DeFi Protocols Swell with Hidden Credit Risk as Investors Use 'Buy, Borrow, Die' Strategy
DeFi lending protocols are quietly accumulating hidden credit risk due to a 'buy, borrow, die' tax trade strategy. Investors buy an asset, let it appreciate, and then borrow against it using a DeFi protocol without realizing the gain through a sale.
This approach saves investors money in taxes but creates a fragile math problem, where the loan-to-value ratio can quickly become precarious. For example, if ETH is used as collateral and its price falls to $2,000 from $4,000, the loan-to-value ratio doubles to 50%, increasing the risk of liquidation.
A study on Venus, a DeFi lending protocol on BNB Smart Chain, found that 3% of traders experienced default between November 2020 and July 2022. The paper defined a borrower as defaulted when their loan remained above the 60% loan-to-value limit for at least seven days without repaying or depositing more collateral.
The 'buy, borrow, die' strategy is particularly attractive because it allows investors to borrow stablecoins against crypto collateral, giving them dollar spending power while preserving exposure to the underlying asset. However, this approach can lead to a system built around overcollateralization, where borrowers must pledge more value than the loan is worth from the start.
The study's authors used the enactment of Section 80603 of the Infrastructure Investment and Jobs Act in November 2021 as an external event to examine how traders responded to expected visibility. The law changed the level of third-party reporting for brokers handling digital assets, giving researchers a way to separate tax-motivated behavior from market chaos.