DeFi leverage

Summary

Focus

This paper focuses on a key pillar in the decentralised finance (DeFi) ecosystem – DeFi lending platforms. Borrowers on these platforms get collateralised loans, which are similar to repurchase agreements (repos) and securities lending. Using trade-by-trade data on major DeFi lending platforms, we construct a daily time series of individual DeFi borrowers' assets and debts, at the wallet level. We document their wallet leverage – ie their asset-to-equity ratio. We also analyse the factors associated with high wallet leverage and the attendant systemic risks to DeFi lending markets.

Contribution

Using granular data from the Ethereum blockchain, we provide a detailed description of the overall trend in DeFi wallet leverage, the differences in wallet leverage across various groups of borrowers and the factors associated with high wallet leverage. We also present new empirical evidence about the impact of high wallet leverage on DeFi lending markets, focusing on the implications for lending resilience and borrower incentives. Finally, we draw parallels between DeFi lending and traditional collateralized borrowing markets like repos.

Findings

We have three sets of findings. First, the overall wallet leverage of DeFi users typically ranges from 1.4 to 1.9, with more active and larger borrowers exhibiting higher leverage. Second, factors that affect wallet leverage include loan-to-value (LTV) ratios, borrowing costs and market sentiment. Yet actual wallet leverage is lower than the maximum allowed by LTV ratio requirements, suggesting that DeFi borrowers tend to be more conservative due to the risk of automatic liquidation. Also, when crypto prices rise, users deposit more crypto assets without taking debts, widening the gap between actual leverage and the maximum allowed. Third, while higher wallet leverage raises the proportion of loans nearing liquidation, it does not significantly impact the incidence of liquidation itself, as liquidations entail substantial costs and are typically triggered by specific events. In addition, although DeFi borrowers can modify their collateral portfolios as long as they meet LTV ratio requirements, we find that most borrowers nearing liquidation do not shift towards more volatile collateral. However, among borrowers that do tilt towards volatile collateral, higher wallet leverage is associated with more aggressive strategic collateral adjustment.

Abstract

In decentralized finance (DeFi), lending protocols are governed by predefined algorithms that facilitate automatic loans – allowing users to take on leverage. This paper examines DeFi leverage – ie the asset-to-equity ratio at the wallet level in major lending platforms. The overall leverage typically ranges between 1.4 and 1.9, while the largest and most active users consistently exhibit higher leverage than the rest. Leverage is mainly driven by loan-to-value requirements and borrowing costs, as well as crypto market price movements and sentiments. Higher wallet leverage generally undermines lending resilience, particularly increasing the share of outstanding debt close to being liquidated. Borrowers with high leverage are more likely to tilt towards volatile collateral when their debt positions are about to be liquidated.

JEL classification: G12, G23, O36

Keywords: leverage, collateralised borrowing, decentralised finance, automated algorithm