Liquidation as a Market: Competition, Congestion, and Equilibrium in DeFi Lending
Published:
Over-collateralized lending protocols rely on liquidation incentives to maintain solvency, yet key parameters such as liquidation bounties, collateral factors, and liquidation thresholds are often fixed or adjusted only through slow governance processes. This paper develops a game-theoretic framework for dynamically adjusting these parameters in decentralized lending markets with competing protocols. We model borrowers, lenders, and liquidators as populations that choose among protocol-collateral pairs as a population game, while the upper-level interaction between protocols is modeled as an equilibrium problem with equilibrium constraints. The framework provides protocols a means to dynamically update parameters in decentralized lending markets. We conclude with numerical experiments highlighting how protocols who use such an algorithm can improve conditions for borrowers while maintaining systemic stability of the multi-protocol lending market.