DeFi Lending During The Merge

Abstract

Lending protocols in decentralized finance enable the permissionless exchange of capital from lenders to borrowers without relying on a trusted third party for clearing or market-making. Interest rates are purely set by the supply and demand of capital according to a pre-defined function. In the lead-up to The Merge: Ethereum blockchain's transition from proof-of-work (PoW) to proof-of-stake (PoS), a fraction of the Ethereum ecosystem announced plans of continuing with a PoW-chain. Owners of ETH -whether their ETH was borrowed or not -would hold the native tokens on each chain. This development alarmed lending protocols. They feared spiking ETH borrowing rates would lead to mass liquidations which could undermine their viability. Thus, the decentralized autonomous organization running the protocols saw no alternative to intervention -restricting users' ability to borrow.We investigate the effects of the merge and the aforementioned intervention on the two biggest lending protocols on Ethereum: AAVE and Compound. Our analysis finds that borrowing rates were extremely volatile, jumping by two orders of magnitude, and borrowing at times reached 100% of the available funds. Despite this, no spike in mass liquidations or irretrievable loans materialized. Further, we are the first to quantify and analyze hard-fork-arbitrage, profiting from holding debt in the native blockchain token during a hard fork. We find that arbitrageurs made in excess of 13 Mio US$, money that was effectively extracted from the platforms' lenders.Finally, we identify alarming security risks to the entire Ethereum ecosystem. Around one-fifth of the staked ETH through LIDO (stETH) was locked as collateral on lending protocols. Mass liquidations caused by spiking rates would have devastating effects on the stETH price and pose security concerns for the consensus layer, as staking power could be bought at a significant discount.

Contagion in Decentralized Lending Protocols: A Case Study of Compound

“…The liquidator repays the borrowed assets and seizes the collateral assets proportionally. 18 Under proportional liquidations, the liquidator acquires collateral worth (1 + 𝜆)𝜁 𝑢 𝑗 (𝑝)𝛾𝑣 (𝑏 𝑢 , 𝑝 ′ ) for each asset 𝑗 used as collateral by user 𝑢. Here, 𝜁 𝑢 𝑗 (𝑝) ≡ 𝑝 𝑗 𝑐 𝑢 𝑗 /𝑣 (𝑐 𝑢 , 𝑝) represents the value of assets 𝑗 relative to the user's total collateral value.…”

“…Algorithm 1: Simulation of liquidation process 18 We assess the impact of this assumption in Appendix B.…”

“…Other studies simulate crash scenarios to explore how lending protocols respond to market price fluctuations [20,24]. Additionally, researchers have analyzed the resilience of lending protocols to significant market events, such as the Ethereum Merge [18] and governance attacks [13].…”