Automated Risk Management Mechanisms in DeFi Lending Protocols: A Crosschain Comparative Analysis of Aave and Compound

TL;DR

This study empirically evaluates the effectiveness of automated risk management features in DeFi lending protocols Aave and Compound across different versions and blockchains, revealing improved risk mitigation in version 3 and distinct investor preferences.

Contribution

It provides the first empirical analysis of cross-version and cross-chain risk management effectiveness in DeFi lending protocols using panel regression models.

Findings

Liquidation events in v3 increase TVL and revenue, especially on L2.

Liquidations in v2 have negligible impact on performance metrics.

L1 blockchains attract large investors; L2 are favored by retail investors.

Abstract

Blockchain-based decentralised lending is a rapidly growing and evolving alternative to traditional lending, but it poses new risks. To mitigate these risks, lending protocols have integrated automated risk management tools into their smart contracts. However, the effectiveness of the latest risk management features introduced in the most recent versions of these lending protocols is understudied. To close this gap, we use a panel regression fixed effects model to empirically analyse the cross-version (v2 and v3) and cross-chain (L1 and L2) effectiveness of liquidation mechanisms, measured through TVL and total revenue as proxies for performance of the two most popular lending protocols, Aave and Compound, during the period Jan 2021 to Dec 2024. Our analysis reveals that liquidation events in v3 of both protocols lead to an increase in total value locked and total revenue, with stronger impact on the L2 blockchain compared to L1. In contrast, liquidations in v2 have an insignificant impact, which indicates that the most recent v3 protocols have better risk management than the earlier v2 protocols. We also show that L1 blockchains are the preferred choice among large investors for their robust liquidity and ecosystem depth, while L2 blockchains are more popular among retail investors for their lower fees and faster execution.