Optimizing DeFi lending: balancing efficiency and incentives

Motivations behind DeFi borrowing and lending: evidence from Aave

Cornelli et al. analyze investors’ behavior in decentralized finance (DeFi) lending protocols using granular transaction-level data from Aave, a prominent DeFi lending platform. The authors used transaction-level data from Aave V2 protocol from December 2020 to mid-July 2022, examined differences between retail and large investors and controlled for various factors like interest rates, crypto prices, and market conditions.

Key findings:

1. Search for yield drives deposits:
   – Lower interest rates in traditional markets led to increased deposits in DeFi protocols
   – This effect was stronger for retail investors compared to large investors
2. Speculative motives drive borrowing:
   – Positive expectations about crypto prices, measured by ETH ( units of Ether) perpetual futures funding rate, led to increased borrowing
   – Higher ETH prices were associated with more borrowing activity
3. Governance motives play a secondary role:
   – There is some evidence that investors borrow to increase voting power in governance tokens
   – This effect was more pronounced for large investors but less significant overall than speculative motives
4. Differences between retail and large investors:
   – Retail investors were more sensitive to interest rate changes in traditional markets
   – Large investors were relatively more driven by governance motives in borrowing decisions
5. Overall implications:
   – DeFi lending primarily moves funds from savers to speculators rather than to productive economic activities
   – The low interest rate environment contributed significantly to the growth of DeFi lending

Why DeFi lending?
Authors: Giulio Cornelli, Leonardo Gambacorta, Rodney Garratt, Alessio Reghezza
From: BIS, ECB

Welfare analysis of DeFi lending markets

Rivera et al. present an economic model of decentralized finance (DeFi) lending facilitated by a Protocol for Loanable Funds (PLF). They argue that DeFi lending faces inherent information constraints, but careful design of the PLF interest rate function can mitigate these inefficiencies. The authors develop a theoretical model with the following key components:

1. A discrete time infinite horizon setting with random measures of lenders and borrowers arriving each period
2. Lenders have heterogeneous outside investment opportunities
3. Borrowers have heterogeneous investment projects but no capital
4. A PLF that sets borrowing and lending rates based on an exogenous interest rate function of the utilization rate (borrowed funds / available funds)

Key findings:

• There always exists a unique DeFi lending equilibrium for any monotonically increasing PLF interest rate function.
• The DeFi lending equilibrium generally produces lower welfare than a competitive market equilibrium due to information constraints. It is impossible for a PLF to always set the competitive market-clearing interest rate due to limited information about supply and demand of loanable funds.
• With proper design, the DeFi equilibrium can generate welfare arbitrarily close to the competitive market equilibrium.

Equilibrium in a DeFi Lending Market
Authors: Thomas J. Rivera, Fahad Saleh, Quentin Vandeweyer
From: McGill University, Wake Forest University, University of Chicago