DeFi Lending Protocols Expose Hidden Credit Risk

DeFi lending protocols have created a hidden credit risk by allowing users to borrow against their crypto holdings without adequate collateral, according to a working paper from researchers at the University of Texas at Austin and the National University of Singapore. This strategy, known as 'buy, borrow, die,' involves buying an asset, letting it appreciate, and then borrowing against it to live without realizing the gain through a sale.

The researchers studied Venus, a DeFi lending protocol on BNB Smart Chain, and found that roughly 3% of traders experienced what they defined as a default. A borrower was classified as defaulted when their loan remained above Venus's 60% loan-to-value limit for at least seven days without later borrowing or depositing.

The tax incentive to defer taxable sales through borrowing has created a fragile math problem, where the debt begins at 25% of collateral worth $4,000 but can quickly rise if the collateral price falls. This has led to a system built around overcollateralization, where borrowers must pledge more value than the loan is worth from the start.

The researchers used the Infrastructure Investment and Jobs Act enacted in November 2021 as an external event to separate tax-motivated behavior from normal crypto market activity. They found that wallets with US-like activity before the new law increased significantly after its enactment, suggesting a reaction to expected visibility.