Liquidity Risks in Lending Protocols: Evidence from Aave Protocol

Lending Protocols (LPs), as blockchain-based lending systems, allow any agents to borrow and lend cryptocurrencies. This paper investigates liquidity risks in the emerging on-chain lending market focusing on the popular Aave protocol. In Aave, a small group of users are both borrowers and depositors, but they account for significant loans and deposits. These users can launch illiquidity attacks by collectively withdrawing deposits and initiating loans. After establishing measurements of potential liquidity risks caused by dual-role users, we find that these users have complex effects on Aave and they can potential magnify liquidity risks and spread them across the LP market. This phenomenon suggests that liquidity risks caused by dual-role users can be a double-edged sword for LPs.