Liquidity risks in the decentralized finance protocol Aave

Bachelor thesis (2021)

Authors

S. Cirikka Electrical Engineering, Mathematics and Computer Science

Contributors

O. Ersoy Data-Intensive Systems - EEMCS (mentor)
Z. Erkin Cyber Security - EEMCS (mentor)
Julián Urbano (graduation committee member)
Faculty
Electrical Engineering, Mathematics and Computer Science, Electrical Engineering, Mathematics and Computer Science
Copyright: © 2021 Selim Cirikka
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Published Date

28-06-2021

Language

English

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Faculty

Electrical Engineering, Mathematics and Computer Science

Abstract

Protocols for Loanable Funds (PLFs) are lending protocols that exist in the decentralized finance (DeFi) ecosystem. They provide users the opportunity of lending and borrowing of cryptocurrencies. The economic model used to ensure liquidity in these protocols are variable parameters and incentives to reach an optimal equilibrium and overcollateralization to make trust between participants unnecessary. However, the design of this protocol can show signs of illiquidity in which the safeguards of the protocol do not function as expected in times of an unfavourable market. In this paper, the liquidity of Aave, one of the biggest PLFs, is empirically examined. A game theoretical model is used to analyze the behaviour of participants to the various incentives in the protocol. Firstly, the potential points of failure in case of a bear market with a volatile asset are evaluated. Secondly, the mechanisms for mitigation of illiquidity in the Aave protocol are examined. Ultimately, diversification of the assets in the safety module is proposed to increase the efficiency of the safety module and therefore decrease the risk of illiquidity in the protocol.