Overview
Permissionless blockchains create a digital space where people can transact privately, without censorship or the need to reveal their identities.
In this new landscape, financial services can be built using smart contracts—automated computer programs that execute transactions on their own, without any need for manual input or trust in a middleman. This model is part of what’s known as Decentralized Finance (DeFi).
This study focuses on Compound, one of the leading decentralized lending platforms, to examine how lending works in this new type of financial system, who is using it, and what factors influence user activity.
Analysis of on-chain data reveals that the average loan term on Compound is quite short—around 31 days—and many borrowers use the platform for leveraged strategies, such as yield farming.
The research also shows that risk in DeFi arises from concentration (a small number of users controlling most of the activity) and interconnectivity (how tightly linked users and transactions are), making traditional risk controls hard to apply.
What Is DeFi and How Does It Work?
Decentralized Finance (DeFi) is a fast-growing financial ecosystem built on blockchain networks like Ethereum. Unlike traditional banking systems, DeFi is open, borderless, and operates without relying on centralized institutions such as banks or payment processors.
Users in DeFi can interact with financial services anonymously, while still preserving privacy similar to cash transactions.
DeFi platforms are made up of decentralized applications (DApps) or protocols, which are governed by code instead of people. These protocols replicate services like lending, borrowing, trading, and managing assets. Smart contracts automate everything—from issuing loans to distributing interest payments.
They also create tokens, digital assets that can be exchanged and used across different DeFi platforms. Because everything is open-source and compatible, developers refer to this as “composability”—like building blocks or “money Legos.”
In traditional banking, financial institutions collect money from deposits or shareholders and lend it out to earn interest, taking on risks like interest rate fluctuations, mismatches in the timing of assets and liabilities, or the chance that a borrower defaults. They also play a role in monitoring borrowers and maintaining liquidity.
However, Bitcoin’s anonymous creator, Satoshi Nakamoto, envisioned a different world—where two parties could trade directly without needing a trusted middleman. While DeFi does allow peer-to-peer interaction, intermediaries in the form of smart contracts are still essential.
These contracts automatically carry out the terms of a loan or transaction, but also introduce new design challenges since users are anonymous and can open multiple accounts.
As a result, traditional lending features like setting custom loan terms or limiting exposure to any one borrower are hard to enforce in DeFi. This opens the door to potential risks that aren’t as easily controlled as in conventional finance.
Case Study: Compound Lending Protocol
Compound is one of the earliest and most widely-used DeFi lending platforms built on Ethereum. It operates differently than a bank. Compound doesn’t take on credit risk, interest rate risk, or mismatched assets and liabilities. Instead, it behaves more like a mutual fund for lenders, where the users collectively benefit from the interest earned and the system is governed by code.
Between May 2019 and June 2020, Compound issued over $61.1 billion in loans to nearly 23,000 unique borrowers. However, usage was highly concentrated—with the top 100 wallet addresses making up 75% of deposits and the top 100 borrowers accounting for 78% of loans. That’s a higher concentration than what’s seen in traditional banking. For instance, research in Norway found that the top 5% of savers held only 53% of all deposits in 2018.
The study explores how rewards from Compound, such as token incentives, influence user behavior. In some cases, borrowing can be profitable, even after paying interest, because of these additional incentives.
Unlike traditional loans that are often used to buy property or fund businesses, DeFi loans are often used for speculative purposes, such as leveraged investments.
This involves borrowing to increase exposure to crypto markets, a tactic known as yield farming. Smart contracts can be used repeatedly in quick succession to maximize these gains, often through recursive lending and borrowing on the same platform.
Risks and Vulnerabilities in DeFi Lending
By analyzing individual wallet addresses and identifying some of the owners—including now-collapsed crypto firms like FTX, Celsius Network, Three Arrows Capital, and Alameda Research—the study found that patterns in on-chain data hinted at systemic risk well before the crypto market crash in May 2022.
Events like mass liquidations in DeFi (when users are forced to sell assets to repay loans) cause crypto prices to fall rapidly and increase market volatility. Since many users borrow using leverage, these liquidations can snowball and make market crashes worse.
This behavior is procyclical, meaning it reinforces existing trends—like falling prices triggering more forced sales.
Further research shows that interconnected DeFi protocols can transmit financial shocks across the entire system. When one platform suffers, the effects can quickly spread to others.
Studies by experts like Acemoglu et al. (2015) and warnings by the U.S. Financial Stability Oversight Council (FSOC) have emphasized that such tight linkages increase the potential for instability in the DeFi ecosystem.
Unique Features of Compound vs Traditional Lending
Compound stands out because it doesn’t behave like a traditional financial institution. Instead of a bank that takes deposits and lends them out with interest, Compound acts as a neutral platform where users supply or borrow funds through smart contracts.
It doesn’t carry credit risk because all loans are overcollateralized—meaning borrowers must deposit more than they borrow.
The platform’s structure also avoids problems like liquidity shortfalls or rate mismatches. However, because it operates in an open, anonymous system, some critical risk management tools are missing—like setting personalized loan terms or enforcing exposure limits. This limitation makes it harder to prevent large-scale risks from building up.
What Makes People Use Compound?
The paper investigates the specific reasons users supply or borrow funds on Compound. One key finding is that COMP token distribution (an incentive program where users earn tokens for activity) plays a big role in user behavior.
When the COMP token was launched on June 15, user activity spiked, showing that financial incentives strongly influence participation in DeFi.
Interestingly, some users created multiple small accounts to try to maximize their token rewards—an example of how the system can be gamed without identity checks.
By studying millions of transactions involving deposits, withdrawals, loans, repayments, and liquidations, the authors provide a detailed view of how users interact with Compound. Their data comes from Google BigQuery, which provides full access to Ethereum’s public blockchain records.
Conclusion: Key Insights From Compound
This study shows that between May 2019 and June 2021, Compound enabled $61.4 billion in lending, typically for short-term use, with many users engaging in leveraged strategies rather than borrowing for spending or investment.
The system’s openness allows anyone to participate, but also introduces new vulnerabilities due to anonymous usage, reward incentives, and user concentration.
These findings highlight the need for a rethink of risk management strategies in DeFi, especially as the space grows and becomes more interconnected. Monitoring transaction-level data and understanding how smart contracts shape user behavior will be critical in making DeFi safer and more stable.
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