Decentralised Finance and Loan Protocols

Scientific project

The project aims to:

• Explore the optimal design of decentralised blockchain-based lending/borrowing protocols
• Identify and address the financial issues associated with the implementation of such protocols

In traditional finance, lending markets are among the largest markets in the world in terms of total outstanding amounts. Recent developments in the decentralised finance industry (or DeFi), suggest that blockchain-based lending markets could also become very important in the coming years.

DeFi refers to a set of decentralised and autonomous protocols, based on a blockchain infrastructure, that replicate the functions of traditional finance but also allow for new developments by taking advantage of the properties of the underlying blockchain. Together with Decentralized Exchanges (DEX), Lending Protocols are the 2 most widely used types of DeFi protocols today.

The idea of most current Lending Protocols is to create a liquidity pool in which:

• Liquidity Providers can come and deposit crypto assets in the form of tokens,
• Liquidity Borrowers can come and borrow the tokens deposited by the liquidity providers in exchange for collateral in the form of other crypto assets (the positions are generally over-collateralised)

The borrowing rate, usually variable (but fixed rates are possible), is calculated to maintain an optimal level of use of the liquidity deposited by the liquidity providers, with different parameters depending on the risk of the underlying assets. The revenues generated by the liquidity pool are then shared among the liquidity providers as a floating rate.

The protocol in principle allows liquidity providers and borrowers to borrow/lend/redeem/withdraw their liquidity at any time. Liquidity is usually ensured by a liquidation mechanism for positions whose collateralisation ratio would fall below a certain threshold.

This brief description of lending protocols corresponds to Aave or Compound protocols, which belong to the first generation of lending protocols. But these protocols suffer from a number of important limitations. First, since resources are shared in a liquidity pool, liquidity providers share the revenues generated by liquidity borrowers and this creates a spread between the borrowing rate and the lending rate that depends on the level of liquidity utilisation. This spread may seem inefficient because it does not correspond to transaction costs that an intermediary could have captured, but to the fundamental idea of bringing all lenders and borrowers in a market together. Secondly, lenders do not have the ability to choose what type of collateral will be used to borrow their crypto assets. In general, the types of collateral accepted by liquidity pools are defined at the governance level of the protocol and lenders have no choice but to be exposed to the risk of the collateral that borrowers choose to deposit.

The purpose of this research programme is to continue exploring the limitations of existing protocols, beyond those already identified, to explore the possibilities of optimal design of these lending/borrowing protocols and to address the concrete questions and issues that will emerge in the course of these explorations.