Decoding DeFI: Collateralization Limits Credit Risk, but Cyber Threats Remain

This collateralisation system is designed to limit the credit risk for the lender, but it does not eliminate it entirely. The lender is still exposed to the risk of a sharp devaluation of the collateral (asset B in the diagram), for example in the event of a contagion between the crypto-assets used as collateral (see article by Tovanich, Kassoul, Weidenholzer and Prat, 2023), or a cyberattack on the platform. On this issue, see also the rapport by the ACPR.

Blockchain, an unrivalled source of data

This blog post studies the data directly available on the Ethereum blockchain, which accounts for 80% of DeFI activity. We analyse two DeFI platforms: Aave and Compound. By way of illustration, according to Defillama, on 1 September 2023, Aave had USD 4.5 billion locked in its smart contracts, of which 85% was on the Ethereum blockchain.

To extract the data, the Banque de France has deployed an archive node in its cloud, in other words an archive of all data generated since the blockchain was created, including historical states, which is synchronised in real time with the global Ethereum network. This node allows us to collect historical data without relying on a third-party data provider. 

We then collected more than a million lending and borrowing transactions from the Aave and Compound platforms for three stablecoins: USDC, USDT and DAI, all of which aim to keep their tokens at parity with the US dollar.  

The setting of interest rates in DeFI 

On the main DeFI platforms, interest rates are set automatically using an algorithm coded into each platform’s smart contract. These algorithms are based on the amount deposited and borrowed for each crypto-asset, and are known to all users. The formula is simple: the borrow rate is an increasing function of the utilisation rate – in other words, the ratio between the amount borrowed and the amount deposited (Chart 3 shows the function applied by Aave for the token USDC).

The interest rates cannot be negative. They can be as high as 80% if there is an imbalance between borrowers and lenders. They rise to a limited extent when utilisation rates are low and very sharply beyond an inflection point decided by the platform and programmed into its smart contract. This inflection point is intended to keep the equilibrium utilisation rate close to a “target rate” (of 80% or 90% depending on the platform), as a high rate will attract lenders to the platform (see Chart 3). The parameters differ across platforms and across tokens, and depend in particular on the risk associated with each crypto-asset. The deposit rate is generally equal to the borrow rate multiplied by the utilisation rate.

Chart 3: Interest rates in DeFI are an increasing function of the utilisation rate