Systemic fragility in decentralised markets

BIS Working Papers  |  No 1062  | 
16 December 2022



Collateral is widely used in financial markets to mitigate asymmetric information problems and to limit credit risk exposure for lenders. In decentralised finance, collateralised lending is automated: collateral value is constantly monitored and margins are enforced by third parties. We focus on the ways in which third party collateral liquidations affect protocol risk, collateral risk and risks to the decentralised financial system.


We collect a unique data set on collateral liquidations on Compound and Aave, two of the largest decentralised applications for borrowing and lending. We observe if the users of these applications liquidate their positions out of their own inventory or obtain "flash loans". We document the high-frequency price impact of such liquidity trades on nine different decentralised exchanges.


Following liquidity trades, we observe lower prices on both decentralised applications and then subsequently on other exchanges, including off-chain markets. This contagion to other exchanges leads to negative feedback loops: loans are liquidated, which leads to downward price pressure on the collateral so that more loans are then liquidated. Our findings illustrate a new form of systemic fragility arising from collateralised lending under DeFi architecture.


We analyze a unique data set of collateral liquidations on two Decentralized Finance lending platforms – Compound and Aave. Such liquidations require arbitrageurs to repay the loan in return for the discounted collateral. Using Blockchain transaction data, we observe if arbitrageurs liquidate positions out of their own inventory or obtain "flash loans." To repay flash loans, arbitrageurs immediately sell the collateral asset. We document the high frequency price impact of such liquidity trades on nine different decentralized exchanges. Consistent with large block trades in equity markets there is a temporary and permanent price impact of collateral asset sales in DeFi. We document the effect of these trades on return distributions. Our work highlights the systemic fragility of decentralized markets.

JEL classification: G1, G23

Keywords: Decentralized lending, blockchain, decentralized finance, system risk

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