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On the Fragility of DeFi Lending

Author

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  • Jonathan Chiu
  • Emre Ozdenoren
  • Kathy Yuan
  • Shengxing Zhang

Abstract

We develop a dynamic model of decentralized finance (DeFi) lending that incorporates two/these key features: 1) borrowing and lending are decentralized, anonymous, overcollateralized and backed by the market value of crypto assets where contract terms are pre-specified and rigid; and 2) information friction exists between borrowers and lenders. We identify a price-liquidity feedback: the market outcome in any given period depends on agents’ expectations about lending activities in future periods, with higher price expectations leading to more lending and higher prices in that period. Given the rigidity inherent to smart contracts, this feedback leads to multiple self-fulfilling equilibria where DeFi lending and asset prices move with market sentiment. We show that flexible updates of smart contracts can restore equilibrium uniqueness. This finding highlights the difficulty of achieving stability and efficiency in a decentralized environment without a liquidity backstop.

Suggested Citation

  • Jonathan Chiu & Emre Ozdenoren & Kathy Yuan & Shengxing Zhang, 2023. "On the Fragility of DeFi Lending," Staff Working Papers 23-14, Bank of Canada.
    • Handle: RePEc:bca:bocawp:23-14
    DOI: 10.34989/swp-2023-14
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    References listed on IDEAS

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    1. Ye Li & Simon Mayer & Simon Mayer, 2021. "Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking," CESifo Working Paper Series 9260, CESifo.
    2. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
    3. Ana Fostel & John Geanakoplos, 2012. "Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 190-225, January.
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    Cited by:

    1. Phoebe Tian & Yu Zhu, 2025. "Liquidation Mechanisms and Price Impacts in DeFi," Staff Working Papers 25-12, Bank of Canada.
    2. Stefan Scharnowski & Hossein Jahanshahloo, 2025. "The Economics of Liquid Staking Derivatives: Basis Determinants and Price Discovery," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 45(2), pages 91-117, February.

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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G01 - Financial Economics - - General - - - Financial Crises

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