The Bank of Canada has published a working paper examining lending protocols in decentralized finance (DeFi) with respect to sources of instability and their relationship to crypto asset prices. Their findings point to potential ways to optimize DeFi lending platforms, or possibly the practical limits of decentralization.
The authors of the article, noble "On the Fragility of DeFi Lending" and published on February 22, acknowledged the inclusiveness that DeFi offers and the advantages of smart contract protocols over the use of human discretion. They went on 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 a loan pool is not easily observable, which implies that borrowers are better informed about the quality of collateral than lenders.”
This is because the borrowers are at least aware of the quality of the assets they used as collateral for the loan. Furthermore, "only tokenized assets can be pledged as collateral, and such assets tend to exhibit very high price volatility." Price and liquidity produce a feedback loop, the paper argued: The price of an asset affects the volume of lending, and that, in turn, affects the price of the asset.
Also, the lack of human involvement in smart contracts can have unintended effects. Loan officers may modify traditional loan contracts 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 data in real time" and even minor changes to the contract can require a lengthy discussion process.
"As a result, DeFi lending typically involves straight-line, non-recourse debt contracts that feature excessive collateral as the only risk control."
Thus, efficiency, complexity, and flexibility are reduced compared to traditional finance and "sentiment-based pricing cycles" emerge. The authors used advanced mathematics to examine a series of propositions for achieving market equilibrium under these circumstances.
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A flexible optimal debt limit was found to provide equilibrium. However, the "simple linear haircut rules" typically designed into smart contracts cannot implement a soft limit. Protocols with that feature would be difficult to create and would be highly dependent on the choice of oracles. Alternatively to that challenge, “DeFi lending could abandon full decentralization and reintroduce human intervention to provide real-time risk management.”
Thus, the authors conclude, the DeFi trilemma of decentralization, simplicity and stability remains unconquered.
Interesting new Bank of Canada study on "the fragility of DeFi lending" https://t.co/BqnjIxnelB
—Ryan Clements (@ryanjclements) February 22, 2023
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