DeFi ‘fragility’ causes and cures explored in highly technical Bank of Canada study

The Bank of Canada has released a moving insubstantial that examines lending protocols successful decentralized concern (DeFi) with respect to sources of instability and their narration to crypto plus prices. Its findings constituent to imaginable ways to optimize DeFi lending platforms, oregon perchance the applicable limits of decentralization.

The authors of the paper, titled “On the Fragility of DeFi Lending” and released Feb. 22, acknowledged the inclusiveness DeFi offers and the advantages of astute declaration protocols implicit the usage of quality discretion. They went connected to place the systemic weaknesses of DeFi. Information asymmetry, a cardinal contented for regulators, was highlighted here, with the twist that, successful DeFi, the asymmetry favors the borrower:

“The collateral creation of a lending excavation is not readily observable, implying that borrowers are amended informed astir collateral prime than lenders are.”

That is due to the fact that borrowers are astatine slightest alert of the prime of the assets they utilized a indebtedness collateral. Moreover, “Only tokenized assets tin beryllium pledged arsenic collateral, and specified assets thin to grounds precise precocious terms volatilities.” Price and liquidity nutrient a feedback loop, the insubstantial argued: the terms of an plus affects borrowing measurement and that, successful turn, affects plus price.

In addition, astute contracts’ deficiency of quality input tin person undesired effects. Traditional indebtedness contracts tin beryllium modified by indebtedness officers successful effect to existent information. Smart contracts are inflexible due to the fact that presumption are preprogrammed and “can lone beryllium contingent connected a tiny acceptable of quantifiable, real- clip data” and adjacent insignificant changes to the declaration tin necessitate a lengthy treatment process.

“As a result, DeFi lending typically involves linear, non-recourse indebtedness contracts that diagnostic over-collateralization arsenic the lone hazard control.”

Efficiency, complexity, and flexibility are frankincense reduced successful examination to accepted concern and “self-fulfilling sentiment-driven cycles” of pricing arise. The authors utilized precocious mathematics to analyse a fig of propositions for achieving marketplace equilibrium successful those circumstances.

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A flexible optimal indebtedness bounds was recovered to supply equilibrium. However, “simple linear haircut rules” typically designed into astute contracts cannot instrumentality a flexible limit. It would beryllium hard to make protocols with that diagnostic and they would beryllium highly babelike connected the prime of oracles. Alternatively to that challenge, “DeFi lending could wantonness implicit decentralization and re-introduce quality involution to supply real-time hazard management.”

Thus, the authors conclude, the DeFi trilemma of decentralization, simplicity and stableness remains unconquered.

Interesting caller survey from the Bank of Canada connected "the Fragility of DeFi Lending" https://t.co/BqnjIxnelB

— Ryan Clements (@ryanjclements) February 22, 2023