywords: Decentralized Finance, DeFi, Protocol for Loanable Funds, PLF

JEL Classification: D40, G20