DeFi Tax Trade Creates Hidden Credit Risk for Lending Protocols

The 'buy, borrow, die' tax trade has become increasingly popular in DeFi, where users can deposit their assets as collateral to borrow stablecoins and avoid realizing a taxable gain. This strategy allows users to defer capital-gains tax for years, but it also creates hidden credit risk for lending protocols.

Researchers from the University of Texas at Austin and the National University of Singapore studied the effects of this trade on DeFi lending protocol Venus, which allowed users to pledge crypto assets as collateral to borrow other tokens. The study found that around 3% of traders experienced a default event, where the loan-to-value ratio exceeded 60% for more than seven days.

The researchers noted that the tax incentive complicates the borrower's side of this system, as reducing risk requires trading, repaying debt, or selling part of an appreciated holding. Borrowers who took out loans to defer a taxable sale will likely wait longer to unwind them, especially when the token has produced a large paper gain.

The use of stablecoins in these trades further increases the credit risk for lending protocols. Stablecoins allow users to turn volatile collateral into dollar spending power, making it easier for them to take on more debt without realizing the full extent of their exposure.