The Paradox of Adversarial Liquidation in Decentralised Lending

We present a holistic framework for risk and reward management for decentralised lending protocols, such as AAVE or Compound. This framework highlights tensions and trade-offs in protocol design and the choice of various risks and incentives parameters.Using this, we identify the fundamental paradox of adversarial liquidation in decentralised lending: If the rewards to liquidators are chosen such that there is an incentive for liquidators to act when a loan is in distress (as is needed for well functioning of the protocol), then it is also the case that liquidators are incentivised to manipulate prices (through front-running the liquidation process), leading to suboptimal outcomes for borrowers.