Security and Credit in Proof-of-Stake DeFi Protocols

Proof-of-Stake blockchains require sufficient staking to be robust; when a decentralized finance (DeFi) protocol is built upon them, investors may refrain from staking if it is more profitable to provide DeFi credit, potentially endangering chain security and viability. We study the interaction between security, credit provision, the blockchain validation rewards for staking (i.e. token inflation) and the pricing rule for lending. We provide conditions under which the chain is viable, and show that a bad equilibrium in which investors anticipate low security may coexist with the good equilibrium with maximal security. Defining efficiency as the maximization of borrowers' utility for a given level of security, we characterize the efficient level of inflation and the set of efficient affine pricing rules. We show that in general, decreasing the staking incentives does not harm security. In an extension, we pin down the unique efficient affine rule; our result is consistent with practice