Debt-Financed Collateral and Stability Risks in the DeFi Ecosystem

TL;DR

This paper analyzes how debt-financed collateral, especially stablecoins, in DeFi lending platforms poses significant stability risks, using a novel classification method to quantify fund flows and debt creation.

Contribution

It introduces a new algorithm to classify fund flows in DeFi and quantifies the extent of debt-financed collateral, highlighting stability risks.

Findings

Widespread use of stablecoins as debt-financed collateral increases systemic risk.

A significant portion of fund flows in DeFi lending is debt-financed.

Debt creation in DeFi amplifies financial stability concerns.

Abstract

The rise of Decentralized Finance ("DeFi") on the Ethereum blockchain has enabled the creation of lending platforms, which serve as marketplaces to lend and borrow digital currencies. We first categorize the activity of lending platforms within a standard regulatory framework. We then employ a novel grouping and classification algorithm to calculate the percentage of fund flows into DeFi lending platforms that can be attributed to debt created elsewhere in the system ("debt-financed collateral"). Based on our results, we conclude that the wide-spread use of stablecoins as debt-financed collateral increases financial stability risks in the DeFi ecosystem.