Liquidations don’t discourage DeFi lending but make users borrow more, new study says

In the traditional financial world, when a borrower defaults on their debt it’s typically a crushing blow that most struggle to recover from.

But in decentralised finance, it appears that the opposite is true.

Those who have their collateral liquidated on DeFi lending protocols aren’t discouraged from borrowing again — it actually makes them borrow more often.

That’s according to a new study from Gregory Gadzinski and Vito Liuzzi, two finance and economics researchers at the International University of Monaco, who published their findings in Economics Letters, an economics journal, on July 31.

“Despite the adverse shock of liquidation, we find that users generally continue to engage with the Aave platform at a higher frequency,” the researchers said, noting that there were outliers to the trend.

The finding is timely, as DeFi lending on platforms like Aave, Morpho, and Compound has soared to an all-time high of over $125 billion, a 62% increase since the start of the year.

With borrowers engaging with lending protocols at a higher rate than ever before, understanding how loan liquidations impact their behaviour is important for risk management and the resilience of DeFi lending markets as a whole.

‘No lasting handicap’

DeFi lending markets share some key differences from traditional lending.

All loans are over collateralised, meaning lenders can only borrow from a lending protocol after depositing collateral. A common strategy is for users to deposit volatile cryptocurrencies like Bitcoin or Ethereum then borrow stablecoins, like Circle’s USDC, against those deposits.

Users face liquidation if the value of their volatile collateral assets goes down too much. The protocol will automatically put the collateral up for sale to avoid taking on bad debt.

In effect, lenders can only lose what they deposit. Even if all their collateral is liquidated, they don’t suffer a total wipeout as they still have the funds they borrowed from the protocol in the first place.

The researchers argue that DeFi borrowers are more likely to borrow again after a liquidation because the DeFi system imposes no lasting handicap equivalent to a bad credit score.

“It also reflects that many DeFi participants are likely yield-seeking traders who treat liquidations as a routine risk (akin to margin calls) rather than a reputation-damaging default,” the researchers said.

Gadzinski and Liuzzi’s study looked at 25,798 liquidations between March 2022 to December 2024 on Aave, the biggest DeFi lending protocol.

They found that after getting liquidated, large players increased their frequency of transactions with Aave, but scaled down their volume. Small wallets, on the other hand, transacted less but did not reduce the size of their borrowing.

Story Continues“Even after large market dislocations leading to heavy liquidations, the lending platform Aave did not experience a user exodus; engagement metrics rose,” the researchers said.

“These findings suggest that, unlike in traditional finance, where default often curtails future borrowing, DeFi usage persists even after liquidations.”

Tim Craig is DL News’ Edinburgh-based DeFi Correspondent. Reach out with tips at tim@dlnews.com*.*

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