Are Decentralized Lending Platforms the Future of Finance?

Are decentralized lending platforms the future of finance?

By Ganesh Viswanath Natraj, Assistant Professor of Finance at the Gillmore Centre for Financial Technology at Warwick Business School

DeFi is a blockchain based form of finance that does not need a centralized financial intermediary, such as a market maker or a bank.

Decentralized lending platforms like Compound and Aave operate on the Ethereum blockchain. These protocols use algorithms to automate interest rates and allocate funds to borrowers using smart contracts, which is programming code on the blockchain.

Through the system of smart contracts, borrowers are required to post sufficient collateral. Users can deposit various collateral types, such as Ethereum, and borrow different currencies like stablecoins such as DAI and USDC.

While academic research in DeFi has yielded crucial insight into market efficiency and systemic risks, an open question is how these markets price interest rates, and whether they are allocating capital efficiently?

This is an important question to understand the limits and potential of blockchain-based technology and whether it can rival traditional lending services.

DeFi lending and leveraged trading

In research with colleagues Amit Chaudhary and Roman Kozhan at the Gillmore Centre for Financial Technology at Warwick Business School, we find evidence that DeFi lending protocols are primarily used for leverage trading.

Leverage trading is based on speculation on future exchange rates of cryptocurrencies like Bitcoin and Ethereum (ETH).

For instance, an investor can take a long-leveraged position on ETH by depositing ETH in a lending protocol, borrowing stablecoins, and using them to buy more ETH in the secondary market.

Long-leveraged trading raises the demand for borrowing stablecoins, causing stablecoin interest rates to go up. This is because interest rates are a function of market utilisation, which measures the ratio of overall borrowing to total supply of the currency.

Conversely, an investor can take a short-leveraged position by depositing stablecoins in the protocol, borrowing ETH, and selling it in the secondary market. This increases the demand for borrowing ETH, leading to higher ETH interest rates.

Therefore, the difference in interest rates between ETH and stablecoins reflects the strength of long and short leveraged positions.

We formally test the role of leveraged trading using data on futures and transaction level data on the borrowing and lending at an investor level on the lending protocol.

First, we establish a statistical link between interest rates and futures. When investors are more bullish on ETH, as indicated by an increase in the futures premium, this corresponds to relatively higher stablecoin interest rates.

Second, we construct long and short leveraged positions based on detailed investor transactions on their borrowing and lending in multiple currencies. Periods of high futures premia correspond to an increase in net long positions on the protocol.

Our empirical findings therefore support our hypothesis that the pricing of interest rates reflect speculative trading.

Measuring efficiency of lending protocols

A key aspect of market efficiency of these protocols is measuring the extent of the integration between lending protocols and futures markets.

For example, if interest rates and futures markets are fully integrated, we expect covered interest rate parity (CIP) to hold.

An arbitrage condition, it states that after hedging exchange rate risk with a futures contract, interest rates on currencies are equalized.

In principle, a deviation from CIP would yield an arbitrage trade. Investors can implement a leveraged position on the lending protocol and simultaneously enter a corresponding futures position, making a profit.

We measure deviations from the arbitrage condition averaging 30 basis points daily. This indicates a significant departure from a financially integrated market. These deviations are largely due to costs such as gas fees, which are fees paid to miners to validate transactions on the blockchain.

Are DeFi lending protocols the future?

In summary, we offer insights into the market efficiency of lending protocols. We show that in their present state, lending protocols are used primarily to facilitate speculative trading in risky cryptocurrencies.

We document weak integration between lending protocols and futures markets. Reducing limits to arbitrage, such as gas fees, and the introduction of futures markets that trade directly on the blockchain, can improve efficiency.