DeFi's 'Buy, Borrow, Die' Strategy Creates Hidden Credit Risk

The 'buy, borrow, die' strategy in DeFi pools has created hidden credit risk by allowing users to borrow against their assets without realizing a taxable gain. This tactic is particularly attractive when using stablecoins, which can provide dollar spending power while preserving exposure to the underlying asset.

In a recent working paper on tax planning and DeFi credit risk, researchers from the University of Texas at Austin and the National University of Singapore examined the Venus lending protocol on BNB Smart Chain. They found that 3% of traders experienced defaults between November 2020 and July 2022, resulting in $133.34 million in accumulated daily exposure.

The tax incentive for this strategy is that it allows users to defer a taxable sale by borrowing against their assets. However, this creates a fragile math problem, as the loan-to-value ratio increases with each new borrow, and interest accumulating on the debt pushes it higher. If the ratio crosses the protocol's limit, the code opens the collateral to liquidation, allowing an outside trader to repay part of the loan and claim some of the asset at a discount.

The researchers used the Infrastructure Investment and Jobs Act, which expanded information-reporting requirements for brokers handling digital assets, as an external event to study the behavior of likely US taxpayers. They found that traders who believed they would be subject to future reporting changed their behavior around the enactment date, highlighting the potential for tax-motivated behavior in DeFi markets.