Phantom Liquidity in Decentralized Lending

Abstract

As two-sided platforms, decentralized finance (DeFi) applications face a key challenge: they need to attract participants on both market sides to function. Most DeFi-platforms rely on an innovative bootstrapping approach called "liquidity mining," which involves rewarding participation on both sides of the market with protocol tokens. We assess the efficacy of liquidity mining on the largest DeFi lending protocols Aave and Compound. Our findings indicate that while liquidity mining attracts deposits and borrowers, its discontinuation prompts withdrawals. Using account-level data, we identify a peculiar strategy driving these dynamics: a small subset of users deposits and simultaneously re-borrows the same stablecoin to capture rewards on both market sides, creating substantial "phantom" liquidity. These strategies account for 18\% of deposits and 32\% of loans, with peaks above 65%. On balance, we show that this opportunistic behavior lowers the utilization rate of capital and the contributions to the reserve funds of the platforms, arguably reducing the accrued value of DAO equity.