Measuring DeFi risk

Jeremy Bertomeu, Xiumin Martin and Ibrahima Sall

Finance Research Letters, 2024, vol. 63, issue C

Abstract: Decentralized finance (DeFi) lending has grown from nonexistent in 2017 to nearly $45 billion in total value locked across the three largest protocols in December 2021 before falling to roughly $15 billion in July 2023. The platforms use cryptocurrencies as collateral, matching speculative margin traders with yield-seeking depositors. Depositors receive claims guaranteed by a basket of collateral. We develop a framework that requires only knowledge of total deposits and borrowings to measure the total protocol risk to lenders and borrowers. Using data from major protocols, the risk measures show that system fragility increased beyond reasonable levels around mid-2021, and we identify time periods exposing lenders to a potential collateral loss conditional on continuing extreme fluctuations in coin prices. Moreover, our results indicate that the liquidation process, a risk mitigation strategy, is not timely and is less effective when risk levels are high. Overall, the model provides two easily implementable aggregate risk metrics that capture the perspectives of synthetic investors and provide early warning signals as the industry moves from collateral-guaranteed deposits to fiat money.

Keywords: Coin; Cryptocurrency; Stable; Protocol risk; Banking; Loans; Collateral; Interest (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:63:y:2024:i:c:s1544612324003519

DOI: 10.1016/j.frl.2024.105321

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