How are interest rates set on DeFi platforms?

The use of decentralised finance (DeFi) has grown massively since the COVID-19 pandemic of 2022, with the total value locked in DeFi hitting more than $70 billion by February 2024.

That is from an almost standing start in July 2018 when, according to DeFi analytics firm DefiLlama, the market was worth just $20,000.

DeFi is a blockchain-based form of finance that does not need a centralised financial intermediary, such as a market maker or a bank, so platforms enable peer-to-peer lending.

Decentralised lending platforms like Compound and Aave operate on the Ethereum blockchain. These decentralised exchanges (DEX) use algorithms to automate interest rates and allocate funds and interest payments to borrowers using smart contracts, a form of programming code on the blockchain.

Through the system of smart contracts, users can plug in to various financial services by depositing crypto assets, such as Ethereum (ETH), and then borrow different currencies like stablecoins such as DAI and USD Coin (USDC).

While academic research in DeFi has yielded crucial insight into market efficiency and systemic risks, an open question is how these markets price interest rates, and whether they are allocating capital efficiently?

This is an important question to understand the limits and potential of blockchain-based and other distributed ledger types of technology and whether they can rival traditional lending services and other financial transactions.

How leveraged trading affects DeFi interest rates

In research with colleagues Amit Chaudhary, Honorary Research Fellow, and Roman Kozhan, Professor of Finance at the Gillmore Centre for Financial Technology, we found evidence that DeFi lending protocols are primarily used for leverage trading.

Leverage trading is based on speculation on future exchange rates of cryptocurrencies like Bitcoin (BTC) and ETH.

For instance, an investor can take a long-leveraged position on ETH by depositing ETH in a lending protocol, borrowing stablecoins, and using them to buy more ETH in the secondary market.

Long-leveraged trading raises the demand for borrowing stablecoins, causing stablecoin interest rates to go up. This is because interest rates are a function of market utilisation, which measures the ratio of overall borrowing to total supply of the currency.

Conversely, an investor can take a short-leveraged position by depositing stablecoins in the protocol, borrowing ETH, and selling it in the secondary market. This increases the demand for borrowing ETH, leading to higher ETH interest rates.

Therefore, the difference in interest rates between ETH and stablecoins reflects the strength of long and short leveraged positions.

We tested the role of leveraged trading using data on futures and transaction level data on the borrowing and lending at an investor level on the lending protocol.

First, we established a statistical link between interest rates and futures. When investors are more bullish on ETH, as indicated by an increase in the futures premium, this corresponds to relatively higher stablecoin interest rates.

Second, we constructed long and short leveraged positions based on detailed investor transactions on their borrowing and lending in multiple currencies. Periods of high futures premia corresponded to an increase in net long positions on the protocol.

Our findings therefore show that the pricing of interest rates on DeFi platforms reflects speculative trading.

How market efficient are DeFi lending protocols? 

A key aspect of market efficiency of these DeFi protocols is measuring the extent of the integration between lending protocols and futures markets.

For example, if interest rates and futures markets are fully integrated, we expect covered interest rate parity (CIP) - ie there is no arbitrage opportunity as the two rates are the same - to hold.

In principle, a deviation from CIP would yield an arbitrage trade. Investors can implement a leveraged position on the lending protocol and simultaneously enter a corresponding futures position, making a profit.

We measured deviations from the no-arbitrage condition averaging 30 basis points daily. This indicates a significant departure from a financially integrated market. These deviations are largely due to costs such as gas fees, which are fees paid to miners to validate transactions on the blockchain.

We showed that in their present state, lending protocols are used primarily to facilitate speculative trading in risky cryptocurrencies.

We found weak integration between lending protocols and futures markets. To improve market efficiency DeFi platforms could reduce limits to arbitrage, such as gas fees, and introduce futures markets that trade directly on the blockchain.

Improving these aspects would help DeFi continue its impressive growth and help it challenge the traditional financial institutions and financial markets and their financial products.

Read the original article in the Blockchain Tribune.

Further reading:

What does DeFi need to go mainstream?

Interest rate rules in decentralized finance: Evidence from Compound

How should governments regulate stablecoins and cryptocurrency?

Ganesh Viswanath Natraj is Assistant Professor of Finance at Warwick Business School and a member of the Gillmore Centre for Financial Technology. He teaches Financial Markets on BSc Accounting & Finance and Fintech: Digital Currencies and Decentralised Finance on the MSc Finance and MSc Business and Finance.

Learn more about blockchain and digital technologies on the four-day Executive Education course Leading Digital Transformation at WBS London at The Shard.

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