DeFi Protocols for Loanable Funds: Interest Rates, Liquidity and Market Efficiency

TL;DR

This paper reviews and empirically analyzes DeFi protocols for loanable funds, focusing on interest rate mechanisms, liquidity effects, and market efficiency across protocols like Compound, Aave, and dYdX.

Contribution

It provides a comparative review of interest rate methodologies and develops a model to analyze inter-protocol interest rate dependence and market efficiency in DeFi.

Findings

Interest rate mechanisms respond to liquidity changes.

Market efficiency varies across protocols.

Interest rates show cross-protocol dependence.

Abstract

We coin the term *Protocols for Loanable Funds (PLFs)* to refer to protocols which establish distributed ledger-based markets for loanable funds. PLFs are emerging as one of the main applications within Decentralized Finance (DeFi), and use smart contract code to facilitate the intermediation of loanable funds. In doing so, these protocols allow agents to borrow and save programmatically. Within these protocols, interest rate mechanisms seek to equilibrate the supply and demand for funds. In this paper, we review the methodologies used to set interest rates on three prominent DeFi PLFs, namely Compound, Aave and dYdX. We provide an empirical examination of how these interest rate rules have behaved since their inception in response to differing degrees of liquidity. We then investigate the market efficiency and inter-connectedness between multiple protocols, examining first whether Uncovered Interest Parity holds within a particular protocol and second whether the interest rates for a particular token market show dependence across protocols, developing a Vector Error Correction Model for the dynamics.