DeFi Lending Platform Liquidity Risk: The Example of Folks Finance

Decentralised finance (DeFi) lending platforms may experience liquidity risk, which occurs when users are unable to withdraw their assets. Researchers and practitioners have found that the concentration of deposits among a small group of users is one of the main drivers of liquidity risk. Typically, lending platforms experience high concentration at the beginning of their operations. As a result, they face a significant liquidity risk that has not been investigated so far. This article closes this gap by investigating liquidity risk from the perspective of a new lending platform, describing the use case of Folks Finance. First, we describe the liquidity risk the lending protocol faces using platform economics. Second, we theoretically assess the efficacy of different liquidity risk measurements. Third, we investigate how a reward mechanism can reduce liquidity risk. We show that the liquidity risk is more pronounced for a new lending platform than for an incumbent protocol. In addition, we find that the Herfindahl-Hirschman index (HHI) outperforms other liquidity risk measurements. Finally, we show that if rewards are sufficient but not too large, a programme that incentivises depositors to lock their assets can reduce liquidity risk and increase liquidity bootstrapping. Several conclusions are drawn from the case study: First, new lending platforms should be particularly cautious regarding liquidity risk. Second, lending protocols should use HHI instead of other concentration measurements when calibrating their parameters. Third, rewards can be used to bootstrap liquidity and incentivise liquidity holdings but should not be overused.