How Tax-Driven DeFi Borrowing Masks Systemic Credit Risk

An investor who purchased ETH for $1,000 and saw it appreciate to $4,000 now wishes to liquidate $1,000. Selling a quarter of the asset would trigger a $750 capital gains tax liability under US law.

Decentralized finance presents an alternative. The investor can deposit the entire ETH holding into a lending protocol, using it as collateral to borrow $1,000 in a dollar-pegged stablecoin.

Because the loan is not considered taxable income, the investor retains full exposure to ETH price appreciation while gaining liquid capital to spend or convert.

Although this strategy defers significant taxes, it introduces a precarious mathematical vulnerability. The $1,000 debt initially represents 25% of the $4,000 collateral, but a decline in ETH to $2,000 doubles the loan-to-value (LTV) ratio to 50%, compounded further by accumulating interest.

Should the LTV ratio exceed the protocol’s threshold, the smart contract automatically exposes the collateral to liquidation, allowing an external trader to repay a portion of the loan and claim the ETH at a discount.

The borrower successfully deferred a taxable event, but the lending pool absorbed the risk generated by collateral price volatility, debt size, and the borrower’s willingness to act before liquidation.

An individual’s tax optimization strategy has effectively been integrated into a shared credit market funded by anonymous users who recognize the wallet only by its alphanumeric string.

Researchers Lisa De Simone from the University of Texas at Austin, Peiyi Jin from the National University of Singapore, and Daniel Rabetti from NUS investigated this connection in a working paper examining tax planning and DeFi credit risk.

Their analysis focused on Venus, a DeFi lending protocol on the BNB Smart Chain where users pledge crypto to borrow other tokens via smart contracts.

Covering the period from November 12, 2020, to July 31, 2022, and the 15 largest tokens on Venus, the study converted roughly 13 million transactions into 1.36 million daily borrower observations. Approximately 3% of traders experienced what the paper defines as a default.

This definition requires clarification, as a DeFi default differs fundamentally from a missed mortgage payment. The paper defines a default as a loan remaining above Venus’s 60% LTV limit for at least seven days without subsequent borrowing or depositing. The $133.34 million total represents accumulated daily defaulted debt, meaning a single troubled loan can impact multiple dates.

The Buy-Borrow-Die Strategy Meets the Blockchain

The conventional manifestation of this approach is the “buy, borrow, die” strategy, where investors acquire assets, allow them to appreciate, and borrow against them to generate cash without triggering capital gains. Continued borrowing can defer taxes for years, and US estate rules may reset the asset’s tax basis upon inheritance, reducing the lifetime accumulated gain.

Historically, this was a strategy reserved for the wealthy, as private banks require valuable collateral and sufficient wealth to withstand downturns. Banks can evaluate a client’s broader finances, determine lending limits, and negotiate terms, providing room to resolve issues before collateral is sold.

DeFi compresses this human-centric dynamic into executable code. Software requires no personal financial history; it simply evaluates the assets within a wallet and applies uniform collateral rules.

Consequently, access broadens, but the cost of this openness is a system reliant on overcollateralization, requiring borrowers to pledge more value than the loan amount from the outset.

Under the Venus configuration detailed in the paper, $10,000 of approved collateral could support up to $6,000 of debt. Maximizing the borrowing capacity leaves virtually no margin for error, whereas borrowing $2,000 provides a significantly thicker cushion. Both accounts are continuously monitored by code utilizing market prices supplied to the protocol.

When collateral depreciates sufficiently to breach the limit, a liquidator can repay part of the debt and seize collateral at a discount, earning a reward for restoring the account’s health. This mechanism is designed to protect the pool before collateral falls below the debt, though rapid selloffs, thin markets, or network congestion can impede liquidators.

Tax incentives complicate the borrower’s side of this equation, as risk mitigation requires trading, repaying debt, or selling appreciated assets.

Borrowers seeking to defer taxable sales will likely delay unwinding their positions, particularly when tokens have generated substantial paper gains or approached the long-term capital gains rate threshold.

Stablecoins make this trade particularly appealing. Dollar-pegged coins transform volatile collateral into liquid spending power, allowing traders to keep ETH pledged while borrowing USDT or USDC for use elsewhere.

Major holders are increasingly borrowing stablecoins against crypto collateral to fund activities while maintaining underlying asset exposure.

The protocol registers a healthy collateral ratio at the loan’s inception. However, it cannot perceive that the borrower purchased ETH at a fraction of its current price, holds a substantial unrealized gain, or deems further holding financially valuable—all of which influence borrower behavior as the loan becomes precarious.

Legislative Changes Turn Venus Into a Natural Experiment

The researchers required a method to isolate tax-motivated behavior from the inherent volatility of crypto markets, finding it in the Infrastructure Investment and Jobs Act enacted on November 15, 2021.

Section 80603 of the 2021 infrastructure law expanded broker information-reporting requirements for digital assets, prompting traders to anticipate increased IRS oversight.

The legislation altered the level of third-party reporting traders expected, providing the authors with an external event likely affecting US taxpayers while leaving international users unaffected.

These regulations apply to custodial firms taking possession of customer assets, while noncustodial DeFi services currently fall outside their scope.

The study’s research value stems from the expectations formed in November 2021, when the new law made future reporting a tangible concern.

The authors compared behavior around this enactment date—years before final rules took effect—to capture reactions to expected visibility rather than an automatic response to an issued tax form.

Since the blockchain does not reveal nationality or tax residence, researchers had to infer which wallets belonged to US users. They looked for activity concentrated during US business hours, unusual behavior on US-specific holidays, and holdings of US-regulated dollar stablecoins. The paper reports multiple versions and a stricter combined definition, as each measure can misclassify individuals.

The basic comparison observes two groups using the same financial machine on either side of a legal event. Both faced identical token prices and Venus rules, while the probable US group had a stronger incentive to care about the reporting provision, helping isolate the tax channel from broad market movements.

Across their primary models, US-linked borrowers were 24.5% less likely to trade assets relative to international users after the law was enacted.

Borrowers utilizing stablecoin debt recorded an additional 23% decline, aligning with the paper’s argument since stablecoins provided immediate spending power while appreciated collateral remained locked.

The paper uses “liquidity” in a narrow, wallet-level sense: the daily probability that a borrower traded any asset. While commonly associated with exchange depth or bid-ask spreads, this study measures portfolio activity and whether appreciated assets remained locked.

This pattern intensified among borrowers with larger gains and higher LTV ratios. Activity declined in December, particularly its final week, when investors often defer gains into a new tax year, and increased once holdings passed the one-year mark associated with lower long-term capital gains rates.

These behavioral checks provide support for the tax interpretation beyond the November 2021 comparison.

The authors estimate that US borrowers in the sample deferred an average of $3,357.42 in capital-gains tax annually, representing approximately 17% of their trading portfolios during the period.

This estimate assumes the inferred wallets belong to US taxpayers, reconstructs their portfolios from blockchain activity, and applies relevant tax brackets, and should be read as a rough scale estimate across the sample.

The Tax Strategy Creates Debt Inside the Pool

The paper’s final section traces the reduced trading into loan performance. Borrowers who rarely trade may leave risky accounts open longer, miss opportunities to repay debt, or fail to add sufficient collateral before the ratio breaches its limit.

From this perspective, it is clearly a major problem, though causality can run in the opposite direction: a default may cause someone to abandon a wallet and cease trading.

The researchers used the law-induced reduction in activity among US-linked borrowers to isolate a drop in trading originating outside the protocol, a statistical method known as an instrumental-variable design.

Using this design, they estimate that a 1% increase in tax-induced illiquidity was associated with an 11.2% increase in defaulted accounts and a 39.6% increase in defaulted loan value. A one-standard-deviation increase corresponded to roughly $350 more defaulted debt per borrower, or 2.7 times the baseline value in the model.

These percentages appear enormous because they describe the borrowers whose activity reacted to the reporting event, a group economists call compliers. Their proper scope is the tax-sensitive portion of the Venus sample, and the estimates explain how behavior affects credit outcomes rather than serving as a universal multiplier for every DeFi loan.

Asset appreciates | Avoid selling and realizing gain | Healthy collateral value | Tax lock-in begins | Stablecoin loan opens | Access cash without sale | Acceptable LTV | Borrower may resist de-risking | Collateral falls | Delay repayment or sale | LTV deteriorates | Trading inactivity rises | Threshold breached | Preserve appreciated asset or abandon wallet | Liquidation condition triggered | Liquidators must act quickly | Liquidation fails or lags | Borrower loss becomes pool risk | Bad debt/defaulted exposure | Losses may hit reserves, token holders, or suppliers

It exposes a critical blind spot in automated lending. Smart contracts track collateral prices, debt balances, interest owed, and liquidation thresholds, but they never incorporate the borrower’s purchase price or tax incentive into their calculations.

Two wallets with identical ETH collateral and identical loans can therefore appear indistinguishable to Venus, even if one owner is willing to sell and the other is actively avoiding it.

This distinction creates a borrower-selection problem. While overcollateralization protects the pool against ordinary price fluctuations, borrowers most attached to appreciated assets may keep debt open longer and trade less as their cushion narrows, concentrating risk among those whose motives the protocol cannot measure.

When liquidation succeeds, an external party repays the debt and removes collateral before lenders suffer a shortfall. When it fails, the cost can pass through protocol reserves, token holders, or asset suppliers, depending on loss allocation. This transforms a personal tax preference into a financial outcome shared by the entire pool.

The paper also identifies a broader set of risks associated with this tax channel.

The study focused on a single protocol during the 2020-2022 boom and crash, inferred US residence from behavior, and used a specialized default definition. The researchers separately found that volatile collateral and liquidation flaws contributed to troubled Venus loans, indicating tax sensitivity is just one potential failure point in a system that could collapse for multiple reasons.

A protocol with deeper liquidity or different collateral limits could yield different results, and a later market with more professional liquidators may behave differently from Venus during the sample period.

Nevertheless, the paper provides something traditional lending data rarely offers: a public view of collateral, debt, borrower activity, liquidation, and abandonment at the individual-wallet level.

DeFi transported a private-bank borrowing strategy onto a public blockchain, extending it to individuals far beyond private banking. In doing so, it demonstrated that automating the loan officer does not eliminate the human motives behind a loan, because tax obligations, attachment to appreciated assets, and reluctance to sell persist through the code and ultimately impact everyone funding the pool.

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