Financial Intermediation and Risk in Decentralized Lending Protocols

Abstract

We provide an overview of decentralized protocols Compound, Aave and MakerDAO that offer collateralized loans for crypto asset investors. Using publicly available information on rates, income, supply and borrow activity, we estimate net interest margins and provide a comprehensive view of the cost of financial intermediation. We find that margins are on average below 1%, which is significantly lower than traditional banking. In addition, we derive a theoretical model for financial intermediation for the protocols and identify the drivers of performance in these new decentralized markets. We test the model empirically and determine the relative importance of market power, risk factors and utilization in the protocol’s financial performance. The results indicate that market power and the volatility in the price of crypto assets have a positive effect on margins. The downward trend observed in margins during the sample period is related to the entrance of new lending protocols.

Keywords: Decentralized finance, Compound, Aave, MakerDAO, collateralize loans, intermediation margins, market power

JEL Classification: C63, C80, E51, G21, G23, G51, O16, O33