The Bank of Canada has released a working paper that examines decentralized finance (DeFi) lending protocols with respect to sources of instability and their relationship to crypto asset prices. Its findings point to potential ways to optimize DeFi loan platforms, or to the practical limits of decentralization.
Authors of the post, with name “On the Fragility of DeFi Credits” and released on February 22 confirmed that DeFi offers inclusivity and the advantages of smart contract protocols over the use of human discretion. They continued to identify DeFi’s systemic weaknesses. Information asymmetry, a key issue for regulators, was highlighted here with the twist that in DeFi asymmetry favors the borrower:
“The collateral composition of the loan pool is not readily observable, meaning that borrowers are better informed about the quality of the collateral than lenders.”
This is because borrowers are at least aware of the quality of the assets they have used as collateral for the loan. Additionally, “Only tokenized assets can be pledged as collateral, and such assets tend to show very high price volatility.” Price and liquidity create a feedback loop, the paper argued: the price of the asset affects the volume of borrowing, which in turn affects the price of the asset.
In addition, the lack of human input in smart contracts can have unwanted effects. Traditional loan agreements can be modified by loan officers in response to current information. Smart contracts are inflexible because the terms are pre-programmed and “can only depend on a small set of quantifiable real-time data,” and even minor changes to the contract can require a lengthy discussion process.
“As a result, DeFi lending typically involves non-recourse linear debt contracts that feature overcollateralization as the only risk control.”
Efficiency, complexity and flexibility are thus reduced compared to traditional finance, creating “self-fulfilling sentiment-driven cycles” of prices. The authors used advanced mathematics to explore a number of proposals for achieving market equilibrium under these circumstances.
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A flexible optimal debt limit is found to ensure equilibrium. However, the “simple linear deduction rules” typically designed into smart contracts cannot implement a flexible limit. It would be difficult to create logs with this feature and would be very dependent on the choice of oracles. Alternatively to this challenge, “DeFi lending could abandon full decentralization and reintroduce human intervention to ensure real-time risk management.”
The authors therefore conclude The DeFi Trilemma decentralization, simplicity and stability remain unconquered.
Interesting new study from Bank of Canada on the “fragility of DeFi loans” https://t.co/BqnjIxnelB
— Ryan Clements (@ryanjclements) February 22, 2023