Debt-Financed Collateral and Stability Risks in the DeFi Ecosystem

Abstract

The rise of Decentralized Finance (“DeFi”) on the Ethereum blockchain has enabled the creation of lending platforms, which serve as marketplaces to lend and borrow digital currencies. Initially, we categorize the activity of lending platforms within a standard regulatory framework. We then propose an Ethereum address grouping algorithm using activity over DeFi protocols and employ a novel classification algorithm to calculate the percentage of fund flows into DeFi lending platforms that can be attributed to debt created elsewhere in the system (“debt-financed collateral”). Based on our results, we conclude that the wide-spread use of stablecoins as debt-financed collateral increases financial stability risks in the DeFi ecosystem.