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Efficiency and Risks of Decentralised Finance [July 2022 Scholar]

In this month’s Scholar Report, we study the Global Financial Stability Report by the International Monetary Fund (IMF). We focus on Chapter 3 which covers DeFi.

Jul 13, 2022
July 2022 Scholar Report

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Key Takeaways

This month’s scholar report summarises the key findings of the Global Financial Stability Report by the International Monetary Fund (IMF). We focus on Chapter 3, which covers Decentralised Finance (DeFi).

  • DeFi has had spectacular growth in the previous two years, potentially providing higher efficiency and investment opportunities. 
  • The efficiency of DeFi is largely because operations are automated through smart contracts, with no need for centralised intermediaries or custodian services.
  • DeFi is also accessible to users with any size of capital, improving financial inclusion.
  • DeFi has lower marginal costs, as compared to traditional financial institutions (banks and nonbanks) in both emerging and advanced market economies. This is due to DeFi’s automated operations, which help DeFi protocols avoid the high labour and operational costs of traditional financial institutions.
  • Regulation should support elements of the crypto ecosystem that enable DeFi, such as stablecoin issuers and centralised exchanges.
  • Risks of DeFi include market risks, such as vulnerability to crypto market volatility. For instance, volatile crypto asset prices often lead to liquidation of DeFi loans. Other notable risks of DeFi include liquidity and cyber risks.

Key Highlights

  • The growth of DeFi has accelerated in recent years, bringing about a rise in the total value of stablecoins and crypto assets deposited in DeFi protocols. The total value locked (TVL) of all DeFi projects on the Ethereum blockchain exceeded US$100B in November 2021.
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  • DeFi has many advantages compared to traditional finance (TradFi), such as automation through smart contracts. Key features of DeFi include decentralised record keeping, decision-making, and risk-taking within the crypto ecosystem.
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  • The total outstanding debt of DeFi lending has increased significantly since 2020, driven in part by the wider adoption of stablecoins. DeFi allows crypto asset holders to borrow various types of crypto by first depositing collateral.
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  • According to IMF staff calculations, over 90% of DeFi borrowing is denominated in stablecoins, while approximately 75% of the collateral is denominated in volatile crypto assets, such as Ethereum and Wrapped Bitcoin.
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  • The high volatility of crypto asset prices leads to frequent liquidation of DeFi loans. Liquidation happens when a borrower’s loan-to-value ratio exceeds a certain threshold. Large-scale liquidations have occurred during sharp drops in crypto asset prices. 
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  • IMF estimated the probability of liquidation in DeFi lending protocols using a stochastic model. On average, the one-year probability of liquidation is 24.7%. The average expected loss (experienced by the DeFi protocol) is around 0.9%, being substantially reduced by overcollateralisation. Lending to riskier, highly leveraged borrowers tends to result in more frequent liquidation with bigger losses.
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  • Cyberattacks related to DeFi increased significantly in 2021, reaching a peak of $921M in Q3 2021. According to IMF’s research, the attacks are mostly due to compromised private keys, vulnerabilities in smart contracts, and scams by developers.
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  • IMF’s analysis shows that DeFi has the lowest marginal cost compared with financial institutions in both advanced economies (AEs) and emerging markets (EMs). This indicates that DeFi has the highest cost efficiency. The marginal cost in this context refers to the incremental cost of additional loan production.
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  • DeFi has lower margins, which help to increase its popularity with depositors and borrowers. As a result, DeFi is becoming a significant competitor to incumbent financial institutions. On the other hand, DeFi is exposed to riskier borrowers, as can be seen from DeFi platforms’ higher expected losses as compared to banks.
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Authors

William Wu PhD (Senior Research Analyst)

Henry Hon PhD, CFA (Head of Research & Insights)

Tags

crypto research

scholar

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