DeFi Protocols for Loanable Funds

Abstract

We coin the term Protocols for Loanable Funds (PLFs) to refer to protocols which establish distributed ledger-based markets for loanable funds. PLFs are emerging as one of the main applications within Decentralized Finance (DeFi), and use smart contract code to facilitate the intermediation of loanable funds. In doing so, these protocols allow agents to borrow and save programmatically. Within these protocols, interest rate mechanisms seek to equilibrate the supply and demand for funds. In this paper, we review the methodologies used to set interest rates on three prominent DeFi PLFs, namely Compound, Aave and dYdX. We provide an empirical examination of how these interest rate rules have behaved since their inception in response to differing degrees of liquidity. We then investigate the market efficiency and inter-connectedness between multiple protocols, examining first whether Uncovered Interest Parity holds within a particular protocol and second whether the interest rates for a particular token market show dependence across protocols, developing a Vector Error Correction Model for the dynamics.

Financial intermediation and risk in decentralized lending protocols

“…This innovation allows the protocol to outsource the oversight of the accounts that are borrowing funds from one or more of the markets. 8 Liquidators are constantly monitoring the health of the account looking accounts with health indicator below 1 because these accounts are subject to liquidation 9 . A liquidator calls a function within the smart contract to liquidate a particular borrower.…”

“…In addition, using the data as opposed to the proposed business models can clarify some misconceptions around the protocols and help practitioners, regulators and academics understand the contribution and challenges of this technological innovation. Some elements of protocols for loanable funds are analyzed in Gudgeon et al (2020). In particular, the authors provide an overview of the different interest rate models used in the protocols.…”

“…This innovation in the form of a seeker was introduced by the Defi protocol, Maker Dao, known for introducing a crypto collateralized stablecoin pegged to USD 9. Although the health indicator is mentioned in the Aave whitepaper liquidators monitor if the ratio of the loan value to the collateral value of a borrower falls below a market defined parameter known as the liquidation threshold 10.…”

From banks to DeFi: the evolution of the lending market

“…4 Paradigm shift in lending enabled by the Internet of Value (Werner et al, 2021), solve entrenched issues native to the current mainstream lending market. These new solutions present themselves in the form of protocols (Gudgeon et al, 2020), sets of rules determining how a lending market operates.…”

Financial intermediation and risk in decentralized lending protocols

“…The optimal utilization rate is a function of the parameters of the borrow rate and the reserve factor. For stablecoins such as USDC, DAI and USDT the protocols use a kinked rate model that introduce a different slope as a function of a particular value of utilization u kink [Gudgeon et al, 2020].…”