IDEAS home Printed from https://ideas.repec.org/p/arx/papers/2006.13922.html
   My bibliography  Save this paper

DeFi Protocols for Loanable Funds: Interest Rates, Liquidity and Market Efficiency

Author

Listed:
  • Lewis Gudgeon
  • Sam M. Werner
  • Daniel Perez
  • William J. Knottenbelt

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.

Suggested Citation

  • Lewis Gudgeon & Sam M. Werner & Daniel Perez & William J. Knottenbelt, 2020. "DeFi Protocols for Loanable Funds: Interest Rates, Liquidity and Market Efficiency," Papers 2006.13922, arXiv.org, revised Oct 2020.
    • Handle: RePEc:arx:papers:2006.13922
    as

    Download full text from publisher

    File URL: http://arxiv.org/pdf/2006.13922
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Walker, Donald A, 1987. "Walras's Theories of Tatonnement," Journal of Political Economy, University of Chicago Press, vol. 95(4), pages 758-774, August.
    2. repec:bla:reviec:v:9:y:2001:i:3:p:505-17 is not listed on IDEAS
    3. Annika Alexius, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-517, August.
    4. Jakab, Zoltan & Kumhof, Michael, 2015. "Banks are not intermediaries of loanable funds – and why this matters," Bank of England working papers 529, Bank of England.
    5. Menzie D. Chinn & Guy Meredith, 2005. "Testing Uncovered Interest Parity at Short and Long Horizons during the Post-Bretton Woods Era," NBER Working Papers 11077, National Bureau of Economic Research, Inc.
    6. Amani Moin & Emin Gun Sirer & Kevin Sekniqi, 2019. "A Classification Framework for Stablecoin Designs," Papers 1910.10098, arXiv.org.
    7. Dorje C. Brody & Lane P. Hughston & Bernhard K. Meister, 2019. "Theory of Cryptocurrency Interest Rates," Papers 1904.05472, arXiv.org, revised Dec 2019.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Proelss, Juliane & Sévigny, Stéphane & Schweizer, Denis, 2023. "GameFi: The perfect symbiosis of blockchain, tokens, DeFi, and NFTs?," International Review of Financial Analysis, Elsevier, vol. 90(C).
    2. Sam M. Werner & Daniel Perez & Lewis Gudgeon & Ariah Klages-Mundt & Dominik Harz & William J. Knottenbelt, 2021. "SoK: Decentralized Finance (DeFi)," Papers 2101.08778, arXiv.org, revised Sep 2022.
    3. Dominik Metelski & Janusz Sobieraj, 2022. "Decentralized Finance (DeFi) Projects: A Study of Key Performance Indicators in Terms of DeFi Protocols’ Valuations," IJFS, MDPI, vol. 10(4), pages 1-23, November.
    4. Hugo Inzirillo & Stanislas de Quenetain, 2022. "Managing Risk in DeFi Portfolios," Papers 2205.14699, arXiv.org, revised Sep 2022.
    5. Marcin Wk{a}torek & Stanis{l}aw Dro.zd.z & Jaros{l}aw Kwapie'n & Ludovico Minati & Pawe{l} O'swik{e}cimka & Marek Stanuszek, 2020. "Multiscale characteristics of the emerging global cryptocurrency market," Papers 2010.15403, arXiv.org, revised Mar 2021.
    6. Massimo Bartoletti & James Hsin-yu Chiang & Alberto Lluch-Lafuente, 2020. "SoK: Lending Pools in Decentralized Finance," Papers 2012.13230, arXiv.org.
    7. Teng Andrea Xu & Jiahua Xu, 2022. "A Short Survey on Business Models of Decentralized Finance (DeFi) Protocols," Papers 2202.07742, arXiv.org, revised Jul 2023.
    8. Raphael Auer & Bernhard Haslhofer & Stefan Kitzler & Pietro Saggese & Friedhelm Victor, 2024. "The technology of decentralized finance (DeFi)," Digital Finance, Springer, vol. 6(1), pages 55-95, March.
    9. Lioba Heimbach & Eric Schertenleib & Roger Wattenhofer, 2023. "DeFi Lending During The Merge," Papers 2303.08748, arXiv.org, revised Aug 2023.
    10. Piñeiro-Chousa, Juan & López-Cabarcos, M. Ángeles & Sevic, Aleksandar & González-López, Isaac, 2022. "A preliminary assessment of the performance of DeFi cryptocurrencies in relation to other financial assets, volatility, and user-generated content," Technological Forecasting and Social Change, Elsevier, vol. 181(C).
    11. Daniel Perez & Sam M. Werner & Jiahua Xu & Benjamin Livshits, 2020. "Liquidations: DeFi on a Knife-edge," Papers 2009.13235, arXiv.org, revised Dec 2021.
    12. Makridis, Christos A. & Fröwis, Michael & Sridhar, Kiran & Böhme, Rainer, 2023. "The rise of decentralized cryptocurrency exchanges: Evaluating the role of airdrops and governance tokens," Journal of Corporate Finance, Elsevier, vol. 79(C).
    13. Kanis Saengchote, 2022. "Decentralized lending and its users: Insights from Compound," Papers 2212.05734, arXiv.org.
    14. Peplluis R. Esteva & Andrés El-Fakdi & Alberto Ballesteros-Rodríguez, 2023. "Invoice Discounting Using Kelly Criterion by Automated Market Makers-like Implementations," Mathematics, MDPI, vol. 11(7), pages 1-37, March.
    15. Estelle Sterrett & Waylon Jepsen & Evan Kim, 2022. "Replicating Portfolios: Constructing Permissionless Derivatives," Papers 2205.09890, arXiv.org, revised Jun 2022.
    16. Lioba Heimbach & Eric G. Schertenleib & Roger Wattenhofer, 2023. "Short Squeeze in DeFi Lending Market: Decentralization in Jeopardy?," Papers 2302.04068, arXiv.org, revised Jun 2023.
    17. Saengchote, Kanis, 2023. "Decentralized lending and its users: Insights from compound," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 87(C).
    18. Şoiman, Florentina & Dumas, Jean-Guillaume & Jimenez-Garces, Sonia, 2023. "What drives DeFi market returns?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 85(C).
    19. Yousaf, Imran & Jareño, Francisco & Esparcia, Carlos, 2022. "Tail connectedness between lending/borrowing tokens and commercial bank stocks," International Review of Financial Analysis, Elsevier, vol. 84(C).
    20. Bhambhwani, Siddharth M. & Huang, Allen H., 2024. "Auditing decentralized finance," The British Accounting Review, Elsevier, vol. 56(2).
    21. Teng Andrea Xu & Jiahua Xu & Kristof Lommers, 2022. "DeFi vs TradFi: Valuation Using Multiples and Discounted Cash Flow," Papers 2210.16846, arXiv.org.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.
    2. A. Can Inci & Bong Soo Lee, 2014. "Dynamic Relations between Stock Returns and Exchange Rate Changes," European Financial Management, European Financial Management Association, vol. 20(1), pages 71-106, January.
    3. Yin-Wong Cheung & Menzie D. Chinn & Antonio I. Garcia Pascual, 2003. "What Do We Know about Recent Exchange Rate Models? In-Sample Fit and Out-of-Sample Performance Evaluated," CESifo Working Paper Series 902, CESifo.
    4. Nelson C. Mark & Donggyu Sul, 2004. "The Use of Predictive Regressions at Alternative Horizons in Finance and Economics," Finance 0409032, University Library of Munich, Germany.
    5. Zsolt Darvas & Gábor Rappai & Zoltán Schepp, 2007. "Uncovering Yield Parity: A New Insight into the UIP Puzzle through the Stationarity of Long Maturity Forward Rates," Money Macro and Finance (MMF) Research Group Conference 2006 84, Money Macro and Finance Research Group.
    6. Carlos Eduardo Castillo-Maldonado & Fidel Pérez-Macal, 2013. "Assessment of models to forecast exchange rates: The quetzal–U.S. dollar exchange rate," Journal of Applied Economics, Universidad del CEMA, vol. 16, pages 71-99, May.
    7. Menzie D. Chinn & Saad Quayyum, 2012. "Long Horizon Uncovered Interest Parity Re-Assessed," NBER Working Papers 18482, National Bureau of Economic Research, Inc.
    8. Ferreira, Paulo & Kristoufek, Ladislav, 2020. "Uncovered interest rate parity through the lens of fractal methods: Evidence from the European Union," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 553(C).
    9. Corrado Macchiarelli, 2013. "On the Joint Test of the Uncovered Interest Parity and the Ex-ante Purchasing Power Parity," Review of International Economics, Wiley Blackwell, vol. 21(3), pages 519-535, August.
    10. Katarzyna Anna Czech, & Adam Waszkowski, 2012. "Foreign Exchange Market Efficiency. Empirical Results For The Usd/Eur Market," "e-Finanse", University of Information Technology and Management, Institute of Financial Research and Analysis, vol. 8(3), pages 1-9, October.
    11. Arnaud Mehl & Lorenzo Cappiello, 2009. "Uncovered Interest Parity at Long Horizons: Evidence on Emerging Economies," Review of International Economics, Wiley Blackwell, vol. 17(5), pages 1019-1037, November.
    12. Zsolt Darvas & Gábor Rappai & Zoltán Schepp, 2006. "Uncovering Yield Parity: A new insight into the UIP puzzle through the stationarity of long maturity forward rates," DNB Working Papers 098, Netherlands Central Bank, Research Department.
    13. Cappiello, Lorenzo & Mehl, Arnaud, 2007. "Uncovered interest parity at distant horizons: evidence on emerging economies & nonlinearities," Working Paper Series 801, European Central Bank.
    14. Norman C. Miller, 2014. "Exchange Rate Economics," Books, Edward Elgar Publishing, number 14981.
    15. Christoph Sax, 2006. "Interest Rates and Exchange Rate Movements: Analyzing Short-term Investments in Long-term Bonds," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 20(2), pages 205-220, June.
    16. Tang, Kin-Boon, 2011. "The precise form of uncovered interest parity: A heterogeneous panel application in ASEAN-5 countries," Economic Modelling, Elsevier, vol. 28(1-2), pages 568-573, January.
    17. Immonen, Eero, 2015. "A quantitative description for efficient financial markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 433(C), pages 171-181.
    18. Lozej, Matija & Rannenberg, Ansgar, 2017. "The macroeconomic effects of the regulatory LTV and LTI ratios in the Central Bank of Ireland's DSGE model," Economic Letters 04/EL/17, Central Bank of Ireland.
    19. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
    20. Alexius, Annika, 2001. "How to Beat the Random Walk," Working Paper Series 175, Trade Union Institute for Economic Research.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:2006.13922. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: http://arxiv.org/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.