Author: @Web3Mario
Abstract: Recently, with changes in the regulatory environment, DeFi protocols have achieved interest rates far exceeding those in traditional financial wealth management scenarios, thanks to on-chain traders' enthusiasm for crypto assets. This has positive implications for two groups of users. Firstly, for some traders, after the prices of most blue-chip crypto assets have broken historical highs, appropriately reducing leverage and seeking low alpha risk wealth management scenarios is a good choice. At the same time, as we enter a macro interest rate reduction cycle, for most non-crypto office workers, allocating idle assets in DeFi can also yield higher returns. Therefore, the author hopes to start a new series of articles to help friends quickly get started with DeFi, and analyze the returns and risks of different strategies using the real data of DeFi whales. I hope everyone supports this. In the first issue, the author hopes to start with the recently popular interest rate arbitrage strategy and analyze the opportunity points and risks of this strategy in conjunction with the capital allocation of AAVE whales.
What is Interest Rate Arbitrage in the DeFi World?
First, let me introduce the concept of interest rate arbitrage to those who are not familiar with finance. Interest Rate Arbitrage, also known as Carry Trade, is a financial arbitrage strategy that focuses on profiting from the interest rate differences between different markets, currencies, or debt instruments. In simple terms, this business follows a path: borrow at low interest, invest at high interest, and earn the interest spread. In other words, arbitrageurs borrow low-cost funds and then invest in higher-yielding assets to earn the interest spread profit.
For example, in the traditional financial market, one of the most favored strategies by hedge funds is the USD/JPY Carry Trade. We know that Japan has maintained extremely low bond yields under the YCC policy, with real interest rates even at negative levels. Meanwhile, the dollar remains in a high-interest environment, creating an interest rate spread between the two different financing markets. Hedge funds choose to use high-yielding US Treasury bonds as collateral to borrow Japanese yen from various financing channels, and then either purchase high-dividend assets from Japan's five major trading companies or convert back to dollars to buy other high-return assets (PS: one of Buffett's favorite strategies). The advantage of this strategy is that it can increase the efficiency of capital leverage. Just this arbitrage path alone can reach a scale sufficient to influence global risk asset prices, which is why, after the Bank of Japan abandoned YCC last year, each interest rate hike significantly impacted risk asset prices.
In the DeFi world, there are two main categories of core innovations: the first is decentralized exchanges (DEX), and the second is decentralized lending protocols. The former guides "price difference arbitrage strategies," which we will not discuss in this article, while the latter is the main source of "interest rate arbitrage strategies." Decentralized lending protocols allow users to use a certain crypto asset as collateral to borrow another crypto asset. The specific subdivisions will vary based on the liquidation mechanism, collateral ratio requirements, and interest rate determination methods, but we will focus on the currently most mainstream "over-collateralized lending protocols" to introduce this strategy. Taking AAVE as an example, you can use any supported crypto asset as collateral to borrow another crypto asset. In this process, your collateral still enjoys native yields and the platform's lending yields, represented by Supply APY. This is because most lending protocols adopt a Peer To Pool model, where your collateral automatically enters a unified liquidity pool, serving as the source of lending funds for the platform. Therefore, borrowers who need your collateral asset will also pay interest to this liquidity pool, which is the source of lending income. What you need to pay is the borrowing interest corresponding to the asset you borrowed, represented by Borrow APY.
These two interest rates are variable and are determined by the interest rate curve in AAVE. In simple terms, the higher the utilization rate of the liquidity pool, the higher the corresponding interest rate level. The reason for this design is that in Peer To Pool lending protocols, borrowing does not have a concept of maturity date like in traditional financial markets. This simplifies the complexity of the protocol while allowing for higher liquidity for lenders, as they do not have to wait until the debt matures to retrieve their principal. However, to ensure sufficient constraints on borrowers' repayments, the protocol requires that once the remaining liquidity in the pool decreases, the borrowing interest rate increases, compelling borrowers to repay and ensuring that the remaining liquidity in the pool remains in a dynamically balanced state, reflecting the true market demand to the greatest extent.
After understanding these basics, let's introduce how interest rate arbitrage is achieved. First, you need to find assets with high native yields + Supply APY to use as collateral. Next, find a suitable borrowing path with a low Borrow APY to lend out the assets. Finally, use the borrowed funds in the secondary market to repurchase the collateral and repeat the above operations to increase capital leverage.
Those with financial knowledge can easily identify two risks in this path:
Exchange Rate Risk: If asset A depreciates relative to asset B, it can easily lead to liquidation risk. For example, if your collateral is ETH and the borrowed funds are USDT, when the price of ETH drops, your collateral ratio may become insufficient, leading to liquidation.
Interest Rate Risk: If the Borrow APY of liquidity pool B exceeds the total yield of liquidity pool A, the strategy will be in a loss state.
Liquidity Risk: The exchange liquidity of assets A and B determines the establishment and exit costs of this arbitrage strategy. If liquidity decreases significantly, the impact can still be substantial.
To mitigate exchange rate risk, we see that most DeFi interest rate arbitrage designs require the two assets to have a certain correlation in price, avoiding significant deviations. Therefore, the main asset choices in this field are two: LSD paths and Yield Bearing Stablecoin paths. The difference depends on what the managed funds are based on. If it is based on risk assets, besides interest rate arbitrage, it can still retain the ability to earn native asset alpha returns. For example, using Lido's stETH as collateral to borrow ETH. This arbitrage path was very popular during the LSDFi Summer. Additionally, choosing correlated assets has the benefit of allowing for higher maximum leverage, as AAVE sets a higher Max LTV for correlated assets, known as E-Mode. With a setting of 93%, the theoretical maximum leverage is 14 times. Therefore, based on the current yield rates, taking AAVE as an example, the lending yield for wsthETH is 2.7% native ETH yield + 0.04% Supply APY, while the Borrow APY for ETH is 2.62%. This means there is a 0.12% interest rate spread, making the potential yield of this strategy 2.74% + 13 * 0.12% = 4.3%.
As for interest rate risk and liquidity risk, they can only be mitigated by continuously monitoring bilateral interest rates and related liquidity. Fortunately, this risk does not involve immediate liquidation, so timely liquidation is sufficient.
How AAVE Whales Use $10 Million to Achieve 100% APR Through Interest Rate Arbitrage
Next, let's take a look at how DeFi whales utilize interest rate arbitrage to achieve excess returns. In previous articles, it was mentioned that AAVE accepted PT-USDe issued by Pendle as collateral a few months ago. This has completely stimulated the profitability of interest rate arbitrage. We can find that PT-USDe is always in a state of supply limit on the AAVE official platform, indicating the popularity of this strategy.
We choose the largest DeFi whale in this market, 0x55F6CCf0f57C3De5914d90721AD4E9FBcE4f3266, to analyze its capital allocation and potential yield. This account has a total asset scale of $22M, but most of it is used to configure the aforementioned strategy.
It can be seen that this account has allocated funds through two lending markets, with $20.6M allocated in the AAVE ecosystem and $1.4M in Fluid. As shown in the figure, this account has leveraged approximately $230M of PT-USDe assets using $20M of principal in AAVE, with the corresponding borrowing distribution being $121M USDT, $83M USDC, and $4M USDe. Next, let's calculate its APR and leverage ratio.
Based on the PT-USDe interest rate at the time of its position establishment, the main locked-in interest rate occurred on August 15 at 20:24, meaning the account's position establishment interest rate was 14.7%.
Currently, the borrowing interest rates for USDT, USDC, and USDe in AAVE are 6.22%, 6.06%, and 7.57%, respectively. We can calculate its leverage ratio and total yield to be 11.5 times and 104%. What an attractive number!
How DeFi Newbies Can Replicate Whale Strategies
In fact, for DeFi newcomers, replicating such interest rate arbitrage strategies is not difficult. There are already many automated interest rate arbitrage protocols in the market that can help ordinary users avoid the complex logic of circular lending, allowing for one-click position opening. Here, since the author is approaching this from a buy-side market perspective, specific project names will not be introduced; everyone can gather information from the market on their own.
However, the author needs to remind readers of the risks associated with this strategy, which can be divided into three main aspects:
Exchange Rate Risk: In previous articles, the design logic of the AAVE official community regarding PT asset Oracles has been introduced. Simply put, when the oracle is upgraded to capture changes in PT assets in the secondary market, the strategy needs to control the leverage ratio to avoid liquidation risks when the maturity date is far off and market prices fluctuate significantly.
Interest Rate Risk: Users need to continuously monitor changes in the interest rate spread. If the spread converges or even turns negative, adjustments to positions should be made to avoid losses.
Liquidity Risk: This mainly depends on the fundamentals of the target yield-bearing asset project. If a significant trust crisis occurs, liquidity will quickly deplete, and the slippage losses incurred when exiting the strategy can be substantial. Users should also maintain a certain level of vigilance and keep an eye on the project's progress.
免责声明：本文章仅代表作者个人观点，不代表本平台的立场和观点。本文章仅供信息分享，不构成对任何人的任何投资建议。用户与作者之间的任何争议，与本平台无关。如网页中刊载的文章或图片涉及侵权，请提供相关的权利证明和身份证明发送邮件到support@aicoin.com，本平台相关工作人员将会进行核查。
