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Measuring DeFi risk

Author

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  • Bertomeu, Jeremy
  • Martin, Xiumin
  • Sall, Ibrahima

Abstract

Decentralized finance (DeFi) lending has grown from nonexistent in 2017 to nearly $45 billion in total value locked across the three largest protocols in December 2021 before falling to roughly $15 billion in July 2023. The platforms use cryptocurrencies as collateral, matching speculative margin traders with yield-seeking depositors. Depositors receive claims guaranteed by a basket of collateral. We develop a framework that requires only knowledge of total deposits and borrowings to measure the total protocol risk to lenders and borrowers. Using data from major protocols, the risk measures show that system fragility increased beyond reasonable levels around mid-2021, and we identify time periods exposing lenders to a potential collateral loss conditional on continuing extreme fluctuations in coin prices. Moreover, our results indicate that the liquidation process, a risk mitigation strategy, is not timely and is less effective when risk levels are high. Overall, the model provides two easily implementable aggregate risk metrics that capture the perspectives of synthetic investors and provide early warning signals as the industry moves from collateral-guaranteed deposits to fiat money.

Suggested Citation

  • Bertomeu, Jeremy & Martin, Xiumin & Sall, Ibrahima, 2024. "Measuring DeFi risk," Finance Research Letters, Elsevier, vol. 63(C).
    • Handle: RePEc:eee:finlet:v:63:y:2024:i:c:s1544612324003519
    DOI: 10.1016/j.frl.2024.105321
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    References listed on IDEAS

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    1. Cheng, We Geng & Leite, Rodrigo de Oliveira & Caldieraro, Fabio, 2022. "Financial contagion in internet lending platforms: Who pays the price?," Finance Research Letters, Elsevier, vol. 45(C).
    2. Jason Scharfman, 2022. "Decentralized Finance (DeFi) Compliance and Operations," Springer Books, in: Cryptocurrency Compliance and Operations, edition 1, chapter 0, pages 171-186, Springer.
    3. Kanis Saengchote, 2021. "Decentralized Lending and Its Users: Insights from Compound," PIER Discussion Papers 162, Puey Ungphakorn Institute for Economic Research.
    4. Daniel Perez & Sam M. Werner & Jiahua Xu & Benjamin Livshits, 2020. "Liquidations: DeFi on a Knife-edge," Papers 2009.13235, arXiv.org, revised Dec 2021.
    5. Andreas A. Aigner & Gurvinder Dhaliwal, 2021. "UNISWAP: Impermanent Loss and Risk Profile of a Liquidity Provider," Papers 2106.14404, arXiv.org.
    Full references (including those not matched with items on IDEAS)

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