Learning DeFi Lending

Hello! Welcome to our first of (hopefully) many community articles. JesseDS is an active member of our Discord community with a lot of great ideas.  Jesse routinely posts great information in the server and we are delighted to present a long form piece by him. We are sure you will find it useful in your understanding of DeFi lending. You can follow Jesse on twitter (@jessedylansmith) or catch him in the Byte Mason’s discord. If you’re a sports fan he’s also working on an NFT project called Big Game Rectangles. Gen1 is already available on paintswap. Check em out!

My Journey Into Crypto Lending

I was encouraged by the Byte Masons crew to create lending related content after reading and responding to Corval’s excellent piece on the subject. For many people, including myself, lending was their first exposure to DeFi. I think it is a fun topic to discuss and I hope my experience and insight are helpful to people starting out now. 

In this article I’ll walk you through different lending scenarios and their benefits. But, more importantly I’ll be pointing out the various pitfalls new users stumble into. I’m still on this journey and learning together is one of my favorite aspects of this community. So please, point out any inaccuracies and we can fix them together.

When I first began my trip into the DeFi world everyone pointed me towards one place – Compound. After a few minutes on the site I was instantly hooked. I could deposit USDC and earn a yield the same way I did at my bank except… the yields were 100x higher. This is what crypto is all about! Plus the tokens were under the control of my own wallet. No more middle man. I was my own bank! The dream of decentralized finance was here.

1. Lending:

Lending is the basis of much of crypto finance. At its core is a simple strategy: deposit your tokens and earn a yield from borrowers who pay an interest fee. When I first began lending, I didn’t think much about the borrowing aspect. I know many people whose exploration of lending stopped here. And why not? It’s easy, not very risky and you earn more than you would at a bank. 

You can compare lending rates across sites, but unless they are incentivized in some way (i.e. the protocol’s own token) rates will average out to be about the same across the network. If the protocol has strong tokenomics  those protocol incentives could be juicy, so it’s worth considering  all the options. 

Different DApps will make different tokens available for depositing or borrowing with most supporting ETH,BTC,USDC,DAI. This is because there needs to be a healthy amount of demand to drive up interest rates for lenders. For example, you can’t lend PoopCoin because no one wants to borrow it. On the other hand, everyone wants more USDC so it’s quite easy to find borrowers. You probably don’t want to waste time depositing a token with low borrowing demand. There is always some risk associated with interacting with smart contracts. Very low yield makes it not worth your while.

One thing that is not stressed enough to new lenders, is that when borrow utilization goes above a certain threshold, lenders are unable to withdraw their funds until more loans are paid back or new lenders deposit more funds. It can be pretty unnerving trying to withdraw and being denied. This happened to me a few times and I’ve learned to check the utilization rates before clicking that “use as collateral” button. 

The threshold for this is dependent on the protocols’ specific borrow rules. Most all loans in crypto are “over-collateralized”, so you can only borrow up to an amount less than your deposit. Some protocols let you borrow up to 80% of collateral and others as low as 30%.  If someone borrows a token and the value of their collateral falls, they will end up above the threshold and will be defaulted on. That lower price may also mean there are not enough funds to pay the lender back, so you have to wait until more funds become available. 

Now for the other side of this market: 

2. Borrowing:

 As I said earlier, I wasn’t initially interested in borrowing. Why would I pay a fee to borrow 80% of something I already own 100% of? Plus, the rates are variable, so I don’t even know what I will have to pay back! I was yet to discover all the interesting strategies borrowing allows. In the end, it wasn’t the borrowing strategies that lured me in, it was the incentives. 

A protocol will reward borrowers with emissions of their own token.  In many cases, especially when the protocol first starts emissions, the rewards will outweigh the borrow fee. You are now actually making profit by borrowing! Of course, this type of reward is unsustainable. You have to pay close attention to the emission schedules, the reward amount and the constantly changing borrow rates so that you know when borrowing is no longer profitable. Enjoy it while it lasts!

Before getting into the more powerful aspects of lending, this is probably a good time to talk about those changing rates. 

3. Variable Rates 

Unlike traditional finance, where the central bank sets rates based on monetary policy; DeFi rates are set based on real time supply and demand. If there are more lenders than borrowers, then borrow rates drop until they are low enough they entice more people to borrow. If too many people are borrowing, then those rates increase until it is not profitable for people to borrow any more. 

As an example consider a yield farm with a crazy high APR for staking or farming a specific token. Protocol’s often do this to drive up pool liquidity. People will begin borrowing the token at a low rate and stake it for a much higher return than the interest they are paying. As more people do this you will see the borrow rate increase until it is higher than the staking reward. Then the game is over. Borrowing is no longer profitable. 

The same variable rate action happens to lending rates too. Yield rates for lenders will increase as borrowing increases, which entices more people to lend, which in turn brings the yield rates back down.

Paying attention to the rate changes is important. If you study the rates, you can start to see where the token demand is, and this knowledge can help you see where the overall market is headed. For example, if the borrow rates on USDC starts to increase over a steady period, and FTM supply yields decrease or remain static, it means demand for borrowing USDC is outweighing lending. People are in essence shorting the dollar and holding their crypto. This is a barometer I use to tell me that the crypto market is healthy.

‍Speaking of health:

4. Loan health

Protocols will assign a health score to your loan that shows the ratio of how much you borrowed relative to the value of the collateral. If it falls too low, then your loan will default and in addition to losing value of the collateral, you also pay a protocol fee.

5. Leverage

This is where the real power of lending comes into play and is the basis for advanced financial strategies. It’s also where you need to be the most careful. Yes, you can make a lot of profit much more quickly with leverage than without. But, unlike holding, staking, or lending, in which your portfolio value can only go to 0 if the assets you hold collapse entirely, leverage brings on the risk of 100% loss on deposits! This can happen if your collateral loses too much value relative to the borrowed asset. Getting involved with leverage is a decision you should make for yourself. Be wary of anyone who seems to be trying hard to convince you to do it. Sounds exciting right? Let’s jump in.

The first concept to grasp is that the process has 3 parts to it:

1) You lend a token to be used as collateral
2) Then you borrow a token against it
3) Then you do something with that borrowed token. 

All 3 steps could use the same token, or all different tokens. Here is what you are doing when you leverage: 

1) You are creating a long position on the first token (collateral)
2) You are shorting the second borrowed token
3) You are creating a long position on whatever you are doing with the borrowed token (typically converting to a different token or staking it). 

An example could be a loan to get a second house. 

1) The deed to the first house is used as collateral
2) Money is borrowed
3) The money is converted into a second house. 

In order for this to be a profitable venture, you want the first house (1) and the new house (3)  to go up in value relative to the value of the money borrowed (2). Buying homes this way is typically a great investment as home values tend to increase over long periods of time. 

Compare this to a car loan. We already know that a car purchase is not an investment, and here is why:

1) Your credit is the collateral.
2) Money is borrowed.
3) The money is converted into a car. 

In this case the credit stays the same(1), and the car loses value(3) relative to the money borrowed(2). A car is a terrible investment. 

Now that you understand why (1) and (3) need to increase in value relative to (2) in order to be a “good” leveraged investment, we can now illustrate why leveraging is so risky:

Remember, there are 3 aspects of a loan:

1) the collateral
2) the borrowed asset
3) the asset you convert the borrowed asset to (or hold/stake it)

For each of these, there are 3 things that will happen (relative to each other):

a) price goes up
b) price goes down
c) price stays the same

So you have 27 potential scenarios. I will classify them as ‘good’ with a checkmark or ‘not good’ with an X depending on whether the result will likely be profitable:

The 27 potential scenarios when lending using leverage in DeFi.

Let’s tally up the scores:

good = 9 cases

not good = 18 cases

If you were to leverage randomly, you would only have a 33% chance to get a net positive scenario. The odds are not in your favor!

This is a simplistic exercise as there are infinite real cases, because tokens can rise or fall at different rates, and interest rates and protocol rewards are variable. But the point is that there will be more chances to fail than to succeed, so you had best be very confident in which direction the three tokens will move relative to each other.

Now that you know how leverage works, let’s discuss some strategies you can use.

6. Looping

Looping works like this:

1) deposit collateral
2) borrow token
3) repeat

Because loans are over-collateralized, and you can only borrow up to some percent of the collateral, you will reach a point where you cannot borrow any more without defaulting due to low loan health.

But why would you do this? In cases where the protocol’s incentive rewards for lending and borrowing are greater than the borrowed interest rate, or supply yields are greater than borrow rates, then you will multiply your profit. In addition, if you borrow the same token that you deposited, then you should not have to worry about default (of course the overall value can still drop if the token decreases in value). This is how you multiply your leveraged position. When you see protocols offering 50x leveraged positions, this is what they are doing behind the scenes. 

The downside to all this is the constant checking to make sure the variable borrow rate doesn’t increase above the protocol reward rate + deposit rate. If you are not borrowing the same token as you deposited, then you also have to make sure to avoid default by deleveraging (a.k.a. unwinding) your position if the borrowed token loses value. The upside potential is huge, but remember, the loss can be 100% of your initial deposit.

Deleveraging works as above, but in reverse. like this:

1) Withdraw token
2) Use withdrawal to repay loan
3) Repeat until completely unwound

There aren’t always opportunities where the deposit + reward APR’s outweigh the borrow rates so you may think that you’ll never get the chance to loop. However, there are cases where you could also get some additional type of income from the collateral in addition to deposit and protocol rewards. Here are a few ways to make this happen:

Liquidity Pool Lending

Your LP positions are earning trading fees (and possibly protocol fees) on top of protocol rewards. Using an LP as collateral would make it so that you are almost always making more on the deposit than you would pay to borrow, which is the right scenario for looping. Protocols like Impermax and Tarot do exactly this. You can deposit your LP and leverage against it. They also made it really easy to loop with a single button click to leverage and deleverage at your desired multiplier. 

Keep in mind that LP’s are made up of two tokens (or more) and can become lopsided if you borrow or lend one more than another. So your health score now has a high watermark as well as a low one. If one token increases in value relative to the other, your loan will default. Depending on how far the variance is, and how leveraged you are, you could lose your entire deposit. 

As with regular loans, you should also pay close attention to utilization rate as lower utilized vaults will have variable rates that swing fast. It is best to use these sites with caution and stick to highly utilized vaults as a beginner. You can also lend individual tokens on these sites. If you find highly utilized vaults, you’ll find the best supply yields.

Interest Bearing Collateral

You can use tokens from Yearn, Robo-Vault, and others on some lending sites. These are tokens that you get in receipt for deposits on those dapps and they increase in value relative to your share of their pools. So in addition to the lending supply rate, you can add on the protocol interest rate. Between the two, it could add up to a rate that is higher than the borrow rate, making it work again for looping. This is all a little meta, as Yearn gets its yield in part from lending, so it isn’t always possible to find a place where you can loop these assets.  But, at the very least, even without looping, the interest bearing asset can help your health score continually improve as it gains value.

Self Repaying Loans

I don’t have personal experience with this type of loan, but reading up on Alchemix, it sounds very interesting. They take your deposit of DAI as collateral and return to you 50% of it in their stablecoin which you can then trade. Your deposit is pooled with everyone else’s and used to gain yield in Yearn’s vaults. The profits they make are used to pay off your loan, making it automatic. It’s a pretty cool concept. The obvious concern would be how long it takes to pay it off. Yearn yields aren’t always fantastic and it may not pay off fast enough to meet your goals.

The final topic is not going to apply to everyone, but it is good to know. Especially if you live in a country where crypto is taxed as capital gains and not as ordinary income.

7. Tax Advantages

In 2021 the news site ProPublica obtained access to the tax return data on the wealthiest people who resided in the United States. They discovered a common theme. All the people on the list paid very little in taxes as a percentage of their overall wealth. The way they did it was by electing not to pay themselves in dollars. In the U.S., sales of stocks are taxed as capital gains, not ordinary income. And if acquired as stock options, they are taxed only when you sell them. 

So instead of selling their assets, these individuals use the stock as collateral to borrow cash. Borrowed money is not taxable in the U.S. and so they legally owe no tax. They continually pay themselves in more stock and so as their collateral increases they can continue to borrow. As long as they don’t borrow an excessive amount and the stock price does not drop catastrophically they can do this forever and never pay tax. They can also leave their entire fortune to their heirs without selling the stock and incurring an estate tax. This allows their heirs to continue the cycle.

Crypto is taxed almost, but not exactly, the same way as stocks are in the U.S. Acquiring crypto is not a taxable event, but selling it is. So there could be cases where you can use the same loophole as the uber wealthy to lend and borrow instead of selling. However, there are some circumstances in which crypto is treated as income and subject to regular income tax such as; yield earned from lending, airdrops, rewards, bug bounty, staking, farming, NFT minting, being paid for goods or services, and mining. 

Creating generational dynasties is not in line with U.S. policy. To curb this loophole, there are new bills being written that would tax people on wealth and unrecognized capital gains instead of income, but so far the bills that are drafted would apply only to people with net worth over $100M. There is also a chance that the bill may never make it into law.

Even if the crypto you receive is treated as income, there is still a tax benefit to long term vs. short term capital gain. So lending and borrowing could be a good strategy while you wait for the tokens to mature.

Here is the part where I tell you that I am not a financial advisor, tax consultant, or lawyer. Please consult a professional before making any tax decisions. Crypto can be treated as income in certain cases and you will want your accountant to help avoid any mistakes.

I hope you enjoyed this article! If you have anything to add to it, please do and share it. I know there are many more advanced strategies that people use in lending and I’d love to hear about them. Also, my new favorite spot to gain knowledge is Learn.ByteMasons.com. You can find all sorts of great content written by people much smarter than me. Check it out!


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