Decentralized Lending

Andreas Park

July 31, 2025: "today I am announcing the launch of “Project Crypto”—a Commission-wide initiative to modernize the securities rules and regulations to enable America’s financial markets to move on-chain."

What's interesting about Defi Lending?

What are the core functions that a DeFi Ecosystem must cover?

creation of assets
trading of assets
borrowing and lending
creation of derivative assets

What are the core functions that a DeFi Ecosystem must cover?

creation of assets
trading of assets
borrowing and lending
creation of derivative assets

Liquidity transformation

convert an "illiquid" asset into cash temporarily
= borrow against some form of collateral

Credit

obtain cash temporarily for a fee
= borrow against your good name

Comparative advantage

borrow an asset
temporarily because you can use it better

MakerDAO/Sky

very hard without identity

this talk:
AAVE/Compound

the empirical part will focus on this episode

: mechanical functions

Pool-based Decentralized Lending: economic function = the price

\[U=\frac{\text{amount borrowed}}{\text{amount available}}\]

AAVE (Aug 12) for USDC

Pool-based Decentralized Lending: economic function = the price

Economists have two immediate questions

Is this a "good" way to run a lending economy?
How do you solve the chicken-and-egg problem?

Riviera, Saleh, Vanderweyer (2025)

Stinner & Park (2025)

Pool-based Defi Lending Theory

Riviera, Saleh, Vanderweyer (2025)

Pool-based Decentralized Lending: economic function = the price

price function is ad hoc
but can it work well = achieve the most efficient outcome?

How do they measure "good"?
- loosely:
  - higher volume
  - = better capital use
  - = most efficient
- best = like competitive market

Riviera, Saleh, Vanderweyer: Results

Without uncertainty over how many people may enter the market, welfare can be made arbitrarily close to competitive equilibrium welfare.

For any admissible borrower interest rate function, there exists a unique stationary equilibrium in utilization

With uncertainty users worry about excessive rates (borrowers) or low income (lenders) => they "internalize and use the lending protocol less"

Economic Intuition

no uncertainty: Users’ informed actions reveal the market state via utilization; DLP can set rates close to competitive levels.
With uncertainty: Random shocks to credit market conditions create rate volatility; risk-averse users reduce borrowing/lending ex-ante to avoid bad outcomes, lowering utilization.

Riviera, Saleh, Vanderweyer: Translating Econ-Speak to Practice: what do we learn?

Practical Implications

Design: Interest rate functions should heavily penalize utilization near 100% and set low rates when far below it.
Limits: No interest rate function can fully remove inefficiency if users face uncertainty.
Oracle problem: Overrated in this context — user uncertainty is the real constraint.

Park & Stinner (2025): Solving the Chicken and Egg Problem: Liquidity and Activity Incentives

In RSV, people show up as per model

In practice: liquidity must come first only if expect borrowers

Phantom Liquidity and Externalities

\(\to\) distortion in utilization - tricky to use as "efficiency" measures as in RSV

To compare to RSV: without PLP, utilization would be higher ceteris paribus

Why economic research for defi markets matters

Why does this work matter?

Blockchains will likely work as new digital financial infrastructures
Smart contracts absorb some of the roles of intermediaries
financial intermediation is century old business that caters to vastly heterogenous customers
How good can mechanic smart contracts and simple processes be?

RSV:
- quite good, but not under all circumstances
- some things that tech folks zoom in on are economically less important
PS:
- it's hard to attract people to a platform but can work
- in defi weird things happens, but it's not all bad