Decentralised finance lending platforms have experienced tremendous growth since 2020. This column uses transaction-level data to study the behaviour of investors in the market. It finds depositing in decentralised finance lending pools is mainly driven by ‘search for yield’ motivations, particularly for retail investors. Borrowing is driven by speculation as well as for governance benefits, with the latter being more common for large investors. Overall, the evidence suggests decentralised finance intermediation moves funds from savers to speculators, as opposed to entrepreneurs with socially productive activities.
Decentralised finance (DeFi) lending involves providing and receiving loans directly through blockchain and smart contracts, eliminating the need for traditional financial intermediaries like banks. In this environment, users can lend or borrow assets in a system that operates without the need for trust, relying on the secure and transparent nature of blockchain. 1 Interest rates are determined by the supply and demand of funds, following a set formula. DeFi lending platforms have witnessed staggering growth, with total value locked (TVL) surpassing $50 billion during market highs in early 2022, up from nearly zero at the end of 2020 (Aramonte et al. 2022).
Yet, evidence documenting the motivations driving users to use these platforms is remarkably scarce. 2 Several key questions remain unanswered. Why do people deposit funds in DeFi lending protocols? Why do people borrow funds through these protocols, particularly in light of the strong need for over-collateralisation? Is there any difference in the behaviour of large and small (henceforth, retail) investors? Generalising these questions to a broader context, how does financial intermediation evolve in a market with anonymous participants?
In this column, we draw on Cornelli et al. (2024) to shed light on these questions, exploiting the evidence gathered from granular transaction-level data from the Aave V2 protocol, one of the leading players in the DeFi lending market.
Our study yields three key findings. First, depositing in DeFi lending pools is mainly driven by ‘search for yield’ motivations. Second, borrowing is primarily driven by speculation, and to some extent, by governance benefits, such as increased voting power in project development proposals. Third, large and retail investor behaviours differ significantly. ‘Search for yield’ is a key driver of deposits, particularly for small retail investors. On the borrowing side, while both retail and large investors are driven by speculative motives, the latter borrow more for governance reasons.
Main differences between traditional financial intermediation and decentralised finance lending
Traditional financial intermediation and DeFi lending differ along three key aspects. First, DeFi lending is characterised by anonymity and, consequently, a complete lack of credit assessment of the borrower. Second, and related to the first point, crypto collateral is the only tool through which asymmetric information problems can be dealt with. Finally, DeFi heavily relies on automation and smart contracts in the lending and borrowing process. Overall, due to its fundamental features, DeFi lacks the relationship-building and trust elements which are typical in traditional financial intermediation. Therefore, (over) collateralisation is the only risk management tool to keep the whole system solvent.
Evidence on deposit activity
What drives deposits in DeFi lending protocols? Our main hypothesis is that investors are driven by search-for-yield motivations when depositing funds in these protocols. Under this hypothesis, investors increase deposits in DeFi lending protocols when interest rates in the real economy — measured by the policy rate or the yield on US Treasuries — fall, and, conversely, decrease deposits when rates rise. Our analysis also explicitly controls for alternative factors, including investors’ expectations about the price of Ether (ETH), momentum trading, developments in the equity markets, and the possibility that users may deposit more funds to increase their borrowing activity, which requires additional collateral.
Our findings reveal a negative relationship between deposits in DeFi lending protocols and interest rates in the real economy. The negative correlation is significant across all maturities, with the magnitude of the coefficients decreasing as the maturity term for US government bonds lengthens (see Figure 1). 3 These results support our hypothesis and align with the view that investors are driven by yield-seeking motivations when entering DeFi lending protocols. Notably, the prolonged period of low interest rates in advanced economies since the global crisis has likely played a significant role in fostering this search-for-yield behaviour. Consistently, by depositing crypto in DeFi protocols, liquidity providers are able to secure higher returns compared to traditional financial channels.
Figure 1 Search-for-yield drives deposits in decentralised finance lending protocols
Note: The figure shows the results from separate panel-OLS regressions of the natural logarithm of the amount deposited in a DeFi lending protocol at the user-reserve level on a monetary policy indicator and a set of controls including the one-day lag of the ETH perpetual futures funding rate, the one-day lag of the natural logarithm of the ETH price, the one-day lag of the natural logarithm of the closing price of the S&P 500, the one-day lag of the natural logarithm of the VIX, the natural logarithm of the borrowing demand at the user-reserve level and user-reserve dummies. The bars report the beta coefficient of the individual monetary policy indicator included in the specific regression. The whiskers denote the associated 95% confidence interval.
Source: Cornelli et al. (2024).
Evidence on borrowing activity
What motivates users to borrow from DeFi protocols, especially considering that most of them over-collateralise their positions to avoid collateral liquidation?
Two explanations are that users may want to invest in a cryptocurrency they do not currently own or acquire a token to gain voting rights. In each of these cases, the decision to borrow the alternative token, rather than selling their existing assets to purchase it, hinges on their outlook for the future price of the token they already hold. Specifically, if they are confident enough that the value of their current cryptocurrency will rise, they will be more likely to borrow.
Another motivation behind the borrowing decisions could be leveraging an existing position. In other words, if someone holds Coin A and expects its price to increase, they can use it as collateral in a lending pool, borrow a stablecoin, and then trade that stablecoin for more of Coin A. This strategy allows them to earn higher returns if Coin A’s price rises. Additionally, if Coin A provides governance benefits, increasing their holdings could offer further advantages.
Our findings suggest that leverage is indeed an important driver for borrowing in DeFi lending protocols. We find that, within-user and within-reserve, the amount borrowed increases with the expectations of higher crypto price, which we use as an indicator of speculative behaviours. Similarly, we observe a positive relationship between borrowing activity and voting power motives, which we measure with the interaction of indicator variables capturing whether a token offers governance benefits and the days when votes on project developments are ongoing. Interestingly, when considered jointly, speculative reasons appear to prevail over voting power motives. However, this result could be driven by the heterogeneous behaviour of the different investor types (i.e. large versus retail).
Behaviours of large versus retail investors
Do depositing and borrowing behaviours differ between retail and large investors? For instance, retail investors may ‘fly to safety’ quickly as interest rates start to normalise from very low levels, while large investors might be more interested in the upside potentials coming from volatile crypto prices, yield opportunities, or market sentiment driven by greed. Figure 2 shows that the level of interest rate matters for both investor types, albeit being significantly more impactful for retail investors. Specifically, the red bars indicate that as, for example, the policy rate increased, the amount deposited in the protocol decreased. This result can be generalised to the yields on US Treasury securities across the spectrum of interest rate maturities, suggesting that the ‘low-for-long’ interest rate environment pushed retail investors to ‘search for yield’ by depositing cryptocurrencies within DeFi protocols. Large investors behave similarly but the magnitude of the effect is significantly smaller as suggested by the blue bars.
Figure 2 Large investors are less sensitive to monetary policy rates when depositing
Note: The figures shows the results from separate panel-OLS regressions of the natural logarithm of the amount deposited in a DeFi lending protocol at the user-reserve level on a monetary policy indicator, its interaction term with an indicator variable identifying large investors and a set of controls including the one-day lag of the ETH perpetual futures funding rate, the one-day lag of the natural logarithm of the ETH price, the one-day lag of the natural logarithm of the closing price of the S&P 500, the one-day lag of the natural logarithm of the VIX, the natural logarithm of the borrowing demand at the user-reserve level, and user-reserve dummies. For retail investors, the bars report the beta coefficient of the individual monetary policy indicator included in the specific regression. For large investors, the bars report the sum of the coefficient of the individual monetary policy indicator included in the specific regression and its interaction term with the Large investor dummy. The whiskers denote the associated 95% confidence interval.
Source: Cornelli et al. (2024).
Overall, these results suggest that compared to retail investors, large investors’ decisions to deposit in DeFi protocols are significantly less affected by the policy rate or US Treasury yields.
When it comes to borrowing behaviour, we also find notable differences between large and retail investors. While speculative motivations are present for both investor types, voting power motives differ between them. Specifically, compared to retail investors, large investors are more likely to borrow through DeFi protocols to increase their voting power and influence token development plans. Intuitively, this strategy is arguably more appealing to large investors, as they can significantly enhance their voting power on project development proposals through borrowing. 4
Conclusions
Our findings suggest that ‘search for yield’ in a low-interest rate environment is a key determinant of liquidity provision in DeFi lending pools, particularly among retail users. Investors borrow tokens through DeFi lending platforms for speculative purposes or to increase their voting power by temporarily boosting their holdings of governance tokens, with speculation being the dominant motive. Our evidence highlights the presence of significant differences among investor types. While both retail and large investors are primarily driven by speculative motives, seeking high returns through leverage, market movements, and price fluctuations, the latter are more likely than the former to borrow for governance reasons, such as influencing project development decisions. Overall, our evidence suggests that, if anything, DeFi intermediation moves funds from savers to speculators, as opposed to entrepreneurs with socially productive activities.
Source : VOXeu
