DeFi Borrower Behavior Key to Gauging Tokenization Risks: BIS Study

The behaviors of borrowers in the decentralized finance space and DeFi market dynamics are important considerations when designing and managing platforms involving tokenized assets, a study by the Bank for International Settlements (BIS) has concluded.

Financial institutions worldwide are increasingly experimenting with tokenizing traditional assets such as bonds and securities. The workings of DeFi lending platforms offer useful insight into the risks associated with tokenization and the potential disruption of traditional finance, the technical study by the central bank group said.

The study concluded that since DeFi borrowers face substantial losses upon automatic liquidation – where collateral is automatically sold when borrowers' positions get too risky – they generally avoid leveraging too much. The borrowers take a conservative approach with a sizeable buffer. Additionally, DeFi users tend to deposit more if they have higher past returns.

The study's authors, Lioba Heimbach and Wenqian Huang, claim to be the first to document individual DeFi wallets’ leverage. Their findings could potentially be relevant to understanding financial stability concerns emanating from DeFi, Heimbach and Huang wrote.

They conducted the study using data from the Ethereum blockchain, focusing on lending resilience and strategic substitution behavior.

The BIS has been exploring the DeFi space for some time now. In 2023, the BIS said it worked with the central banks of France, Singapore and Switzerland to successfully test cross-border trading of wholesale central bank digital currencies and DeFi elements – specifically automated market makers. In 2022, two BIS papers said that DeFi could lead to bumpier financial markets and may not fix the problem of large intermediaries dominating.

This latest study was conducted between January 2021 and March 2023 to specifically look at the largely unexplored "intricacies of user behavior and pool dynamics within DeFi lending." The importance of conducting the study was based on the recognition that DeFi protocols have been facilitating collateralized borrowing on an "economically significant scale" with highs of over $35 billion in deposits and $25 billion in outstanding debt, the study said.

Read More: Central Banks Successfully Test Cross Border Trading of Wholesale CBDC Using DeFi